Book Review: Power Failure
Power Failure: The Rise and Fall of An American Icon by William D. Cohan (2022)
Winning Now, Winning Later by David M. Cote (2020)
The most popular business books are those that chronicle spectacular failure: witness the recent best-sellers about Theranos, Uber and WeWork, all of which have been adapted into successful mini-series. Byrne Hobart has theorized that this is because tragedies make for a compelling narrative, and because the people involved are motivated to talk, in the hope of absolving themselves of blame.
Then again, maybe business failure stories are compelling for the same reason that true crime stories are so popular: They make us feel more prepared to handle and avoid similar situations, and they make us feel better about our own lives by comparison.
Publication-worthy business failure stories frequently fit one of two patterns: straightforward fraud (CNBC’s American Greed recently wrapped its 15th season) or the meteoric rise and fall of an overly ambitious startup (LTCM, WeWork). In both cases, the sums of money involved are usually small — at least by the standards of Corporate America — and the warning signs were clearly visible all along. There is something almost comforting about the patterns these stories follow: both the perpetrators and the victims are greedy, arrogant, and delusional, and the reader gets to feel superior to everyone involved.
The collapse of General Electric stands apart. GE was the bluest of the blue-chips: descended from Thomas Edison and J.P. Morgan, it was one of the original twelve components of the Dow in 1896, and grew to become one of the leading technology giants of the early 20th century. After WWII, GE evolved into an industrial behemoth with dominant positions in a dizzying array of electricity-adjacent markets, from jet engines and turbines to light bulbs and home appliances.
In the 1980s, GE ascended to new heights. Jack Welch took the reins as CEO in 1981, and he established GE a major player in media and financial services while reinforcing GE’s position in select attractive industrial markets. For most of the 1990s and 2000s, GE was the most valuable company in America, with a valuation topping out at over $1 trillion in 2023 dollars. While GE had some skeptics and critics at the time, it was typically seen as a corporate paragon, regularly named by Fortune as the most admired company in the world. Welch was regarded as a management guru, and his underlings were routinely poached to become CEOs at other Fortune 500 companies.
And then, a few years ago, it all unraveled in spectacular fashion. Much of the supposed success from the Welch era of the 1980s and 1990s proved to be illusory, the product of temporary tailwinds and aggressive accounting. GE’s fortunes worsened under the reign of Welch’s handpicked successor, Jeff Immelt, who took over in 2001. Immelt struggled to cope with the problems he inherited, which were compounded by the 2008 financial crisis and major missteps of his own. In 2017, when the extent of GE’s problems became clear, GE’s stock nose-dived, and Immelt was pushed out.
GE has been one of the worst performing mega-cap stocks of the modern era. A $1,000 investment in the S&P 500 in 2000 would be worth over $2,700 today (excluding dividends), while a $1,000 investment in GE in 2000 would have dwindled to only $210. Even going all the way back to Welch’s appointment in 1981, the S&P has outperformed GE by a three-to-one margin.
There is something unsettling about the fall of GE. The villains of most failure stories are obviously flawed: most of them are fraudsters, and many of them are comically inept to boot. By contrast, Jack Welch could have been the hero of a Michael Lewis book, the unconventional maverick that defied skeptics to turn a bureaucratic plodder into a nimble world-beater.1 We discussed his successes in a recent edition:
[Welch] decided that GE should get out of businesses where they were not #1 or #2, an idea so successful that it has become almost conventional today. He aggressively deployed capital, making big internal investments in airplane engines, gas turbines, and cable television that all paid off handsomely. He demanded that managers hit their numbers, and his rigorous operational reviews were legendary.
Jack Welch had most of the traits we typically associate with a great executive. He was incredibly smart (earning his PhD in chemical engineering in only three years), he was demanding of his subordinates, and he worked tirelessly. He had deep operating experience, he was willing to buck convention, and he produced quantifiable results. He was charismatic, ambitious, and a world-class marketer and publicist. And yet, he will forever be remembered as the father of the biggest corporate disaster in American history.
The story of the fall of GE is worthy of an authoritative book, and we looked at a pair of early entries a couple of years ago – Lights Out, written by the WSJ journalists that covered its fall, and Hot Seat, Jeff Immelt’s memoir.
Power Failure, weighing in at nearly 800 pages, is the most ambitious yet. The author, William Cohan, did an early-career stint as a junior analyst at GE Capital in the 1980s, before becoming an investment banker and then a business writer, putting him in a unique position to tell the GE story.
