Variant Perceptions

Category: Buffett

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

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.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.

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A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.

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Munger on the perfect turnaround

GEICO is a very interesting model. It’s another one of the hundred or so models you ought to have in your head.

I’ve had many friends in the sick business fix-up game over a long lifetime. And they practically all use the following formula—I call it the cancer surgery formula:

  • They look at this mess.
  • And they figure out if there’s anything sound left that can live on its own if they cut away everything else.
  • And if they find anything sound, they just cut away everything else.
  • Of course, if that doesn’t work, they liquidate the business.
  • But it frequently does work.

And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.

All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there.

And when you think about it, that’s a very simple model. And it’s repeated over and over again.

And, in GEICO’s case, think about all the money we passively made…. It was a wonderful business combined with a bunch of foolishness that could easily be cut out.

And people were coming in who were temperamentally and intellectually designed so they were going to cut it out.

That is a model you want to look for.

Charting Banking XXIII: tangible common equity

More than 3 years after Lehman, I continue to get involved in board discussions over the uses of the tangible common equity (TCE) and its close relative the TCE ratio.

TCE ratio = Tangible Common Equity / Tangible Assets

I am not a fan of using TCE for valuations, very seldom you will encounter a bank going through an orderly liquidation. In good times earnings show and in distressed times, like the ones we live, is precisely when banks can not liquidate orderly. They either,

  1. Survive: and go on to live better times
  2. Dilute: increase capital to navigate bad loan issues
  3. Sell: to a bidder with the balance sheet to navigate the bad loans
  4. Collapse: so who cares about valuation after a wipeout

Surprisingly, most capital raised has been negotiated around TCE multiples, usually close to 1x TCE. To have a future it is first essential to survive the present so capital sets the rules. I will argue though that with credit issues declining fast, current and potential earnings multiples should increase in importance. The age of TCE multiples should and will recede.

The second use of TCE, and the one that I personally use, is the TCE ratio. A measure of leverage and its close cousin: excessive risk taking.

Why the TCE ratio and not all the other capital ratios that regulators use for capital adequacy, like tier 1 leverage, tier 1 capital, total risk? I am old-fashioned, and I think it is important to be skeptic of measures that open opportunities to hybrid capital, that is partly debt, or use “risk” weighted measures of assets, when there are no “safe” assets only safe underwriting. When financial booms come, hand in hand with financial deregulation argued for by the banks themselves, exoteric metrics can easily hide or tempt risk taking.

Leverage is not the only way that banks can take risks, bad loans and investments are even worse. But a risk taking bank will pull all levers and high leverage is a good warning signal. For example, let’s see the TCE ratio for American banks at the bottom of the 2009 crisis.

It does not look like all banks were pushing the envelope but what about the Big 4! Some will argue that these are precisely the banks with high pre-provision profitability to cushion the crisis, with Warren Buffett one of them, and it has some truth.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do. (…)

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Even more, I would argue that this set of banks was not even very responsible for the bubble. Investment banks and other banks that had already collapsed should carry more of the blame.

But add a fizzing real estate bubble to large real estate loan and securities portfolios. Who should you trust with this mounting evidence of too much risk taking? Or as Buffett would say

banking is a very good business unless you do dumb things

So with all the complaining about the new emphasis on the TCE ratio in the dark days of 2009, I wonder … what was new? Banks lobby for deregulation and more leverage only later to complain of regulation “overreach” . The system flatlined only because they asked for the rope to hang themselves.

And let’s not forget that capital for the whole system is important. Capital works as a cushion and help banks to recognize loses faster instead of gambling on a rosier future. To be the lonely good bank, and most were prudent, when the national banking system is collapsing is no consolation. As the Bank of Ireland sadly learned.

The flip side of the TCE ratio is that its improvement also signals banks reducing risk, voluntarily or not, and the progress has been spectacular.

