Chapter 149 - How to Lose $100,000,000 and Other Valuable Advice
What I learned from Royal Little
Today’s Chapter is based on the book “How to Lose $100,000,000 and Other Valuable Advice” by Royal Little.
Royal Little was an American business executive known as the founder of Textron and the originator of the modern corporate conglomerate concept. He pioneered diversification by acquiring companies in unrelated industries, setting a pattern for many future corporations and earning the title “the father of conglomerates”. Little led Textron from a small textile firm to a major multi-industry corporation before retiring in 1960.
Here’s what I learned:
Avoid Bad Businesses
“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
— Warren Buffett
Royal Little’s journey in business is a reminder of how important it is to avoid investing in the pitfalls of seemingly golden opportunities. In fact, early in his career, he learned the hard way that unusual extraordinary profits and high return on capital often signals impending competition. This lesson stems from his experience in investing in the textile industry, where he observed the importance of having an economic moat. He emphasizes that in a competitive market, capital flows to profitable sectors, inevitably driving down returns.
Little tells the story of how he invested $2,500 from his army pay into Lustron, a textile company believing that the company would maintain its 100% Return on Equity. He mentions that “when an opportunity came along to buy a few shares of Lustron common stock I invested my entire savings in the company for which I was working, believing that I was going to make a great fortune investing in a company making such a high return on its capital. Unfortunately, the earnings were caused by the material shortages of fibers for the textile industry, which were caused by the enormous consumer demand for textile products after the government had taken so much of these products out of the market during the war.” As such, Little warns us against investing in companies with a high return on capital which doesn’t have any competitive advantages.
“In our free enterprise system that high rate of return will not last. Capital will pour into that industry from other sources, and ultimately the rate of return even in the best of companies will decline to 15 to 20 percent. You will almost certainly take a loss on the investment that you made when the rate of return was too high.”
— Royal Little
Unfortunately for Little, he had to make this mistake a few times before truly learning from this trap. As a matter of fact, Royal Little is well known for being the founder of Textron, a large conglomerate, that first started as a small textile company that made synthetic yarn. He quickly realized his mistake, as he once said, “In the textile business, it is dangerous to count on high profits continuing in any phase of this business. Invariably, capital pours into the production of any product that is unusually profitable, and within a couple of years there is overproduction and no longer high profit.”
In fact, to explain how awful of a business Textron was in, Little wrote the following in the 1939 report:
“To indicate how capital intensive the synthetic yarn industry is, the 1939 report stated: One dollar of capital is needed to make one pound of yarn per year. With an average selling price of 54¢ per pound it would require nearly two years of steady operation for the total sales dollars to equal the capital investment. Approximately $500,000,000 of new capital would be needed to duplicate the country’s present manufacturing facilities.”
— Royal Little
Royal Little is not the only one who made a mistake investing in the textile industry. In fact, the Oracle of Omaha himself has also invested in a textile company, Berkshire Hathaway. However, he quickly realized his mistake and started divesting into other industries, similarly to Royal Little at Textron.
This reminds me of the importance of solving your own moat. As we have previously learned from Jim Weber, it is primordial to focus on a specific niche if you are in a competitive industry. As a matter of fact, when Weber took over as CEO in 2001, Brooks was struggling to compete with industry giants like Nike and Adidas. The company was spread too thin, trying to cater to too many categories. Weber made a bold decision: Brooks would focus solely on performance running. This pivot became the foundation of its success.
Weber’s philosophy was clear: you don’t have to be everything to everyone. Instead, you can dominate a smaller, more focused market. Brooks narrowed its focus to performance running, developing products that catered specifically to serious runners. This decision was a game-changer. As he explained, “Going forward, I told them, we would pivot to a running-only brand. Real performance for real runners. Our product would perform for the most discerning runners, earning their trust mile after mile, and our brand would embody the spirit and soul of all who run.”