What sets Cohan’s effort apart is that he got almost everybody to talk to him for his book. He managed to interview both Jack Welch (before he passed away in 2020) and Jeff Immelt, and many former and current senior GE executives as well. Dozens of GE critics, counterparties, and journalists also weigh in throughout. (Not for nothing does Cohan begin with the parable of the blind men and the elephant.) As a result, the book is packed with interesting original anecdotes and pieces of gossip, which Cohan skillfully interweaves around contemporaneous news coverage of GE to give a comprehensive picture of the events that transpired. The result is almost more of an oral history, giving the reader a variety of perspectives on how GE failed.
Still, as comprehensive as Power Failure is, it still doesn’t offer a clear answer to one simple, important question: How did GE lose so much money?
In fairness, this might be an impossible question to answer because of GE’s intentionally obfuscatory accounting, but it’s worth exploring here. It is no small feat for a diversified conglomerate to be one of the worst performing stocks over a long period of time despite some major commercial successes along the way. GE built a leader in aircraft engines, going from $1 billion of annual profit in the mid-1990s to $7 billion in 2019. GE did the same in power turbines: GE’s power systems business was making nearly $6 billion a year during the peak of the power plant cycle in the late 90s and early 00s ($10 billion in current dollars), nearly a third of GE’s earnings at the time, and continues to be the market leader today. On the other hand, there is no single division or bad decision that can be singled out for GE’s collapse.
While we don’t have clear math showing us where GE lost all that money, Power Failure suggests some leading culprits to examine:
Poor operating discipline, particularly after Jack Welch left. It is repeatedly suggested that GE’s operating performance slipped under Immelt.
GE Capital. Before the 2008 financial crisis, GE Capital contributed over half of the company’s earnings, and after the crisis, its earnings power disappeared and it was sold off for parts.
Poor capital allocation. GE actively bought and sold hundreds of businesses, and they frequently bought high and sold low.
Even though GE mostly delivered solid operating results in their core industrial businesses over this time period, performance was mixed elsewhere. Here is Comcast’s Steve Burke, describing the situation at NBCUniversal (NBCU) when he took over in 2011:
Burke quickly concluded that NBC had been terribly managed under GE and the culture was abysmal…[Burke] quickly ascertained…that the incentive at NBCU wasn’t to make money. “The game here was to keep GE, to keep Connecticut, happy,” he said. “So the game then became telling a story, as opposed to running businesses, and the incentives were to do that. And then GE–and I fault Immelt on this–they never had the intellectual curiosity or the drive to really understand the businesses.” As one example, Burke cited the way GE managed the local NBC news affiliates. Under Comcast’s management, the local stations made $650 million, up from $150 million under GE. “We invested in local news and we put guys in place who knew what they were doing,” he said, and “and GE never took the time to do that.”
NBCU historically only contributed about 10% of GE’s annual earnings, but after a few years under Comcast’s control, NBCU’s profits more than doubled. In the meantime, GE’s profit machine sputtered. By 2017, only six years after it was taken over by Comcast, NBCU’s annual operating profit surpassed that of its former GE parent.
In time, GE’s industrial businesses would run into operating issues of their own. The biggest culprit was the Power Systems division, which was dependent on the global demand for new gas-fired power plants. In the 1990s and 2000s, gas-fired plant construction was running at all-time highs, but by the 2010s, demand was falling off a cliff. In an effort to hit unrealistic earnings targets demanded by Immelt, divisional management made some ill-advised decisions. Here is the John Flannery, Immelt’s successor as CEO, learning about what happened:
At one point, the Power team was discussing with Flannery and [GE CFO] Bornstein a $1.1 billion unsecured exposure that GE had in Angola from selling the country railway and power equipment. “We sold a bunch of power equipment in Angola, and we just took an account receivable,” one person in the meeting remembered. “No cash. No security. No nothing. They’re not paying it. Of course, we book the income and the sales.”
GE’s problems in media and industrials were minor compared to what happened to their finance subsidiary, GE Capital. Under Welch, GE transformed its tiny financing arm into a behemoth involved in real estate, aircraft leasing, commercial lending, and insurance. By the 2000s, GE Capital accounted for more than half of GE’s earnings.