What about Europe? As is public knowledge, European banks have their issues. And it is not just the sovereign debt exposure. Some big banks need capital and the TCE ratio is one if several guidelines that hint on this despite all their complaining.

Does this mean that the American banks are threatened? Good banks but sadly part of a collapsing global banking system?

Not so fast. Retail banking crisis are more of a local/national affair connected to local/national deflation. International assets  are usually not big or risky enough in retail banks balance sheets. But that is an assumption that must be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.

Charting Banking XX: short history of the last 25 years

US Bancorp is a great bank, did a great job navigating the crisis and is a Buffett stock. I just wish it was cheaper.

This March 2007 presentation on the business of banking was first shared by Noise Free Investing and I was reminded of it while looking for some info for the Charting Banking series. Some of the interesting points are:

  • Importance of fee income
  • Sector consolidation after the 1987-88 crisis
  • Branches are still a key asset
  • Non bank competition / shadow banks share (the info I needed)
  • New risks in modern banking
  • Regulation as a friend and a barrier to entry (Walmart?)
  • Customer loyalty and how to measure it
  • Supermarket banking shortcomings

Thinking about investing in insurance companies?

I made a mistake in the last post. How could I possible hide some interesting data in an inconspicuous link at the end of a boring side comment? David Merkel deserves better than this.

These are the historic reserve deficits of some large insurance and reinsurance companies with long tail risk. His main target was teflon Hank Greenberg that has been denying any responsibility in the AIG debacle. Some chutzpah given all the evidence indicating compromised underwriting standards, under-reserving, increased leverage and declining ROA under his reign. AIG Financial Products and its CDSs were the last consequence of Greenberg’s risk taking leadership and his nonnegotiable 15% ROE target: the ultimate yield hog

But that is old history, soon to be forgotten to become the foundations of the next bubble. Much more interesting for our own purposes is David’s heavy lifting in evaluating reserve practices of such interesting companies like Berkshire, Markel, and White Mountains.

I know that David has liked PartnerRe for a long time and now it is at a probably conservative 0.76x book value. Cincinatti Financial is one that I have not analyzed either but it is priced at 0.88x book value. If you are interested, I suggest to check their investment record and current portfolio; if we are taking long tail risk please tell me that at least we are doing something interesting with that float. They do not have the investment reputation of a Berkshire or a Markel but that just might be appearances.

Probably the most surprising chronic under reserving is White Mountains. For those that do not know, White Mountains has been a staple of value investing portfolios and they themselves were early investors and promoters of Michael Burry’s Scion Capital. And as David mentions, conservative accounting is something they talk about. Does anyone have absolutory or confirming evidence?

As a passive investor, I tend to avoid long tail risk insurance companies like the plague. David’s work is rear view, an evaluation of past decisions, but you can not be sure about their current ones in a soft pricing environment. Even risky banking construction and development loans have durations of just a couple of years, so many of the big bad C&D loans are probably behind us. That is not the same with long tail insurance and when things go sour, turning around an insurance ship with long tail inertia is a Titanic work.

I am also a skeptical man, how can I be at ease with an investment based on management’s pedigree when so much is at stake? It is not that I distrust them personally; it is about having seen from the inside that controlling the commercial areas is an almost impossible organizational act. If you want to know more about the gap of what is needed and what we have, you should read about how National Indemnity operates in Buffett’s letters.

Some well respected companies like Fairfax Financial had their share of problems in the early 2000s and an old standing company like Lloyd’s was brought down to its knees by the weight of asbestos claims. Bad underwriting and reserving can bring down even short tail risk companies like Lincoln General: former part of Kingsway Financial situation currently under litigation.

Not to detract from a beaten sector, but at current prices personally I am preferring other alternatives in the financial sector.

PD: If someone has done or seen similar analysis with Fairfax Financial, Montpellier RE, Greenlight RE, Aspen or others, could you be kind to share it with us mere mortals? Too busy analyzing other financials.

