This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
One of the most curious instances on record of a disastrous investment on the part of a corporation in extending its own business, is that of the Assets Realization Company. This company was organized for the specific purpose of giving financial relief to embarrassed concerns, by taking over the assets which they could not otherwise dispose of. It is frequently possible to purchase from such concerns plants, machinery, securities, and other assets of great value, at bargain prices. It was the expectation of the organizers of the Assets Realization Company that they could take their choice among properties thrown on the market in this way, and could rehabilitate them or adapt them to other uses or see to it that they were managed in a more efficient manner, and in this way realize large profits for themselves. The plan seemed fundamentally sound, and for some years the Assets Realization Company was successful. As it proceeded, however, the company gradually extended its operations into the underwriting of securities of new corporations, which for one reason or another could not be marketed. Furthermore, it is stated that some of the assets which had been taken over from insolvent corporations could neither be utilized nor resold, and remained as a dead weight on their hands. Eventually the company became afflicted with the same disease which it had undertaken to cure, and was itself so loaded down with unrealizable assets that it was compelled in 1914 to go into the hands of receivers. It had extended its business beyond the limits of prudence.
Another instance of unwise extension was the purchase by the United States Cordage Company in 1894, of a binder twine mill from the McCormick Harvesting Machinery Company for $900,000, of which $500,000 was paid in cash. At the same time that the company was paying out $500,000 for this mill, it was borrowing $500,000 in order to meet interest payments for its funded debt. The new mill could not at once become a dividend payer, but rather called for additional investment. Therefore it is not surprising that within a short time the United States Cordage Company found itself in financial difficulties.
Shortly after the formation of the Consolidated Cotton Duck Company in 1905, it was decided to purchase the H. Spencer Turner Company, which was the chief selling agent for the products of the Consolidated Company. The arrangement increased the funded debt of the Consolidated Company by about $1,500,000, which was its total investment in this extension of its business. The chief assets of the Turner Company consisted of its good-will and trade connections acquired in handling the Consolidated Company's own trade marks and brands. Instead of assisting in the marketing of the company's products, the move really stimulated competition, inasmuch as other selling agents, fearing that their independence might be threatened, began to establish duck mills of their own.
Many large corporations have been led astray by the idea that it was necessary for them to extend their business by attempting to buy up all competitors. The chief result has been that they have "held the bag" for all kinds of trouble-making schemes. The contrary policy is ably set forth by Chairman A. W. Green in the annual report of the National Biscuit Company for 1901. Mr. Green says:
When the Company started it was believed that we must control competition, and to do this we must either fight it or buy it. The first meant ruinous war of prices, the second constantly increasing capitalization. Experience soon proved to us that instead of bringing success, either of these courses, if persevered in, must bring disaster. This led us to ask ourselves whether the Company, to succeed, must not be managed like any other large mercantile business. We soon decided that within the Company itself we must look for success.
We turned our attention and bent our energies to improving the internal management, to getting the full benefit from purchasing our raw materials in large quantities, to economizing the expense of manufacture, to systematizing our selling department, and above all things to improving the quality of our goods. It became the settled policy of this Company to buy out no competition, and to that policy, since it was adopted, we have steadfastly adhered and expect to adhere to the end.
Another very common fallacy on the part of manufacturers is the notion that they must handle their own retail outlets, and to do so must build up a group of chain stores. This policy has, in fact, been successfully followed by many important companies, such as the George E. Keith Company, manufacturers of "Walk-Over" shoes, the Regal Shoe Company, a great many brewing companies, etc. In practically every such instance, however, it will be found that the policy has been followed as a means of protection, not as a profit-maker in itself. The dangers of extension along this line are not to be minimized. The manufacturer, in the first place, is going into a line of business with which he is not familiar and where it is difficult to avoid numerous pitfalls. In the second place, he is likely to find that the move brings him the active hostility of the retailers who have previously served as his agencies, thus making it necessary for him to develop his chain of stores more rapidly than he had anticipated and to invest more money than he had counted upon.
It is a fact often commented upon that successful corporations, as they expand, ordinarily tend to earn smaller and smaller returns on the actual value of their property. One common explanation is that at the beginning one or two managers exercise close personal supervision over the whole enterprise, and direct it by their insight and wisdom into the most profitable channels; whereas later their duties are necessarily delegated in part to men of less ability. The economist offers in explanation the "Law of Diminishing Returns," which is simply the principle that the most advantageous opportunities for utilizing capital and energy are taken at the beginning, and the less advantageous opportunities are left for future development. Yet, neither one of these explanations applies in the case of many corporations which are ably managed and which continually raise and invest fresh capital without decreasing the average rate of return. Modern methods of organization and management and the advantage of being able to employ specialized talent go far toward offsetting the first difficulty above named. As to the economic principle, it applies, to be sure, but only after the industry has been so far developed that all its highly advantageous opportunities have been sought out and utilized; and that is a condition which obtains in very few lines of business. We may safely infer that one important cause for a decline in the rate of return is to be found in the strong tendency to make extensions of original businesses along lines that are not wisely chosen. The results of each move are not foreseen and calculated with sufficient care.
As an example of profitable extension on a great scale, we may take the case of the General Electric Company. During the nine years, 1905-1913, the capital stock increased from $48,000,000 to $101,000,000. However, $23,000,000 of this increase represented a stock dividend in 1912 and another $10,000,000 was due to conversion of debenture bonds, leaving only $20,000,000, or slightly over 40%, as an actual increase of invested capital. During these nine years, the profits applicable to dividends doubled and the gross sales nearly tripled. All this has been accomplished by steady progress in extending the business along lines that had previously been mapped out. It is an inspiring record of what may be accomplished by persistent and consistent effort.