GE Capital’s large profits were dependent on the spreads enabled by GE’s AAA rating, which enabled it to borrow at rock-bottom rates. Also, GE Capital was unusually willing to fund its balance sheet with short-term commercial paper, with no backup lines of credit. This allowed it to capture even larger spreads when short-term interest rates were low, but exposed them to a potential liquidity crisis in the event that investors got cold feet and refused to roll over their debt. When that liquidity crisis hit in 2008, GE Capital teetered on the edge of bankruptcy.
Warren Buffett and the US government helped GE Capital avoid disaster, but the days of cheap borrowing and low regulatory oversight were over for good. According to Trian, the activist investment firm that got involved with GE in the mid-2010s, return on tangible equity at GE Capital was 40% in 2007, but that collapsed to only 8% in 2014. GE Capital went from a profit machine to a candidate for liquidation, and indeed, GE would choose to exit the business entirely in 2015. In hindsight, GE Capital’s pre-crisis profitability was completely unsustainable.
While GE’s operating issues in media, finance, and power account for a share of its struggles under Immelt, they can hardly have been major contributing factors to GE’s underperformance dating back to Jack Welch. NBCU may have underperformed, but it should still have been a successful investment considering how little GE paid for it. The same can be said for GE Capital and Power Systems: they may have over-earned for many years, but they should still have delivered a very high return on investment overall.
That leaves capital allocation as GE’s biggest problem. Welch was able to establish an image as a shrewd dealmaker in the 1980s, when he bought RCA for a song, and was able to pay for it by selling the parts he didn’t want (like TV manufacturing) while retaining the part he did want for free (NBC). Welch certainly deserves credit for being far-sighted about getting out of low-quality commodity manufacturing businesses, but his overall track record on acquisitions was actually fairly mixed.
He missed a chance to close a home run acquisition of Cox immediately prior to getting the CEO job, and he became enamored with finance and insurance, which led to a string of troubled acquisitions, including Kidder Peabody and Employers Reinsurance Corporation (ERC). Finally, at the end of his tenure, he agreed to a deal to acquire Honeywell for a small amount of GE stock, but got cold feet and didn't push to get it through EU approval, allowing the deal to fall through. Today, Honeywell is almost twice as valuable as GE.
GE’s capital allocation problems really took off under Immelt. Immelt did some smaller deals in water, security, and oil and gas that proved to be ill-timed. To Immelt’s credit, he almost managed to mostly get out of the struggling insurance businesses he inherited without too much damage, but he ultimately retained a small piece of ERC that led to a $15 billion loss later on. Finally, Immelt ramped up GE’s exposure to consumer finance in the years leading up to the 2008 financial crisis, another small bet that blew up.
In 2009, at the bottom of the market, he sold NBCUniversal to Comcast for only $30 billion. By 2017, NBCUniversal was making over $8 billion a year before tax, and was worth over $100 billion. (GE is worth only $85 billion as of this writing.) Finally, there was the notorious 2015 acquisition of Alstom’s power business, which was so troubled that it resulted in a $22 billion writeoff just three years later.
Jack Welch was public in his distaste for stock buybacks, preferring to use cash for acquisitions instead. GE’s track record demonstrates why investors so often prefer buybacks, and are particularly loathe to allow companies to invest outside their core business: managers are high on ego and low on investment expertise. Management teams can vaporize years of earnings with just a few bad deals; GE was making less than $10 billion a year after tax (and declining) while they were losing $15 billion or $20 billion at a time on bad investments.
Power Failure also doesn’t really offer an overarching theory of why GE failed. Power Failure lists many different things that went wrong at GE — bad management, bad acquisitions, bad incentives, bad accounting, bad luck — but almost all companies suffer from some of these issues without running into a GE-scale disaster. Maybe the failure of GE was the result of an unlucky confluence of individual problems, but it feels like for a group of smart, hard-working people to produce such an exceptionally catastrophic result, there must be a larger lesson to be drawn.
One possible clue comes from the story of David Cote, a star GE finance executive who rose to become the head of the Appliances division in the 1990s, and was one of five early candidates to succeed Jack Welch as the CEO of GE. However, he was eliminated before the three finalists were chosen, and he was asked to leave GE. It is suggested that Cote was doomed by the divisional assignment he drew; the finalists were the ones who had been assigned to oversee GE’s crown jewels, while he was stuck trying to fix a basket case.
Cote eventually landed a position in 2002 as the CEO of Honeywell, a much smaller industrial conglomerate – Cohan at one point refers to it as a “mini-GE”. Honeywell had been run since 1991 by Larry Bossidy, who before then had spent his career as a top executive at GE, a close associate of Jack Welch.