No position

The art of profitability

I am a better investor because I am a businessman, and a better businessman because I am an investor – Warren Buffett

This book review is a lot about me, and at the end you will find a book and how it inspired me. I will not try to sell you that nonsense that my story can help others. I just felt that my journey overlaps with the story, and since I know myself pretty well and want to know myself better, I thought they complemented well. So please, if you do not like too many I’s and me’s just skip them and go directly to the book review.

Some of us have followed the roundabout way to become an investor. After three years in the investment department of a small insurance company (two people, the CIO and myself) I decided that it was more fun to learn about good businesses and not just to invest in them. I have had enough of dealing with brokers and their nonsense pitches, fund managers high on themselves while copying each other, and internal politics with a focus on outcomes instead of processes. In summary, I was not learning much.

So enough! Time to know about good businesses and how to run them. So I cashed my investment profits and moved to the US to study an MBA. Some of you will laugh at that thought but it sure started a fun journey.

If I ran a business school there would be only two courses: how to value a business and how to think about markets. No modern portfolio theory, no beta, etc. – Warren Buffett

Most of you will realize that Warren Buffett is clearly thinking on chapters eight (Mr. Market) and twenty (Margin of Safety) of the Intelligent Investor in that quote. It is also clear that he made that comment for effect: his target was the foundations of modern finance.

Having had the fortune and misfortune of also completing an MBA, I think the quote focused so much on that very deserving target that it missed the mark on other aspects of an MBA and of being an investor. First of all, even for an investor I would add at least three courses to that curriculum

  1. How to find good, cheap and safe ideas? (Greenblatt and K. Fisher, also competing for worst book title ever)
  2. How do I manage a portfolio of ideas across the credit cycle? (Lynch and Klarman)
  3. What can we learn from history? (Kindleberger and Livermore)

Because for an investor reaching a certain size or managing other people’s money, net-nets are not enough. The framework stands, but he should also become a good sociologist, risk manager and historian.

But even more, the output of business schools is not supposed to be investors but businessmen (not that they are doing it). These are some of the things a businessman should know:

  1. What is a good business?
  2. How good businesses start, grow and decline?
  3. How do you reinvigorate a business?
  4. What is good management?
  5. How do you manage a portfolio of good businesses?

And of course, negotiation, motivation, networking, all that soft stuff …

This is a different journey, from economist, passing through historian, entrepreneur, sociologist, and finally becoming … an investor. This knowledge is a good fit to the basic investor arsenal, as Buffett hints on that initial quote, and is usually learned over time. Others, like me, decided to learn it at the beginning and realized at the end that there was more about investing that you thought.

So being a sui generis investor let me suggest a book from this other path. A book that I am almost sure you have never heard before. A book that tries to answer that first question: what is a good business?

The Art of Profitability was written by Adrian Slywotzky a management consultant VP of Mercer (firm that I think changed its name to Oliver Wyman after the merger). Maybe for these reasons, the book carries the consultant sins of trying to put new names to known things, being self promotional and somewhat condescending in parts. But if you look beyond those flaws, you will find an honest and inspirational effort on teaching how to learn about profits and good businesses. And if you can believe this former management consultant, Slywotzky is very good.

  • Its focus, while teaching all these business models, is in the process of learning and how to inspire a newcomer.
  • It is not your usual dry checklist of what a good business is, like Porter’s Competitive Advantage, but a list that can be added, combined and transformed.
  • Provides a fantastic list of business cases and books on a wide range of subjects to explore the limits on how to create profits. And I assure you, no matter how experienced you are, you will learn a trick or two.
  • Inspires not only to read a second time Sam Walton’s Made in America, but also a third and a fourth.
  • Made me realize that I may have known pretty well Berkshire Hathaway as a business but that I had missed Warren Buffett the investor. Believe it or not
  • It emphasizes the importance of measuring things while avoiding being more precise than necessary (Cuánto!)
  • Can be a good reference book to be reminded of the simple but not simpler in business, side by side to Updegraff’s Obvious Adams.
  • It asks more good dumb questions than it answers.

