Wednesday, June 1, 2016

Three Lessons from Dead Companies Walking

An important element of selecting companies with the ability to continually grow their dividends is weeding out organizations that are on the path to failure. For this reason, Scott Fearon's book Dead Companies Walking was the most useful investment book I have read in the past year. Not only does Scott indicate the six common mistakes that he looks for before short-selling a company's shares, he also writes about attributes to look for in long-term investments and shares how to become a better investor.

Six Common Mistakes Unsuccessful Companies Make

Through numerous real world examples, Scott expands on the six common mistakes that leaders of unsuccessful companies make.

1. They learned from only the recent past

2. They relied too heavily on a formula for success

3. They misread or alienated their customers

4. They fell victim to a mania

5. They failed to adapt to large shifts in their industries

6. They were physically or emotionally removed from their companies' operations

Of the above six mistakes, numbers two and four really hit home with me. Despite being comfortable with my position in six of the seven biggest Canadian banks, their annual exercise of raising retail banking fees in their Canadian operations while cutting personnel costs is unsustainable in the long-term.  Banks that rely on the same formula will no longer see any new investment dollars from me, as I will instead direct those new funds to financial institutions who focus more on international growth and investments in technology (i.e. TD Bank and Bank of Nova Scotia). My personal observation regarding manias is that they tend to happen with more frequency. The dot-com bubble, automobile manufacturer meltdowns, sub-prime housing lend crisis, and the current oil market mania all abruptly impacted multiple areas of the economy and the effects were long lasting. Leaders of companies must quickly identify and react to the various manias in order to ensure survival.

Also worth noting is that Mr. Fearon raises a key red flag to look for in companies that are in the process of failing. Seeing a company's revenues fall while their debt is growing is an important warning signal for all investors. When companies need to access external capital to finance their operations for an extended period of time, it proves the organization is not self-sustaining. When external sources of debt financing dry up, companies will try to tap shareholders for their capital needs. For investors, this will result in a diluted stake in a failing business.

What Makes a Good Long-Term Investment?

What jumped out at me most in Scott's book was the importance of continuous improvement and innovation if companies want to experience long-term success. We seem to be entering an era of business in which a disproportionate large share of revenues and profits go to winning companies. Category killing organizations like Amazon, Google, and Netflix are dominating industries that they themselves help create, while displacing traditional industries. Mr. Fearon argues that you cannot put a price tag on a company's ability to continue to innovate, a point on which Apple's current shareholders would likely agree.

Mr. Fearon also notes that organic growth, whereby the company expands slowly through reinvesting their operating cashflows into the business is a characteristic of a winning company. Although this path to growth is slower than borrowing to acquire another business, it shows that management has the patience to first generate profits, and the mental discipline to reinvest them into projects with positive returns on investment.

If a strategy is not working, management has to demonstrate the mental flexibility to abandon it, and go in another direction. Instead of blaming things outside of the company's control (i.e. the weather, the stagnant economy, government policies, etc.) management has to accept the blame themselves, and move onto another strategy. Scott talks about what a good quitter he is, and how much money that has saved him as an investor over the years.

Becoming a Better Investor

Flexibility is also key to growing as an investor. Scott talks about how he missed out on investing in Starbucks and Costco because he was very stuck to his 'Growth at a Reasonable Price' philosophy. A lot of us in the dividend growth community are susceptible to group think and ignoring other investment philosophies if we become too set in our ways. One of the reasons I bought two ETFs for my son's RESP was in order to test a different strategy. The benefits and lower maintenance of index investing are hard to argue against. On a similar note, Scott indicates that the ability to exit losing investments quickly is essential for investors. He notes that his philosophy of "quitting early and quitting often" has helped him preserve capital.

The second last chapter of the book is incredibly negative on the american financial industry. Scott discusses the various tricks and frauds that financial companies and investment houses commit in order to separate investors from their money. He goes onto say that the SEC and other entities whose job it is to regulate the financial industry are under-resourced and do not perform their functions as they should. Simply knowing that a financial advisor, bank representative, fund manager, or company executive has their best interests in mind, and not yours, should have help you as an investor. You are the one who cares the most about your financial situation.

Conclusion

I agree with Mr. Fearon that failure should be recognized and even celebrated in the investment community. After reading his book, I am much more open to the concept of short-selling stocks, as failure is a natural and normal part of the business process. Regardless of what type of investor you consider yourself to be, I highly recommend you take the time to read Dead Companies Walking.


Having you ever considered shorting a company's stock? If so, which company?






2 comments:

  1. Great post, DiH. Those are some of the attributes that I notice with some of my holdings as well....as such Ive started cutting out some of the losers and am further considering a few more.

    R2R

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    1. Thanks R2R. I meant to comment on your excellent post last week 'Multipronged Approach to Investing'. We seem to share the opinion that most dividend growers are overvalued at current levels. Best of luck with your recent contrarian purchase of Silver Wheaton!

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