Turnaround Lessons: When the tough gets going
I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over – Warren Buffett
Eastman Kodak should be an eye opener. Some turnarounds are just too tough.
So I decided to go over my watch list and highlight the ones that look difficult and not ready for the prime list. They are guilty until proven innocent: they have to show that things are improving, according to plan not from a stroke of luck, before considering them again. I then went through the list and classified the reasons why I disliked them:
- End of a Demographic Trend (Gap)
- Technological Disruption (Kodak)
- Power Shift in the Value Chain (Newell Rubbermaid)
- Deteriorating Industry (Mesa Airlines)
- Threat of New Business Models (Dell)
- Second in a Winner Takes All (Yahoo)
- Quantity, Quality and/or Structure of Debt (Anthracite Capital)
- Marginal Player (too many to mention)
Let’s leave the point of quantity, quality and structure of debt for a future post since it merits its own discussion. The commonality among the rest is an external threat to the core long term profitability. That makes them tough:
- Success is not entirely dependent on the company
- Even good management performing at its best could fail
To enter new industries, launch new products, develop new capabilities, change business models is risky revolutionary change. Here are some Bain & Co estimates on the probability of success of different radical solutions to a deteriorating core business
The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.
A good financial position, like Dell’s or Yahoo’s, can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.
So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.
The first time I heard the term value trap I could not understand what it meant. Why not simply call it a mistake?
I think I can now define one specific situation for a value trap: a good company, facing deteriorating profits forced by external forces, with a good management team, hoping to save the business, but that is taking too much of a gamble on a low probability plan.
Maybe this framework could be the start for a checklist on recognizing potential value traps, and put them at the level of others potential mistakes that need an extra margin of safety.
Did I depress you enough? Over the next posts I hope to brighten the spirits.