In 2000, GE agreed to acquire Honeywell, in a stock deal where Honeywell shareholders would have received 8% of the combined company. However, the EU moved to block the deal on antitrust grounds, and while the case was pending, GE got cold feet after getting a look at Honeywell’s aggressive accounting. The deal fell through, and Cote was hired to forge a path forward for Honeywell as an independent company.
Cote had an incredibly successful run at Honeywell, leading it until his retirement in 2017. While GE foundered, Honeywell soared. A $1,000 investment in Honeywell in 2003 would be worth over $9,000 today, while the same investment in GE would now be worth only $450. Remarkably, Honeywell managed to surpass GE in overall value as well: Honeywell’s current market capitalization is $140 billion, while GE is now worth less than $90 billion. GE is slated to be broken up, but as it stands today, is nothing more than a mini-Honeywell.
This would seem to be the perfect natural experiment. A GE cast-off takes over a small company run by Jack Welch’s former right-hand man, and turns it around and surpasses GE. What did Cote do so differently from Welch, Immelt, and Bossidy, to get such a spectacular result?
Fortunately, Cote wrote a book about his experience, entitled Winning Now, Winning Later. It is fairly standard for the business advice genre, a short work with stories from his time at Honeywell, with the corresponding lessons he learned. He is scathing when describing the culture he inherited at Honeywell, but diplomatic enough to not mention any of the perpetrators by name, not even Larry Bossidy. Nonetheless, the dysfunctional culture he describes encountering at Honeywell is almost identical to the flawed culture Cohan describes at GE, from the scattershot approach to M&A to the practice of using accounting gimmicks and shortcuts to “hit the numbers” at the end of each quarter.
What is Cote’s diagnosis of the root problems at Honeywell? Cote opens the book by telling the story of an internal meeting at the beginning of his tenure, a business review of Honeywell’s Aerospace division. The head of Aerospace was steeped in the old culture, and had even been a candidate for the CEO job that Cote won. The meeting does not start well:
We sat down in a conference room so that team members could present their strategic plan to me. A copy of the plan had been placed on the table facing each seat. Flipping through mine, I saw that it was thick–maybe 150 pages long, full of charts and tables. Uh oh, I thought, not good. I had found so far at Honeywell that executives and managers often made presentations far longer than necessary, overwhelming audience members with facts, figures, and commentary to preempt sharp, critical questioning.
Nevertheless, Cote interrupts them with sharp, critical questions. The Aerospace team responds with annoyance — they had planned to put on a show and receive a pat on the back — but Cote interrogates them about the root cause of the $800 million in cost overruns on their biggest project. The team eventually relents and agrees to probe the root causes of their biggest issues, and they turn the ship around. Cote concludes (emphasis mine):
What I learned, to my chagrin, was that Aerospace had become adept at lying to itself, shoehorning costs here and there into a budget without acknowledging them openly. This put enormous strain on the organization, which then had to patch together aggressive bookkeeping and special deals with customers and others, to make its goals. A dysfunctional approach if I’d ever seen one.
Cote says that this approach was pervasive at Honeywell:
Lacking any drive to think deeply about their businesses, and unchallenged by leadership to do so, teams held meetings that were essentially useless, their presentations clogged up with feel-good jargon, meaningless numbers, and analytic frameworks whose chief purpose was to hide faulty logic and make the business look good. When you did a bit of digging, you found that most executives didn’t understand their businesses very well, or even at all.
Cote defines this as intellectual laziness. It is the tendency of organizations to “juke the stats” and lie to themselves instead of diagnosing and solving root problems. This kind of anecdote is everywhere in Power Failure; recall Steve Burke’s appraisal that GE “never had the intellectual curiosity or the drive” to understand and manage NBCU.
Here we should observe what intellectual laziness is not:
It is not actual sloth. People are working hard, just not directed in a way that creates value. Cote acknowledges that the Aerospace division put in a lot of work to prepare a 150 page presentation. It is not like Honeywell had evolved into some kind of adult daycare; they were just in denial about the nature and depth of their problems.
It is not necessarily fraudulent or illegal in any way. Yes, the organization is being dishonest with itself, but it is fundamentally a form of mismanagement rather than willful deception. It is true that intellectual laziness might eventually evolve into fraud, as business performance declines and leadership is tempted to shift from making the numbers to making up the numbers (to steal Buffett’s turn of phrase), but that is not inevitable.
