Sunday, February 2, 2014

Business is complex

Not many things in life are simple or straight forward.  I changed the headlight in my wife's car yesterday.  What should have been a simple task was needlessly complex and at one point involved the removal of her front grill.  Most things are complex; relationships are, success is, parenting is, diet is.  And of course business is complex as well, although if you read enough blogs, academics, and armchair CEO's you'd start think otherwise.

Giving armchair advice is a well honored tradition in the US.  Across the nation tonight tens of millions of viewers will be lounging on their couches offering advice on what the coaches and players should be doing.  Disregard the fact that most of them couldn't catch a football, or run 100 yards, it doesn't matter, these viewers are suddenly experts and know better than participants on the two best teams in the league.  As in sports the same is true with business.

Investing is mostly a passive activity, we read about a company, make a decision and then wait.  During the length of our investment we might witness a management team's mistakes, or their actions which result in success.  Unless we're an activist investor we are simply watching from the sidelines.  We commit our capital and hope things work out, it's an educated hope, but still a hope.

While we wait for an investment to work we might read about the success and failure of other investments or companies.  Eventually with enough experience, or enough reading we start to think that we know what a company should do.  The problem is reality is no case study.

The business world is much slower than we'd like, and full of emotions and relationships that drive decisions.  All things that we aren't privy to on this side of the screen.

My favorite type of armchair advice that's offered to executives is on the subject of turnarounds.  I can't tell you how many write-ups I've read where the author will offer up a few simple steps, which presumably if taken will fix everything.  If only life were that simple.  I sometimes wonder if success were so simple why don't these authors write the CEO and offer their advice.  Maybe the CEO never considered trimming unnecessary expenses, or increasing sales, or expanding geographically.  We're only fooling ourselves if we think that management is really that dense.  Do you think they never considered selling their crown jewel property, or making staff cuts?  If increasing sales is really that simple why aren't sales increasing?

To understand why a turnaround, or fixing business problems is so complex let's think through some paradoxes.  Why is it that a store can have three locations doing the exact same thing with varying sales?  Why do some stores underperform?  When management scouted locations they thought they had a promising location that could generate sufficient traffic, why would they knowingly open an underperforming location?

Why is it that something that was a popular and successful brand a decade ago can be a has-been brand today?  Why did consumer tastes change such that the company, which continued business as usual failed?  Why can two companies develop a similar product and one company finds success with it while a second company experiences failure?

There aren't simple answers to any of these questions.  There could be a different explanations for each situation, but most resolve around people.  A business is a collection of people all attempting to move in the same direction and accomplish something together, which is generating a profit.  Some groups of people do this better than others for reasons too numerous to count.

A company with a distinct competitive advantage can lose it if a few key personnel leave and the company's culture changes.  Likewise an underperforming company can become a cash machine with new management that understands the market and is able to motivate employees.

The problem for investors is that we don't and can't know any of this without knowing both management and their employees well. Sometimes managers or employees make what seem to us like strange decisions because their careers and paychecks are on the line.  Or maybe there's a key employee who can make a strong and compelling argument that the market will turnaround, or a key asset shouldn't be sold, we just don't know.

I'm always wary of academics, or investors who will offer drive-by advice on how to fix a business situation.  A company will encounter trouble and suddenly a college professor or portfolio manager will offer a few platitudes that if the company implemented would solve their problems.  If all it took were mental models, or case study solutions why aren't professors or portfolio managers ever CEO candidates?  I've seen the opposite happen, a portfolio manager gets voted to the board of a holding and suddenly the easy solutions aren't feasible, and making changes at the holding are more difficult than expected.

The question is how do we get comfortable making an investment without interviewing every employee at the company to understand what's happening?  I think the answer is we need to let the company's financial results speak for themselves.  A company with excellent management and an exceptional culture will have exceptional results.  Every company claims to have a great culture, true outstanding cultures will be set apart by superior results.  Similarly a company with poor management and poor culture will have poor results.  The best way to invest in a turnaround is to invest after the company has already started to turn around.  Management will have shown via the company's results that their actions have been successful.

I think there's a misconception about how I invest at times.  I like to buy cheap companies, and cheap assets, but I prefer to avoid turnarounds.  I prefer companies that are ignored and misunderstood, or that have under utilized assets.  It's hard enough to run a successful business, it's even harder to change a company's culture, or to turn around a company that's encountered difficulties.

Business is complex, there are many seen and unseen factors that influence decisions.  The sooner we recognize that, and accept it the better off we are.

5 comments:

  1. I cannot agree more on this post.

    A lot of times we observed genius investors jumped out, making presentations on how to unlock enterprise value if they are in control of the company. For example, if the target company is a prestigious retail operator and owns a lot of real estate that are on books at historical prices, these genius investors would say something along the lines of "let's create an entity and let the parent company do a sale-and-leaseback with that entity, so the parent can receive the real estate value.". Unfortunately, we see times and times again that it is easier said than done. (e.g. Edward Lampert & Sears, Bill Ackman & JC Penney , Target, Borders)

    I am not listing the above mentioned failures to disparage these famed investors. It almost seems like they get involved with the company to prove that they are more than good investors, they can be turnaround specialists as well. However, I am thinking that if a company needs a significant amount of financial maneuvering, operational overhauls, and management changes, then it is hard to say this company is undervalued. The value might be there no doubt, but the realization of value is also important. If the realization is unnecessary difficult, then it is better to use our time to research on simpler ideas.

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  2. Great read! I would add that you can just play probabilities as well by investing in a diverse group of companies with characteristics that have been shown to beat the market -- not always a need for very deep analysis. They don't even have to be traditional value metrics, either. Two that come to mind are investing in firms with management that have large personal holdings in the company or management that is buying a lot of stock.

    Cheers,
    Evan

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  3. Nate, really nice post. I agree, it's easy to pass judgment sitting on the sidelines. Like calling the Bronco's loss an embarrassment. I'd like to see that reporter go out and take a couple of reps on a pro football field and see what happens.

    Mike

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  4. Got to disagree on this one, at least partially.

    My favorite part of writing articles is offering free advice. As to if it is generally useful or not, does it matter? The risk/reward is enormous. The cost is almost nothing and the time spent by a decision maker to read it is what, 30 seconds? If it is helpful, it might change things, if not, it is safely ignored.

    Sometimes an outside perspective can actually help, and sometimes easy solutions really are that - easy to see for one not immersed in pressing, yet non-strategic details.

    As for the large shareholders who press for change - I think if we had more of it, the corporate business world would be a better place. I see the problem of complacent, under-invested and under-committed management as far more significant than the annoyance from investors who might broadcast ideas that are not helpful.

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  5. Hey, you should have a look at TGL.TO (TGA for US) or SWE.V (TSX Venture)

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