Business Failures Six Signs

Telltale Signs

While there are many ways that businesses can fail, typically business failures can be categorized into

one or more of the six following general categories. When considering a potential short sale that is not

a clear fraud or fad (see previous article), try to identify which key error(s) the business is making that

will cause it to fail.

1) The company fails to respond to gigantic changes in its industry

This category of business failure tends to make for the most dramatic of short-selling opportunities.

Examples include when Apple totally transformed the smartphone industry, and competitors such

as Palm, Nokia, and Research In Motion totally missed the boat, resulting in near total losses for

shareholders. The fall of Kodak, which utterly failed to respond effectively to digital photography

offers another iconic example. (see our case study on Kodak here) The fall of the newspaper industry is

another sterling example of what happens when companies fail to adapt properly to a rapidly changing

industry.

2) The company’s management is not physically or mentally tied to the company’s operations

When looking for great investments, you want to see a management team that is hyper-focused with

operating the business, and has its incentive structure aligned with the business’ ongoing success.

The alternative, an unattached and disinterested management team, can be a great indicator for short

sellers. A prominent current example would be Ron Johnson, J.C. Penney’s former CEO. He refused

to relocate to J.C. Penney’s headquarters after he was hired away from Apple. Located far away from

the company’s headquarters, his management was notably out-of-touch with the company’s culture, and

during his tenure the company suffered a disasterous 25% fall in same-store sales as it drove away its

customers. Removed from the day-to-day affairs of their businesses, long-distance management teams

generally struggle to deliver satisfactory results to shareholders. As short sellers, that’s exactly what

we’re looking for.

Mining companies are a good industry to look for this particular problem. Many management teams

of companies producing or exploring for gold and other metals have properties in far-flung developing

countries while their management team holes up in cushy Canadian head offices thousands of miles

away from the action. When companies are blindsided by “unexpected” problems with local resident

opposition or government pushback, the management team is often countless time zones away, and

unable to adequately address the situation. On the other hand, when the company’s management lives

near the mining operation, it tends to be more proactive in managing risks and has a better handle on

local political and environmental risks.

3) The company became entranced with some financial mania

This sort of failure tends to occur when a large wave of investment hits an industry and causes

companies to lose base with reality. Notable examples include past investment bubbles such as the

internet boom of the late 1990s or the subprime housing craze of 2004-07. It’s easy in hindsight to

make fun of companies that did foolish things during these past bubbles, but in the moment, it’s easy

to get lost in the hype of a new technology or new financial product that seems to have altered the

business landscape. Be very wary whenever the words “This time is different,” are spoken regarding an

investment idea.

In can often be risky to short companies in the middle of a euphoric bullish move, many short sellers

suffered ruinious losses prematurely shorting during the internet bubble, for example. One better

alternative is finding companies who are adjacent to the impacted industry, and seeing if they make

irrational decisions to try to capitalize from the hype in the neighboring industry. For example, instead

of shorting homebuilders directly during the housing craze in 2005, instead you could have looked at

the regional banks and insurance companies that were underwriting the homebuilders and subprime

borrowers driving the boom.

Searching there, one would have found vulnerable businesses such as Ambac, MBIA, and AIG that

were all taking catastrophic risk in return for receiving modest upside from the housing boom. This

offers an ideal risk/reward profile to short sellers who suffer manageable losses if the short idea doesn’t

work and reap a windfall if the financial mania does indeed go sour. Unlike a, say, homebuilder

whose stock could easily double or triple during a housing boom, numerous companies in industries

adjacent to the housing boom garnered only moderate incremental gains from the hysteria but suffered

catastrophic losses when the mania subsided.

4) The company based its decisions on the recent past

There are several errors that fall in this category. All suffer from a general hystorical myopia where

management focuses only on the recent past. One type happens when management bases its investment

and debt leverage levels on recent industry cycles. For example, imagine an airline that bases its new

airplane orders based on traffic data over the past 20 years. Every time their seats fly more than 80%

full on average, they step up new orders, and every time seat capacity utilization falls below 70%, the

airline slows down new orders and mothballs some of its oldest airplanes. According to a 20-year chart

of data, the cycle always tends to hit its peaks and valleys at those levels so management confidently

uses the metric to guide its capital investment decisions.

In 1999, the airline aggressively ordered new planes as the economic boom drove passenger numbers to

record highs. By summer 2001, the slowing economy lowered demand, and the airline, seeing capacity

usage fall to 70%, decided to curtail its new orders and take a more cautious approach to managing

its balance sheet. According to history, at this level, the cycle would reverse and fortunes would turn

up. Then September 11th

drops from 70% to 30%, and the airline ends up in bankruptcy shortly thereafter.