It is not stupidity or incompetence, either. In this example, the Aerospace team had the capability to identify and solve root problems, but they had just never been forced to do so by senior management. They were doing stupid things, but not because they were stupid; they were just responding to the culture and incentives in place.
Cote preaches that managers should instead strive for intellectual rigor, to probe deeply to identify and confront root problems and think creatively and rigorously to find solutions. He argues that “leadership [is], at its core, an intellectual activity.” In his framework, leadership is almost entirely about picking the right direction for the organization and getting the team to move in that direction. Needless to say, there is no way to pick the right direction without having a deep understanding of the business and approaching problems with rigor.
He argues that unless leadership enforces intellectual rigor, middle managers will manipulate their reported metrics (which he says that “any ninny” can do) while underlying business performance suffers. Cote shares numerous examples of this kind of short-term manipulation from the previous regime at Honeywell, such as the tale of a manager who made his quarterly numbers by chopping down the trees around his factory and selling the lumber for a one-time gain. He then reinforces his point with similar stories from his time at GE.
Cote’s formula for success is not some kind of complex 4-D chess, which GE so often seemed to be engaged in, but simplicity itself. The focus on avoiding denial and properly diagnosing root causes is reminiscent of the “five whys” technique pioneered by Toyota. (This is not the only approach Cote cribbed from Toyota: he also successfully implemented what he called the “Honeywell Operating System”, a customized version of the Toyota operating system.) There are no bonus points for complexity or originality in business: Cote took a couple of simple ideas from a successful company and applied them rigorously.
With the framework of intellectual rigor in mind, let’s revisit what went wrong at GE. At one point in Power Failure, Cohan is quizzing the former leadership of GE Capital about the practice of “earnings smoothing”, the art of making reported earnings grow consistently each quarter, even as the underlying business produces volatile results.
GE Capital was central to GE’s ability to manipulate reported earnings. Accounting rules allow a company to book a profit whenever they sell an asset for more than they paid for it. In the course of their normal business, GE Capital owned hundreds of billions of dollars of assets, like bonds and office buildings and parking lots (which they funded with short-term and long-term borrowings). Over time, real assets tend to appreciate, at least in nominal terms. Whenever GE was having a bad quarter, they would sell some of these appreciated assets–say, an office building that was bought decades ago for $10 million that was now worth $20 million–and report the $10 million accounting profit as a part of regular earnings, to compensate for the earnings shortfall from the core business. As for GE Capital CEO Gary Wendt put it in Power Failure:
I always had a lot of [asset sales] available for the quarter. I had to because I knew [Jack Welch] was going to call up and say, “I need another $1 million or another $2 million or whatever,” and so I’d go over to [GE Capital CFO James] Parke and I’d say, “Okay, let’s do this one and this one.” Making your earnings was just life to us.
This kind of one-time accounting gain from asset sales is fundamentally different in nature from operating profits from selling jet engines and power turbines. The $20 million office building was already worth $20 million before GE sold it, despite being on the books for $10 million; selling it converts it to cash but does not make shareholders any wealthier (in fact, by triggering a tax bill, it can make them worse off), despite the accounting profit that gets booked. Bundling these kinds of accounting gains with normal operating results only serves to obscure the true performance of the business from investors.
Regardless, the most of the senior GE executives who talked to Cohan continued to stand behind the practice of earnings smoothing:
Over lunch at a Connecticut pub, Denis Nayden, who was one of Wendt’s successors at GE Capital, also defended the practice of harvesting GE Capital assets as needed. “What’s the job of a public company?” he asked rhetorically. “Produce earnings for shareholders.”
“The job of a public company is to produce earnings for shareholders” is a hell of a thing for the former chairman of GE Capital to be saying after the collapse of GE. If you ask GE’s investors, they would say the job of a public company is to make money for shareholders. GE was among the best at consistently “producing earnings” for shareholders; they did so for decades. They were just abysmal at making money.
There is a plethora of ways to produce short-term earnings without making money, and GE somehow seemed to engage in all of them. You can sell appreciated assets to record an accounting profit. You can overpay for assets with high current earnings and poor long-term prospects. You can sell power equipment to Angola on credit, with little hope of ever getting paid in cash. You can book immediate paper profits from the long-tail insurance policies you sell today, and then find out two decades later that your assumptions were too optimistic and you have to come up with $15 billion of cash to plug the gap. There are no magic metrics, and GAAP earnings are as subject to Goodhart’s Law as any other measure.