In short, it is the sort of book that starts a new learning journey. Go and read those first six pages of the prologue in Amazon. If you get hooked, believe me that the rest of the book is much better. And by the way, the first time I heard about Graham and Dodd was in the The Art of Profitability

You must think independently and you must think correctly – Graham and Dodd

Charting Banking II: net interest margin

Net Interest Margin (NIM) = (Interest Income – Interest Expense) / Earning Assets

In simple terms, what a bank does? It borrows money to lend it. That has been historically its main income source until recently, when fees became important. The net interest margin therefore is a very important metric, equivalent to the cost of production of a commodity producer. You will see in the chart several banks that Buffet has had for a long time with very high NIMs, starting with Wells Fargo of course.

With the interest spread becoming more favorable the net interest margin of several institutions has been expanding. For several of the represented banks the NIM is higher than 3% close to the times where they could borrow at 3% lend at 6% and be in the golf course by 3. The old 363 rule, from the times when there was no significant fee income.

Not all bank institutions (Banco Popular BPOP) are in that expanding NIM sweetspot yet since their non accrual assets, very closely related to non performing assets NPAs, can be a drag in the interest income. But NPAs do not even need to improve to start having a positive effect in NIMs, they just need to stabilize.

No Position

Maguire Properties, a tale of two cities (Part I)

Even during TCI’s most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one “compartment” (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole) – Investor’s Consigliere Blog

At MidAmerican, we have substantial debt, but it is that company’s obligation only. Though it will appear on our consolidated balance sheet, Berkshire does not guarantee it. Even so, this debt is unquestionably secure because it is serviced by MidAmerican’s diversified stream of highly-stable utility earning – Warren Buffett

“In my 40 years in real estate, I’ve found there is only one metric that matters replacement cost– Sam Zell

If you want to invest in hard assets (real estate, utilities, gas pipelines, oil fields, shipping, etc), you need to know how to analyze debt quality. I am not fan of debt, but most of the companies in this arena use easy credit in boom times taking advantage of their tangible and tradable assets, or collateral as bankers call it. Collateral makes it so much easy. So if you want to profit from busts in these cyclical industries it is important to separate those that were prepared for the bust from those that were just trading stinky sardines.

To make things as easy and illustrative as possible, I am going to use as an example Maguire Properties (MPG). What I like about this example is that it is a pure equity REIT buying and developing properties with debt. No investment in CDOs, CMBSs or RMBSs like a mortgage or hybrid REIT. In summary, no weird instruments that could obscure the lessons of non-recourse debt, stable earnings and buying below replacement costs.

So we are clear, I own MPG stock but it is a small position. There are still some necessary steps in the turnaround and it is just beginning to solve its issues. MPG is unusual both because of the quality of its assets and scale of its debt. The company has assets of $4.2 billion and liabilities of $4.7 billion. So $500 million of negative equity? Yes, but please bear with me.

Robert Maguire is the 74 years old founder and former CEO, fitting so well the part of gutsy developer that it is almost tragic. He built several of the most prominent skyscrapers in downtown Los Angeles. The Downtown skyline is dominated by Maguire properties: Gas Company Tower, One California Plaza, US Bank Tower, Two California Plaza, and the Wells Fargo Tower.

MPG problems can be traced back to the $3 billion purchase in 2007 of a section of Equity Office Properties from Blackstone Group that they had just recently bought from Sam Zell in a legendary deal. These deals were made at the market’s top and included office buildings leased to brokers and financial institutions in Orange County that were at the epicenter of the mortgage bust (i.e. New Century).

Facing a stock price tailspin and concerns about MPG’s financial strength Robert Maguire tried to raise money to take it private. Having failed, he stepped down as chief executive in May 2008. Those of you that have followed the Premier Exhibitions posts know how I consider waiting for change of management a critical first step before investing in a potential turnaround. And that is even truer when the CEO is a brilliant, gutsy and stubborn founder.