“In footwear, many believe the conventional wisdom that says brands must play in all categories, across myriad price points. They believe that a company can’t survive by playing a narrow game. Our contrarian philosophy was to focus only on premium running, turning a narrow focus into a strength.”
— Jim Weber
Weber was inspired by Warren Buffett’s investment philosophy, particularly Buffett’s emphasis on building moats around businesses, as a matter of fact, the concept of a “moat” was central to his strategy. A moat, in business terms, refers to a company’s ability to maintain a competitive advantage over its rivals. Weber explains that “In business, a moat leverages the medieval castle metaphor, describing a business’s competitive advantages that allow it to successfully grow and defend its position with customers profitably against any would-be competitor.”
Weber believed that, “If you are entering a new business with serious competition, you need to prioritize solving for your moat.” For Brooks, the moat problem was solved once they focused on delivering premium products for performance running only. Weber’s decision to focus on a niche market also allowed Brooks to create a distinctive brand identity. Rather than trying to compete with larger, more diversified brands, Brooks leaned toward areas where competitors weren’t focusing on in order to create a brand that stood out in the croweded sportswear market.
“The goal for a brand is not to emulate the competition but to find unaddressed opportunity in between the strengths that your competitors already own.”
— Jim Weber
This focus on a niche not only helped Brooks survive but thrive. By 2010, Brooks had become the fastest-growing brand in running, surpassing Asics in market share in the specialty run channel. As Weber reflects, “I was convinced that Brooks’s opportunity in premium performance run was big. Plus, our Run Happy positioning was novel and unique. Given the size of the category, we had a billion-dollar idea.”
But more importantly, Weber understood that a moat isn’t a static defense; it’s a dynamic, evolving entity that requires constant reinforcement and innovation. He was consistently trying to find ways to protect Brooks’ moat. This reminds me of the following saying:
“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way - it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses-or virtually all of our businesses-have pretty darned good moats.”
— Warren Buffett
Avoid Sunk Cost Fallacy
“The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause. The more we invest, the greater the sunk costs are, and the greater the urge to continue becomes.“
— Rolf Dobelli
One the greatest lesson we can learn from Royal Little is the concept of avoiding the sunk cost fallacy and to continue investing our time and our money in a lost cause. In the case of Little, he was frustrated with the cyclical nature of textile businesses, as such, he pioneered the concept of conglomerates through unrelated diversification, transforming Textron from a textile firm into a multi-industry giant.
By doing so, Little solved two of his problems: first, it would avoid him continuing to invest in a low-margin industry with plenty of competitors and second, he would be much better protected against economic downturns. As he once said, “after having tried desperately in the past to make a success of (1) yarn processing, (2) parachute manufacturing, (3) the completely integrated Textron brand operation, and (4) low-cost southern mills, I decided that there must be some better medium than the textile business in which to use the stockholders’ capital to their advantage. “
“In addition, as you have seen, the highly cyclical nature of the textile business and its relatively low margin of profit even in good times had convinced us that we must find some better way of making a fair return on our stockholders’ equity capital.”
— Royal Little
This idea of creating a conglomerate, a company composed of completely unrelated businesses was introduced to Little by Eliot Farley who believed that there was potential in putting completely unrelated businesses in one corporation.
Here’s how Little explains the objectives of building a conglomerate at Textron:
Eliminate the effect of business cycles on the parent company by having many divisions in unrelated fields.
Eliminate any Justice Department monopoly problems by avoiding acquisitions in related businesses.
Eliminate single industry’s temptation to overexpand at the wrong time. Finance the growth of only those divisions which show the greatest return on capital at risk. Rather than overexpand any division, use surplus funds to buy another business.
Confine acquisitions to leading companies in relatively small industries. Never buy a small company in a $5 to $10 billion industry. One of my particular “No-No’s”—never buy a company that manufactures a product with an electric wire attached—no radios, televisions, washing machines, driers, electric stoves, or refrigerators.