According to Power Failure, almost every time GE made a major decision that destroyed shareholder value, the obsession with manipulating earnings was front and center in the thought process. GE lost a lot of money in insurance, but why was a manufacturing company in the insurance business in the first place? Well, insurance companies offer a lot of accounting leeway, in terms of the way reserves are taken and assets are sold for profit, and could act as “shock absorbers” that let Jack Welch report smooth earnings when other divisions stumbled.
Why did GE Capital recklessly allow itself to become dependent on funding from short-term commercial paper, a practice that would almost bankrupt it in 2008? Well, short-term borrowing lowers interest expense, which boosts short-term earnings.
Why did GE buy a subprime mortgage broker in 2004? They had just spun off their insurance business, and Immelt felt they needed to replace the earnings that the insurance business had previously generated.
Why did GE keep expanding GE Capital? Well, it was a good way to increase earnings. Why didn’t GE sell out of noncore businesses like real estate and media when valuations were sky-high in the mid-00s? GE didn’t want to lose the earnings those divisions produced. The catastrophic 2015 acquisition of Alstom? Immelt thought the synergies would definitely increase earnings. The mistimed $40 billion stock buyback in 2015? Jeff Immelt decided on a $2 per share earnings target, and wanted to do anything he could to hit that goal. Never in Power Failure does it seem like GE management gave any thought to shareholder value when making major decisions: it was always earnings, earnings, earnings.
Even putting aside the obsession with reported earnings, GE’s culture seems to have been generally lacking in intellectual rigor. GE’s strategies were supported by narratives that sounded compelling at a superficial level, but fell apart under any kind of scrutiny.
A classic example: Jack Welch liked to tell everyone that his brilliant insight about expanding into finance was that it had higher revenue per employee than industrial manufacturing, thus it must be a better business to be in. Of course, that is nonsense: there is no reason to expect there to be any relationship between revenue per employee and return on invested capital.
Welch told this story even after GE learned this lesson the hard way in the 1980s, overpaying to acquire Kidder Peabody, a venerable investment banking firm (investment banking being perhaps the highest revenue per employee business that exists), a deal that was an endless source of trouble, and ultimately led to a $2 billion loss when GE finally got rid of it in 1995. (Cohan discovers when talking to a former director that Welch managed to prevent this massive loss from affecting reported earnings by raiding the reserves of the insurance business.)
Return on invested capital is mostly determined by factors like barriers to entry and sustainable competitive advantage, which GE’s industrial businesses had in spades but which GE Capital completely lacked — after all, money is a commodity. After the financial crisis, GE Capital’s return on invested capital collapsed not because revenue per employee declined, but because GE Capital’s lenders and regulators came to understand the true risk inherent in the business, and demanded higher rates, lower leverage, and closer oversight.
As GE placed no value on intellectual rigor, it is no surprise that they ended up promoting executives on the basis of polish and storytelling ability. So it was that when it came time to pick a new CEO, Welch elevated Jeff Immelt, a slick-talking salesman with little understanding of GE’s businesses and little patience for details, and dismissed David Cote, who would go on to have so much success at Honeywell.
It is not clear that GE’s decision-making process was any worse under Immelt than it was under Welch. Immelt would be skewered by accusations that he encouraged “success theater”, a culture where executives never confronted root problems and pretended everything was going well, but the culture of extreme intellectual laziness certainly dated back to his predecessor. In fact, Welch’s best-selling autobiography was subtitled “Straight from the Gut”.
It would be technically accurate to state that the dramatic collapse of GE resulted from a perfect storm of mistakes — wrong CEO, bad investments, strategic missteps, operational snafus. But underlying all of those seemingly unrelated mistakes was one thing: this culture of intellectual laziness, the willingness to juke the stats and tell comforting stories rather than diagnose and solve root problems. GE failed to create shareholder value because they didn’t really try to create shareholder value; they were content to be able to report some shiny meaningless numbers and a pleasant narrative.
Lest this seem like pure hindsight bias, it should be noted that these criticisms were leveled at GE from outside observers dating back to the 1990s and 2000s, initially from skeptical short sellers, but eventually also from respected investors like then-PIMCO chief Bill Gross.
