Decline and Fall

So far in my journey as a student of investing, I have gravitated towards the strategy of buying stakes in good businesses at reasonable prices. Execution of this strategy often involves investing in these great businesses when they are going through a period short term turmoil. This sounds simple enough. 

Although it sounds simple, it is quite challenging in practice. Investor's typically study a business' history and forecast its future. Evaluating historical track records is undoubtably a crucial part of analyzing  a business and is helpful for developing conviction in investment ideas. However, historical greatness does not imply future success. So, when great businesses sell-off, you run the risk of buying optically cheap businesses where the silent creep of impending doom has set in and the sell-off is, in fact, appropriate.

To learn how to avoid making such mistakes, I have read Jim Collins' How The Mighty Fall, which presents institutional decline as a staged disease. Collins develops a framework for identifying great companies, which are on the path of decline and fall. Here are my notes on Collins' framework.

Stage 1: Hubris Born of Success

For Collins, this stage is characterized by a change in the internal orientation of the company from an emphasis on understanding why you adhere to certain practices, to simply insisting that they are best. This in turn might mean that management stops focussing on the core business, failing to renew obsessively. Thus, the primary flywheel is neglected. 

Stage 2: Undisciplined Pursuit of More

Contrary to popular belief, not a lack of innovation, but overreach is the more common cause of decline, particularly for great businesses. This is for two reasons. First, when hubris kicks in, bravado (not insight and understanding) starts to drive decisions. Second, when businesses start to pursue new projects outside their circle of competence without the right people, they are forced to institute bureaucratic processes. Collins would say a culture of bureaucratic mediocrity replaces a culture of disciplined excellence.

Stage 3: Denial of Risk and Peril

This follows from stages 1 & 2. Management starts to "discount negative data, amplify positive data, and put a positive spin on ambiguous data". The last of these three is perhaps most dangerous. In stage 2, businesses take undisciplined risks. In stage 3, leaders fail (i) to cut losses when the facts change and (ii) to maintain a sharp focus on customer loyalty and stakeholder engagement.

Stage 4: Grasping for Salvation

Companies may stumble towards the end in stops-and-starts. Along the way, there are always moments of exuberant hope. A charismatic visionary, bold and revolutionary bets, that much-mentioned hoped-for-blockbuster. People become so desperate to avoid the worst outcome that they cling to the few straws (frayed as they may be) of hope. However, as is the case with a critical patient, the next speed bump is only too often around right around the corner. As goes the discerning Buffetism, turnarounds seldom turn. 

Stage 5: Capitulation to Irrelevance or Death

In Stages 1-4 organizations burn through cash. By stage 5 they are mere shadows of their former selves.

I find this this framework super useful. But, as a rookie, small investor who is not privy to the internal workings of a business and cannot meet management, I am faced with a practical issue: how do I determine if the silent creep of impending doom has set in? Collins' book suggests the following markers which one can look out for in company presentations and transcripts.

• Good decisions are attributed primarily to skill, and bad ones to luck
• Management exudes a know-it-all attitude
• M&A inconsistent with core business and values
• Personal interests are placed above organizational interests
• Management bets the ranch on grand visions and complete overhauls as opposed to taking a build, test and grow approach. 
• Hype about the future and insufficient focus on risks
• Constant reorganization and chronic restructuring
• Leadership churn
• ALSO: Watch out after a legendary leader steps away