If GE investors had been told about the recent challenges at the company 15 years ago, would any of them have believed them to be possible? Investors who invested in GE stock 15 years ago have lost more than 40% of their capital through the end of October 2018. This compares with a gain of over 250% over the same time period in the S&P 500 index, which tracks the performance of large U.S. stocks. What can we learn from the challenges at GE to become better investors?
A Brief History of GE
From 1981 until 2001 GE was led by Jack Welch, who served as Chairman and CEO of the company. Over that period of time the company’s stock produced a total return of over 21% per year, outperforming the S&P 500 index by over 7% per year. An investor who purchased $10,000 worth of stock at the beginning of 1981 and reinvested all dividends would have stock worth over $540,000 by September 2001, over 3 times as much as the same initial investment in an index fund tracking the S&P 500.
The GE of that era was known for rarely missing a quarterly earnings estimate, providing frequent instant gratification to the short-term oriented Wall Street analysts. It grew both organically and via numerous acquisitions becoming a sprawling conglomerate across many different business lines. Not only was it perceived to be a household name, but it was also considered a superbly managed company whose managers were held in very high esteem by other companies. The conventional investor view of the time was that the stock was the bluest of the blue chips, an unstoppable growth machine with a superior culture and an attractive portfolio of businesses.
Jeff Immelt, a GE-insider, took over as CEO in September 2001, an unfortunate time given that the economy was already entering a recession. He inherited a business portfolio with a significant portion in financial businesses that employed substantial financial leverage and overall produced less than stellar returns on capital.
Despite Immelt’s efforts to reshape GE’s portfolio, the company’s reputation lost a great deal of its luster during his tenure. The Great Recession of 2008-2009 hit GE’s financial subsidiaries particularly hard, leading to precipitous declines in earnings that the company never fully recovered from. Overall profits declined between 2000, the last full year that Jack Welch was CEO, and 2016, the last full year when Jeff Immelt occupied that role. The high initial expectations embedded in the stock price when Immelt took over as CEO, combined with the company’s poor performance during his tenure, led to abysmal stock returns. An investor who purchased $10,000 worth of GE stock when Immelt took over as CEO and reinvested all dividends would have stock worth less than $11,000 upon his departure, compared to over $33,000 had the same amount been invested in an index fund tracking the S&P 500. The stock underperformed the index by 7% per year.
The board felt that the solution to the challenges facing GE was another insider, John Flannery, who took over as CEO in August 2017. Flannery appeared to take charge quickly, lowering expectations for the company’s profitability and announcing a plan to split the company into several pieces. Long gone were the days of Jack Welch, when everyone blindly accepted that GE’s sprawling conglomerate structure was a competitive advantage that led to superior managerial culture and shareholder returns.
Unfortunately events moved faster than Flannery was able to control them. Key business units continued to disappoint. GE’s financial businesses produced unexpected write-offs. Expectations set not long ago by management continued to be missed. This time the board didn’t wait and acted swiftly, replacing John Flannery in October 2018, just over a year into his tenure. During Flannery’s short time as CEO, GE’s stock produced a loss of over 50%.
The new CEO, Larry Culp, is the first outsider in recent history. He is widely viewed as having successfully led Danaher Corp for over a decade, building a strong culture that combined acquisitions with organic growth. One of his first moves at GE was to reduce the quarterly dividend to a nominal 1c level, acknowledging the magnitude of the trouble that the company is in.
Investing Mistakes Made by GE Investors
1. Over-Extrapolating Past Results into the Future – Investors were mesmerized by the high profit growth rates produced by GE under Jack Welch and assumed that they were sustainable far into the future. They didn’t stop to think about how the future might differ from the past.
2. Focusing on the Short-Term – Some investors became caught up in Wall Street’s quarterly earnings game where success is measured by whether or not the company beats the average of analysts’ quarterly estimates. Amazingly, the company seemed to almost always exceed analyst earnings expectations, reinforcing a perception of management acumen and providing investors with an expectation of a quick reward.
3. Confusing Conventional with Conservative – Retail and institutional investors derived a sense of comfort from how well-known and well-regarded the company was. Institutional investors further knew that many of their peers held GE stock and that it was a large component of important benchmarks against which they were measured. They thought that their clients would not be as quick to blame them were GE’s stock to underperform as they would if the poor results were to come from a lesser-known company’s stock. It felt safe to be in the middle of the herd. Conventional wisdom made GE appear to be a very safe, conservative investment. The future turned out to be quite different.
4. Ignoring High Embedded Stock Expectations – At the end of the Jack Welch era, almost no price appeared to be too high to investors, with GE’s stock’s Price to Earnings (P/E) ratio approaching 30x, down from a peak of over 40x in 2000. This compares to a P/E ratio of approximately 15x that U.S. stocks have been valued at on average since World War II. To justify such high valuation the company would have to produce profit growth far above that of the average company just for the stock to achieve market-level returns.
5. Not Understanding the Business Well Enough – Conglomerates with many disparate businesses make it harder to thoroughly analyze each business unit. Some businesses are also inherently tougher to analyze than others, and those with opaque assets relying on high levels of debt to generate profits are among the hardest to properly value. Investors became overconfident by listening to management promises and did not grasp how poorly they understood the long-term economic characteristics of some of the major businesses in GE’s portfolio.
1. The future can be, and frequently is, different from the past. There is evidence that above-average growth rates revert to the mean over time. Furthermore, as a company becomes larger it is harder for it to achieve the same profit growth rates that it generated from a much smaller base. Investors also need to guard against adverse business developments, such as changes in the competitive environment, when assessing a company’s future prospects. Studying the past record of a company is good first step, but automatically assuming that it is going to be repeated is a mistake.
2. Investors should focus on the long-term. Over time stock prices tend to converge on the values of the underlying companies. As Benjamin Graham famously said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Investors would be much better served attempting to “weigh” each company’s future cash flow stream rather than to try to guess quarterly earnings.
3. Real conservative investing focuses on achieving safety of principal and an attractive return through thorough analysis of both the underlying enterprise and the valuation of the stock. It doesn’t matter how well known a company is or how safe its stock is perceived to be by others. As Warren Buffett has said, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."
4. Valuation is a lens on long-term expectations. On average stocks at very high valuation levels have underperformed the broad market over time due to the high expectations that need to be exceeded to justify above-average stock performance. That doesn’t mean that companies can’t meet or exceed these high expectations, but it does mean that the base rate probability (the frequency of similar events in the past) is low and that the losses should results fail to meet the high bar can be substantial.
5. Many businesses are too hard to properly value. Some businesses are more predictable than others for structural reasons. Conversely, the nature of other businesses makes them opaque and susceptible to material adverse developments that are hard to predict even with thorough analysis. There are many possible investments to make, and there is no shame in passing on a particular company if it is too unpredictable to properly value. The greater error is to be arrogant enough to think that you can know the future of even the most challenging business and to risk your capital based on that view.
Will the new CEO, Larry Culp, turn GE around? Is now, when GE’s stock is out of favor, a good time to invest? The future is still being written, and these are difficult questions to answer. Perhaps that is the point. One of the best things about investing is that you don’t have to answer challenging questions, but can instead seek out easier ones. If you think you are qualified to assess the future of GE under the leadership of a deservedly acclaimed CEO and from a much lower valuation level, then it is something that you should thoroughly examine. Certainly the pessimism surrounding the company makes it an intriguing investment candidate for further study. However, many investors might benefit from seeking out easier questions to answer. Investing is all about the right balance between confidence and humility, and those who know their limits will be rewarded in the long-term.
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Note: An earlier version of this article was published on Forbes.com and can be found here.