None of this is to say that GE didn’t also have other issues. Certainly, there are examples of GE executives being dumb, lazy, or dishonest. There was certainly hubris, arrogance, and a delusion of exceptionalism. But those factors exist at most big, successful companies, and big, successful companies rarely collapse so spectacularly.
It might seem counterintuitive that the root problem at GE could have been something as simple as intellectual laziness, so it might help to consider an analogy.
Imagine you have several boats running a race from New York to Liverpool. The participants will try to maximize their speed, maybe by optimizing the design of the boat, or by adding sails, or by adding the largest possible engine. But one determining factor is whether the boat actually stays on course; the fastest boat will still lose badly if it starts drifting toward, say, Lisbon, or even Cape Town.
Initially, the fastest boat might seem to be on course, maybe because it’s early in the race, or maybe because the winds are keeping it generally on track. But the fastest ship will lose the race very badly if it isn’t pointed in the right direction. GE was always focused on optimizing for speed, but with little thought given to navigation.
If GE’s culture of intellectual laziness under Welch and Immelt were really to blame for its spectacular collapse, why didn’t the cracks show much sooner? Honeywell was already teetering after only a decade under Cote’s predecessor, but GE grew and grew for over thirty years under Welch and Immelt before everything fell apart.
Here it is helpful to think about what GE had going for it:
GE had some good industrial businesses – strong franchises in good markets – and good businesses can handle some level of mismanagement and still produce good returns.
GE legitimately did some things well. Cote is complimentary of many aspects of the way GE was run, and Welch made a few good big bets, getting GE deeper into good businesses like jet engines and cable television.
GE management was great at telling a compelling story, so much so that Welch became a best-selling author after his retirement. A lesser storyteller might have been forced to confront his issues much earlier, but GE management was good at seducing investors and drawing their attention away from unaddressed problems.
GE benefited from major, major tailwinds for a very long period of time. In hindsight, GE in the 1990s and 2000s rode two bubbles: a one-time burst of construction in gas-fired power plants following electricity market deregulation, which led to huge profits for the power turbine business; and a concurrent boom in the financial services, which made it possible for GE Capital to grow and borrow cheaply and recklessly with no regulatory oversight. Temporary windfalls from those businesses covered up GE’s issues and allowed them to grow. In the 2010s, those bubbles burst, turning tailwinds into headwinds, and revealing the underlying rot in the organization.
GE expanded rapidly in finance and long-tail insurance, where the feedback loop is particularly long and noisy. GE’s bad decisions didn’t catch up to it for years or decades: remember that the bill for bad long-term care policies didn’t come due for two decades after they were written.
In a world with perfect short-term feedback, intellectual laziness would never be an issue. Managers that refuse to address root problems or fail to understand core truths about their businesses would be quickly punished by competitive markets and replaced by more competent leaders.
The real world is a messier place, full of noise, randomness, and lags. Subpar, intellectually lazy managers persist for years by taking over strong franchises built by their predecessors, riding big secular waves, and seducing investors with their charisma and storytelling ability. This works only until the tide goes out, at which point people realize that they have been swimming naked the entire time.
GE is the most extreme example of this common phenomenon. GE managed to get as big as they did by riding an extraordinary confluence of tailwinds that covered up their sins for decades, instead of mere years as in the case of Honeywell.
Intellectual laziness is in fact at the root of many sudden corporate disasters. At the time of this writing, the collapse of Silicon Valley Bank (SVB) has captured headlines. SVB was one of the top performing publicly-traded banks over the last decade: riding the tech boom, it grew to become the 16th largest bank in America, and at its peak, its stock was up almost 50 times from its 2009 lows.
SVB was done in by a massive wrong-way bet on low interest rates, initiated in early 2021. How could a team of experienced bankers at one of the country’s largest banks possibly have erred so badly? As bank analyst John Maxfield has documented, while SVB was betting the farm on low rates, other leading bankers were publicly discussing the risk of higher rates and the steps they were taking to mitigate that risk, and came through this episode unscathed.
The Washington Post reported that mid-level bankers at SVB were indeed aware of the risk at the time:
In buying longer-term investments that paid more interest, SVB had fallen out of compliance with a key risk metric. An internal model showed that higher interest rates could have a devastating impact on the bank’s future earnings, according to two former employees familiar with the modeling who spoke on the condition of anonymity to describe confidential deliberations.
Instead of heeding that warning — and over the concerns of some staffers — SVB executives simply changed the model’s assumptions, according to the former employees and securities filings.