Having made a complete analysis of all major manufacturing companies’ return on net worth and found that only about twenty-five in 1952 earned over 20 percent on common stock equity, I set that rate of return in 1953 as Textron’s goal for the future.
There’s a few key takeaways here. First, because of Little’s experience in manufacturing, it is understandable for him to be focusing on acquiring companies that were manufacturers compared to companies in retailing or service industries. Second, it was primordial to invest in companies that are leaders in a small niche industry rather than a company in a big but competitive market.
“We also felt that it would be advisable not to buy any businesses that were in huge industries doing $5 or $10 billion in sales, where the company we might purchase would be a tiny part of such an industry. It appeared to us that if we could buy a leader in a relatively small industry we would be far better off.”
— Royal Little
This reminds of what we have previously learned on compounders companies who have a strategy of relentlessly acquiring small private companies by using their free cash flow. As explained by the REQ team, most of the time, these acquired companies are usually not constrained by industry or geography. The entire global market of small and medium-sized enterprises tend to be their playground. As Lifco’s CEO once said, “if we were forced to only buy companies in our dental division, we would not been able to grow as much or profitably as we have done.”
This relentless acquisition of companies creates a virtuous cycle: the cash flows from existing businesses fund new acquisitions, which in turn generate more cash flow. This self-sustaining cycle is the mechanical heart of the compounding machine, ensuring that growth is not a sporadic event but a predictable, repeatable process.
“With the money we earn we buy quality companies that generate more money, which enables us to buy more quality companies—it’s that simple.”
— Johnny Alvarsson, ex-CEO of Indutrade
However, for the compounding effect to work, it is clear that reinvested capital must generate high returns. As such, CEOs of compounders are, first and foremost, masters of capital allocation with a fanatical focus on metrics like Return on Invested Capital (ROIC) and Return on Total Invested Capital (ROTIC). They must be extremely disciplined when it comes to valuation as overpaying for an acquisition is a cardinal sin.
REQ explains that “Avoiding overpaying for acquisitions is crucial. Paying a 10 × multiple for a private company, compared to 5 ×, is the difference between 10% ROIC and 20% ROIC assuming 100% cash conversion. The higher the price paid, the greater the need for cash conversion to support self-financing growth. If you overpay, the deal has to work a lot harder to pay for itself.” As a matter of fact, the key for a compounder is to have the newly subsidiary quickly repay itself and to generate free cash flow back to the main company.
This can be perfectly illustrated by the success of Bergman & Beving, whose founders always had a distinct focus on profitability. They invented a profitability benchmark which involved maintaining profits divided by working capital (P/WC) at levels exceeding 45%. REQ explains that “According to the Superinvestors of Bergman & Bevingsville, a business is considered self-financed when the return on working capital (P/ WC) is higher than 45%. By achieving P/ WC > 45%, the business can generate the necessary cash to cover taxes, interest, and dividends, and make required investments in existing businesses through capital expenditures, working capital, and financing acquisitions. The goal of being self-financed means that growth, whether organic or through acquisitions, will not dilute current shareholders through equity raises or rely heavily on debt financing. It highlights the importance of capital efficiency in generating cash.”
This reminds me of an episode of The Knowledge Project where **Palihapitiya explains that he would be livid for a company to declare dividends if it could reinvest and generate superior returns.
“If you, as a CEO Shane, if I was an investor in your company, and you said, “Chamath, I generate 30% free cashflow, and I’m going to give you a dividend.” I would say, “Shane, f*ck you.” I don’t want that money. What am I supposed to do with it? Reinvest it. Grow faster, please.”
— Chamath Palihapitiya
Avoid Bad Managers
“I think management is incredibly important. I’ve been burned many times when I didn’t pay enough attention to that. Businesses, as I already told you, are very fragile. Most of them don’t survive very long. Leadership, both depth of leadership as well as quality of leadership, matters a huge amount.”