What went wrong? Simply they extrapolated too much on recent history. Unexpected events always

occur on a long-enough timespan, and an unflexible management team will commit the company

too heavily to one set path, inviting disaster if the future diverges significantly from the recent past.

When an unexpected event like 9/11 occured, nearly the whole American airline industry, which

had “learned” that passenger demand was quite fixed when the opposite was in fact true, suddenly

ended up on the verge of bankruptcy. The oil industry at present appears to have fallen into this same

trap, having based its expanison plans on an errant belief that oil prices had entered a “new normal”

where the price would never again fall below $80/barrel based on only a few years’ worth of evidence.

Overnight, the price dropped to half that level.

Another form of this sort of historical myopia occurs when companies start imitating other recent

successful businesses. One sector where this often occurs is biotech, where one disease target will catch

everyone’s fancy. When one biotech company is acquired or a new outbreak hits the news, investors

will, like lemmings, bid up all other competitors with a drug for the same condition higher, and other

biotech companies will rush to enter the field as well. One month, everyone will be researching ebola,

hit, people no longer have any desire to fly, airplane seats capacity suddenly

the next month, they all move on to hepatitis. A management team taking its cues from what’s driving

up competitors’ stock prices – rather than focusing on maxmizing their own operations – is likely

distracted and ineffectual.

5) The company relied on doing things a certain formulaic way

These management teams tend to have operate businesses that have had a long run of success and then

slowly lose their way. The companies that fall into this trap tend to be older distinguished enterprised

with long storied histories with older and well-respected management teams. Over time, they gradually

lose touch with their customers, and as new generations come along, the company’s products or

way of interacting with clients just don’t meet with the same success as in the past. Given the recent

troubles of two storied American institutions, we’ll use McDonald’s and Coca-Cola as two examples of

management teams that may be stuck in this error.

Both companies have long relied on gigantic advertisting budgets with feel-good messages to create

iconic American brands that have been beloved for decades. Both companies had massive market share

in their core products’ spaces at their heyday, but both have been gradually losing steam in recent years.

Both companies seem to have missed the boat as far as the trend toward fresher and healthier food and

beverage choices.

In McDonald’s case, they are getting beaten by two types of companies, one that does their burger

segment better (Steak Shack, Five Guys, Habit Restaurants, In And Out Burger, etc.) and also

competitors serving a healthier fast-casual such as Panera and Chipotle. In the wake of the competiton

McDonald’s has doubled down on their old formula, using more advertising and cosmetic adjustments

to try to spice up a brand that has lost its shine. So far, management appears unable or unwilling to

make the sorts of deeper changes necessary to adapt to a new generation with fundamentally different

eating preferences.

For Coca-Cola, the company has built its empire on selling soda. Competitors, namely Pepsi-Cola,

wisely entered food and other related products to reduce its dependence on its namesake product years

ago. As soda consumption falls, will Coke be able to readjust its aim to shore up its falling reputation

and sales trajectory? The company has made forays into water, milk, and energy drinks to try to

shake things up, but so far, the company’s reliance on advertising to drive soda sales appears to have

the company stuck in a rut. If the company can’t make a better impression with increasingly health-
concious consumers in coming years, the company’s fortunes will continue to fade.

6) The company drove away its customers

Finally management teams sometimes re-make their product offering without keeping their actual

customers in mind. Ron Johnson at JC Penney illustrates this example as well. He built a store that

would be attractive to high-class yuppies such as himself, neglecting the fact that the stores’ actual

customers at the time he took over were predominately poor-to-middle class, included many Hispanics,

and bargain hunters. He removed Spanish signage from stores, made customers wanting to use cash

have to go to a special register, took plus-sized items out of the stores, and ended the company’s long-
running coupon marketing strategy. Predictably, the company’s actual customers were outraged by the

changes, Johnson was thinking of a very different idealized customer than the actual flesh and blood

people walking into his stores.

Another example comes from the video rental industry. In the late 2000s, Blockbuster inexplicably

stopped focusing its energies on its online site and refocused its efforts on its traditional video rental

stores, adding new product offerings such as video games and candy to its brick and mortar stores in

a badly misguided attempt to win back customers. This inevitably backfired, further speeding the rush

from Blockbuster to Netflix. Blockbuster soon ended up a bust, filing bankruptcy shortly thereafter.

Netflix itself squandered much of the goodwill, bizarrely seperating its DVD-rental by mail service

from the online streaming product. This greatly confused customers, causing many cancellations

and causing great harm to the company’s brand. Netflix had to abruptly reverse the change a short-
time later. When management misunderstands their customers’ wants and needs, good short-selling

opportunities often follow.

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