The episode shows that executives knew early on that higher interest rates could jeopardize the bank’s future earnings. Instead of shifting course to mitigate that risk, they doubled down on a strategy to deliver near-term profits, displaying an appetite for risk that set the stage for SVB’s stunning meltdown.
“Management always wanted to tell a growth story,” one former employee involved in the bank’s risk management said. “Every quarter, there was always this pressure to deliver earnings.”
Instead of proactively managing the critical, root problems of running a commercial bank, SVB’s management team took the intellectually lazy path, propping up near-term reported earnings while destroying shareholder value.
The psychologist Adam Mastroianni has an excellent Substack where he frequently writes about strong-link problems and weak-link problems. We frequently evaluate managers as if their output will be determined by their best strengths — we commonly look for executives with exceptional intelligence, motivational ability, and salesmanship.
On the other hand, we know that a manager’s output is also subject to certain weak-link traits. Case studies like GE and SVB demonstrate that intellectually lazy managers are eventually doomed to produce bad results, no matter how hard they work or how exceptionally smart they are.
If intellectual rigor is predictive of future success in a way that does not show up in traditional short-term metrics, then it must be important to identify underrated managers like David Cote, and avoid overrated managers like Jeff Immelt.
At this point, we have to ask: how does one identify management teams that demand intellectual rigor, and avoid management teams that are intellectually lazy?
The answer is simple, but not easy. In each example we presented here, the intellectually lazy managers are actually initially exposed when they present their story to a knowledgeable audience. To be sure, they are able to assemble a narrative that sounds convincing to a layman, peppered with vanity metrics and impenetrable business-speak.
However, the narrative is usually all form and no substance, pure business theater. It leans heavily on rhetorical tricks: accounting chicanery employed to meet previously announced financial targets might be rationalized as “exceptional dedication to meeting our public commitments”. (The implication being that if you don’t fudge the numbers, maybe you’re just the type of person that doesn’t take their commitments seriously.)
Nonsense axioms are invented out of thin air – recall the continued insistence of former GE executives that companies must consistently announce growing earnings, in the face of the evidence that most successful companies did no such thing.
Then there is the midwit appeal to complexity: anyone who argues that the narrative is a convoluted, illogical mess is accused of being an ignorant simpleton who is incapable of grasping such sophistication and brilliance.
The intellectually lazy narrative always contains these sorts logical gaps. When confronted about these inconsistencies, managers respond with plausible-sounding non sequiturs, answers that might be accepted by a novice but would never pass muster with anyone with real expertise.
In the case of GE, experienced analysts knew that an inherently cyclical business could not produce perfectly smooth metrics, and they also realized that GE Capital’s reliance on cheap short-term funding was not sustainable — points they raised at the time. At Honeywell, David Cote immediately identified the flaws in the stories that his underlings were telling, and called them out. At SVB, management would not even publicly acknowledge the interest-rate risk they were taking on to keep earnings moving up and to the right, even as their peers were explaining the steps they were taking to proactively manage their exposure to rising rates.
The goal of an analyst is to become knowledgeable enough to “separate the bluffers from the doers”, to borrow a phrase from Shelby Davis, another legendary investor we studied previously. The intellectually lazy bluffers talk in circles, while the intellectually rigorous doers are able to explain their logic impeccably and concisely. For examples of the latter, read any of Jeff Bezos’s or Jamie Dimon’s annual letters, or better yet, watch an excerpt of any of Warren Buffett’s annual meetings.
History teaches us that bull markets and secular booms create lots of GEs and SVBs, mismanaged companies that put up great numbers through a combination of luck and recklessness; in fact, the combination of recklessness and strong tailwinds will often make the worst-managed companies appear to be top performers for long stretches of time. There are no doubt more GEs out there waiting to be uncovered, and books like Power Failure will always be useful case studies for those who wish to avoid them.
Lessons from the Titans (2020) — A fantastic book written by a trio of former industrials analysts, looking at what worked and what didn’t in the sector, including GE and Honeywell as case studies.
Thanks for reading MD&A! Subscribe for free to receive new posts and support my work.
Michael Lewis’s heroes do succeed by taking an unconventional approach, but more importantly, his heroes are usually unconventionally rigorous – the protagonists of Moneyball, The Big Short, and The Premonition all dive deep into the data to get an edge. Here we argue that GE management was unconventionally lazy, with matching results.