— Mohnish Pabrai
At the heart of Royal Little’s success in acquiring so many companies was his belief in people. He learned that no business strategy succeeds without capable leaders and with a proper incentives structure in place. As he explains, “No business, however promising, is worth backing unless the management is capable. This situation illustrates dramatically how one man can be a failure in a new business and another man can turn it around and be successful in two years. If you are smart enough—or lucky enough—always to back competent people, you will never lose money.“
This was especially true when Little investing was investing in early stages companies as a venture capitalist. He mentions, “I must stress the importance of backing the right people. If it had been possible for us to have spotted those who had inherent management capabilities, and if we had limited our investments to those people, our results would have been far superior. There is no question that the most important thing in venture capital financ ing is people! people! people! just as the most important thing in real estate financing is location! location! location!”
Oddly enough, Little warns us to not invest in companies where the inventor is the president of the company, fearing that “The inventor will constantly be experimenting with possible improvements of the product rather than settling upon a formula and producing big tonnage for an established market.“ He does mention one exception though, Edwin Land. As we have seen previously, Land was the founder of Polaroid and while he was the inventor and the founder of the company, he was extremely successful in business. In fact, Land is often mentioned as one of Steve Jobs’ hero.
“Industry is best at the intersection of science and art”
— Edwin Land
Furthermore, once Little had competent people in place, it was primordial for him to set a proper incentives structure in order to keep them within the company. This was especially true since most of the great managers were obtained through acquisitions. As he once said, “When you make the owners of a small business you purchase wealthy, try to have some meaningful incentive so that they will continue to work hard for you in building up the business.“
While it was the norm to have bonuses tied to profits, he pioneered a compensation plan at Textron that was revolutionary, one that tied bonuses directly to return on assets, ensuring that managers were rewarded for efficient use of capital.
Therefore, Little “adopted a basic plan that involved incentive being tied to the return that the company earned on the divisional net worth. Our plan required that there would be no bonus unless the management made at least 10 percent pretax on the divisional net worth and that the maximum bonuses could be reached if an unusually high rate of return was made. Under the maximum bonus, the divisional president could earn 100 percent of his base salary, the second group could earn 75 percent; the third group 50 percent; and the next group 25 percent. It was our feeling that these plans should go far enough down in the organization so that everyone who had an opportunity to make or lose money for the company as a result of their decisions should be included“
“For many years in the past the directors of the company had made awards in current earnings to a large number of key people as additional compensation. The directors have recently adopted an incentive compensation plan, based upon engineering studies, which will be directly related to the return which management makes on capital used in operations.”
— Royal Little
This approach to incentive reminds me of the incentive structure at Berkshire Hathaway, a fellow conglomerate: compensation should align the management’s interest with those of the shareholders. Warren Buffett and Charlie Munger want their managers to think like an owner. As Munger once said, “The basic rule on incentives is you get what you reward for. So, if you have a dumb incentive system, you will get dumb outcomes.”
As we have previously learned, Munger explains how important incentives are in running a business. My favourite example on the power of incentives from Munger come from Federal Express:
“The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work.
And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.”
— Charlie Munger
Charlie Munger also provided an interesting case study on how Les Schwab tire store was able to come out ahead despite competing with the bigger tire companies such as Goodyears and later on, with huge price discounters like Costco and Sam’s Club. How did he do so? Munger believes that a big part of this is due to the fact that he “must have a very clever incentive structure driving his people. And a clever personnel selection system, etc.”
Beyond the Book
Read "Moats - Competitive Advantage" by Investment Masters Class
Read "The Art of Thinking Clearly" by Farnam Street
Read "A Deep Dive into Shareholder Value Creation by Acquisition-Driven Compounders" by REQ
Read "THINKING ABOUT MANAGEMENT?" by Investment Masters Class
Read "The Power of Incentives: The Hidden Forces That Shape Behavior" by Farnam Street
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