Sunday, September 14, 2008

War, Part II: Strategy, Operations, and Tactics

In any war, the planning is broken down into three categories: tactics, operations, and strategy. Tactics refers to the plans within a battle; operations refer to the plan within a broader campaign; and strategy refers to the final military and political goals of the war. The history of warfare provides infinite examples of mistakes made in all three. And the same holds true in the battlefield of business. We can use the separation to great utility in investment research. Is the business we are looking at facing problems because of the recent direction it has taken with the company? Is it in dire straits because its method of fulfilling its consumer need is becoming ineffective? Or, is there really no need for their service in the first place?

I'll give you some examples which I think qualify. Back in 1963, American Express got caught within the "Salad Oil Scandal":

The scandal involved the company Allied Crude Vegetable Oil in New Jersey, led by Tino De Angelis, which discovered that it could obtain loans based upon the inventory of its salad oil.[2]

Ships apparently full of salad oil would arrive at the docks, and inspectors would confirm that the ships were indeed full of oil, allowing the company to obtain millions in loans. In reality, the ships were mostly filled with water, with a only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. The company even transferred oil between different tanks while entertaining the inspectors at lunch.[3]

The money was splurged and banks were stuck holding loans with worthless collateral. The scandal cost American Express over 58 million, and the stock dropped over 50%.

But what had really happened here? The problem was not that the company's services were poorly delivered and unnecessary. Rather, it was a one-time bad decision to loan money to characters with deceitful intent. The underlying business was in fact still very valuable, with several competitive advantages to protect its future profit stream. The stock subsequently rose significantly and became one of Warren Buffett's prized investments.

What about an operation problem- one where the fulfillment of a need proves inefficient? For example, consider classified advertising after the introduction of the internet. If you wanted to find or sell something in the old days, you really had only one product which would reach your local market, and that was the newspaper. Newspapers recognized this and made a killing by chaarging high rates for putting these into their papers. It's no wonder that newspaper execs often looked at classifieds as their "gold mines."

But the internet not only introduced competition to this field, it also slowly began to demonstrate a superior ability to fulfill the need for classifieds. The internet had several advantages: it could be posted for cheaper, it could reach a larger audience, and once it was posted it would remain up there for as long as the poster wanted. The internet also made it easier to search and find what their customers wanted. All this served to slowly make newspaper classifieds less and less effective, and their recent results reflect that.

Finally, a problem in strategy. Can businesses really exist and thrive for some period of time when they are reality adding no value to their customers. The answer is yes. I've mentioned one example before with the rise of the mortgage lenders. During the housing boom, the business of loaning money to people soared, and more importantly, people would pay a premium to loan value to buy these loans off you. This allowed several mortgage lenders to spring up and thrive by making loans and dishing them off to other lenders. But in principle, it was founded on an unsustainable practice. Economically, all these firms were doing was saving their customers the trip to their local bank (or providing them with exotic products that just really shouldn't have been made). Either way, competition would have eventually narrowed the gap and vastly eliminated this business.

So there you have it- examples of problems in strategy, operations, and tactics. As an investor, its important to recognize which type of problem you are dealing with and to include that information into any investment analysis.

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