Too much money can be a bad thing

For some companies, the world ends with a bang and a whimper. A long, protracted whimper.

Thus it was for the giant British conglomerate Marconi, which has fallen from 8 to a low of 0.12 over the past year, the product of an unwise strategy of acquiring telecommunications companies with cash.

These days, it seems the whole world is criticizing the acquisition binge that occurred in the telecommunications sector, but the anger at Marconi seems to especially strong. Other telecommunications companies destroyed value on a more massive scale, but at least they didn’t do it in cash — they paid for overvalued shares with other overvalued shares.

In the Marconi affair, blame has partly settled on a management group that seems to have been picked based on its ability to satisfy the City — notably chief executive Lord Simpson of Dunkeld, whose track record in selling businesses (at a tidy profit for the shareholders) made him the choice of the merchant banks to “unlock” the value in Marconi.

But the City itself is now getting some hard stares for its insistence, in the mid-1990s, that Marconi start spreading around some of its large cash reserve. This it did, through acquisitions in the telecommunications business at the top of the cycle. The merchant banks did not trouble to question the strategy that drove these acquisitions, or the unrealistic projections for the sector’s growth. And management, which could have stood up to the merchant banks, appears instead simply to have done what it was told.

The mineral industry will be familiar with the phenomenon of investment bubbles: it’s one of this business’s chronic problems. How often has a speculative phase in the capital markets fuelled investment in resource projects, only to turn sour once the projects came into production?

Overcapitalization is a misallocation of resources. This is true in any business. We saw it in this industry in the late 1990s, when the junior exploration bubble fed large amounts of capital into the costly and ultimately unrewarding exercise of defining large, low-grade gold resources, few of which made it into production.

Several factors contributed to this bubble effect. One is that many explorers used relatively low cutoff grades to outline resources, on the grounds that low grades were then economic to mine. But that approach was based on the the assumption that gold prices would rise or maintain their mid-90s levels; if prices fell, the low-grade resources would be sterilized.

Another was a faith that the commodities markets would stay up, as though the business cycle had stopped. This was not merely making the wrong bet on the gold price (though that was part of the picture); it also showed itself in optimistic assumptions about long-term prices for by- and co-product metals.

Yet a third factor was that analysts’ valuations for gold companies — and consequently the target prices that went out to brokers and investors — were increasingly based on a dollar value for every ounce of resources. Some of those valuations were simple comparisons with a “peer group” of other gold companies, whose economic situation may not have been directly parallel — an example not so much of comparing apples to oranges as comparing apples to fruit in general.

Nobody could have known that the gold price would plunge as it did in the last years of the decade; or, to be more precise, those that did know can pocket their winnings and stop reading editorials like this one. But it has always been common sense during good times in the commodity markets to plan new production based on conservative price assumptions. Over-optimism sown in the boom times was reaped as asset writedowns after gold prices fell: throughout 1999 and 2000, gold companies jettisoned reserves and resources that needed high prices to be economic.

No less, the idea of peer comparisons, while ideal for a quick take on a company’s value, needed to be refined to take grades and production costs into account. The back-of-the- envelope calculation of dollars per ounce obscured too much.

The result was that the capital markets tended to reward companies that were ready to make the most optimistic forecasts. The willingness of the investment industry to take flyers on the most aggressive projects and long-shot acquisitions made it easy to send money where it would do the least amount of good. Let us not forget the pressure the Street put on some companies to jump into property acquisitions without making careful projections about those projects’ futures.

In some ways, the industry got off lightly this time. Projects were cancelled or put on hold, but comparatively few were actually built and put into production. Held up against the mortal production miscues of the flow-through years (roughly the mid- to late-1980s), a few golden years of resource delineation look like indiscretion rather than immorality. But exploration costs money, as does acquiring exploration projects: between 1993 and 1996, the industry’s exploration expenditures doubled, to US$4.6 billion, and its acquisition expenditures tripled, to US$12 billion. Numbers like those compare to the figures of the flow-through days.

The market has been fixing this, however slowly. There have been mine closures and reductions in capacity, and some of the overcapitalization has been turned back into cash. No doubt, there’s more of that still to come before the really good times return.

And thus it is in the telecommunications business, where overcapacity may weigh on the sector for a long time. Only through plain old business development and hard work will that capacity start earning a return.

The market is not always right. The market does not always do everything right. But, like democracy, it does usually offer the surest way to fix anything that’s gone wrong.