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Setting shareholders’ cash on fire

Has so much money ever been wasted by so few?

Mining investors could be excused for wondering exactly that as resources companies seemingly fall over themselves to take write-down after write-down – and there appears no end in sight.

Earlier this year we saw BHP Billiton (ASX: BHP) take $3 billion in writedowns on its aluminium and nickel operations, but that huge number has paled into almost insignificance in recent weeks.

The world’s largest gold miner, Barrick Gold (NYSE: ABX), took an $8.7 billion writedown earlier this month, just a few months after a $4.2 billion charge, and local competitor Newcrest (ASX: NCM) yesterday revealed it would book a $6.2 billion hit to profits as it writes down the values of mining operations in different parts of the world.

An accounting term that shades an important truth

Now, these writedowns don’t have any ‘cash’ impact on the company – they simply reduce the asset values on the books, but investors shouldn’t be too complacent about them. A write-down says two things.

First, the value of the company is now worth less, largely because the profitability of its assets – mines in this case – have been impaired, likely permanently. When a company buys an asset, it does so because it believes there will be a stream of profits flowing from it that will justify the amount paid. When those profits stall from a flood to a trickle – or worse, when there never was a flood, but management hoped there might be, one day – the company and its auditors have little choice but to confess their mistakes and acknowledge that the future is likely to be less rosy than previously hoped.

Second, while the writedown is a ‘non-cash charge’ in the vernacular, that’s a convenient way to try to sweep the problem under the rug. While no money is actually lost from the company when the writedown occurs, that doesn’t mean real money hasn’t been wasted. A writedown is a tacit admission that, through ill-discipline, poor decision making or bad luck, management paid too much for the asset at some point in the past.

Don’t just stand there, buy something

Real cash was spent – and wasted – on assets that subsequently weren’t as profitable as they should have been. That’s money that could have been used to buy back shares, pay increased dividends or for more productive and successful acquisitions. Instead, it was metaphorically lit on fire in a quest for growth.

For CEOs – and mining CEOs in particular – it’s an occupational hazard. Shareholders demand growth, and the money burns a hole in managers’ pockets. With existing resources being depleted with every passing day, the pressure builds to find the next big opportunity.

The current systems of remuneration don’t help, either. Most large company managers have a large proportion of their pay contingent on growth. If they’re lucky, they’ll make some great acquisitions. If they’re really lucky, the duds won’t go bad until after they’ve left the company.

It’s the same system that caused the managers of investment banks to take outsized risks that led – at least in part – to the GFC. It’s a casino game where you get to toss a loaded coin – heads, I win, tails, I don’t lose. Those bankers who managed to keep the music going pocketed year after year of bonuses. When the music stopped, almost none of those bonuses were required to be repaid. Heads, they won… tails, they didn’t lose.

Why management counts so very much

Some CEOs likely understand the game and are happy to play along. Others are likely just seduced subconsciously. Whatever the motivation, such behaviour can waste millions of dollars, and that’s another reason why management is such an important factor to consider when buying shares in a company. Investors need to ask themselves “Do I trust not only management’s integrity, but also their ability to make the right decisions when it comes to spending my money?”

Maybe the resources bosses were just unlucky. Perhaps they genuinely believed everything would be okay. What seems clear (and to be fair, we’re using hindsight here) is that they weren’t sufficiently careful to avoid paying too much or allowing for a scenario where demand and prices were lower than they had expected.

Foolish takeaway

The earlier on you learn this lesson, the better off you’ll be: investors should be very wary of companies that require ongoing large acquisitions or greenfield developments to continue to grow their earnings. Unless you have absolute faith and confidence in those running the company, your money is likely better off being invested elsewhere.

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Motley Fool investment analyst Scott Phillips does not own shares in any of the companies mentioned in this article.

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