Well, it is more than a  year since Robert Maguire’s departure and only recently good news are starting to surface.

  1. MPG announced in August that it was handing over the keys to seven of its office buildings in Orange County and Los Angeles to lenders.
  2. On December, MPG announced they sold one of its prized properties: the Lantana Media Entertainment Campus, home to several entertainment firms (i.e.: Larry David Productions of Seinfeld and Curb your Enthusiasm fame). The deal was valued at more than $200 million. Minus $175 million of debt it should report a profit

How is it that abdicating properties or selling prized ones for a small profit improves the prospects of a company? That is the power of non recourse debt. But to understand what is going on, it is important to lay down the investment thesis that is the subject of part 2.

Long MPG

Turnaround Cases: Premier Exhibitions Part 1 ($PRXI)

A great investment opportunity occurs when a marvellous business encounters a one-time, but solvable problem. You just need to know the business to recognize this – Warren Buffet

So after reviewing some situations where a turnaround was threatened by tough issues that were not completely on management’s control, we now move to situations where the core business is healthy but the performance has been compromised by solvable issues. This is usually the result of bad luck (it sometimes happens), internal issues brought upon themselves by incompetent leadership or by management’s inability to rise to a solvable new challenge.

What is the point of having a blog and end discussing examples with a strong consensus. Instead I am going to propose a controversial case: Premier Exhibitions (PRXI). You probably never heard that name before but you probably heard the names of its two exhibitions: Titanic and Bodies. Both are hit shows not only in the US but around the world and both continue to attract crowds. Bodies shows cadavers treated with a technical process that makes them viable for exhibition and Titanic shows pieces recovered from the wreckage. Someone appropriately used the adjective macabre to describe the situation however that is not necessarily bad. As Peter Lynch once wrote

Something that makes people shrug, or turn away in disgust is ideal – One Up on Wall Street

If you agree with that statement then Premier may be your kind of stock. This is a company well known for value investors since Mark Sellers, a respected hedge fund manager, is its majority shareholder. There are several articles on Premier’s good economics and the potential value of its Titanic assets so I am just going to make the introductions. Dear reader, here is Premier Exhibitions:

Most of these articles were written before Premier hit an earnings bump. That bump’s cause, consequence, solution and opportunity are going to be the topic of several posts, but as an appetizer let me show you the historic stock price:

Wow, that is what I call a rise and fall. You just have to go through Yahoo’s board to retrace the story and is really something. You can read how early adopters bought the story of the unrecognized Titanic assets, were joined later by growth investors that valued the successful new Bodies exhibition, how pricing got out of hand with momentum investors pumping pie-in-the-sky projections and the sudden collapse. Now it had gone full circle becoming a value stock again: I recommend you to check the Complete Growth Investor podcast on Premier and get their free report. This is indeed the story of an Icarus growth stock.

The collapse has wrongly been attributed to the 20/20’s attempt on character assassination of Bodies –that I still recommend to watch, also here is Premier’s response – and the settled investigation of the bodies’ origin. To the contrary, both were short term attendance boosts because as we know there is no such thing as bad publicity.

The reason for the collapse was simpler: an outsized and undisciplined organization built by an entrepreneurial one man rule seeking growth on too many fronts without the needed processes to manage that growth. This is a story repeated time and again that has been the subject of some best sellers like “Inside the Tornado” and “Build to Last”. I do not offer these books necessarily as testaments of good research but as witnesses of the topicality of the challenge.

All investing is risky and growth stocks have their particular set of challenges. Their stocks multiples can collapse fast when earnings or growth disappoints. And the probability of disappointing is higher than people think: these are some Bain and Co. estimates of success for growth initiatives

Growth

If this is not material for a good series, I do not know what is. It certainly has drama. In the next part we are going to address the story of Premier’s collapse and discuss if it is solvable.

Long PRXI

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

Core

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.