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Yes, Even Good Companies Go Bad

If you have read management books in the past, you would have realized that most of them exhort companies to go from good to great.

Regrettably most companies, in reality, move in the opposite direction – from good to great to good…and then they slip into mediocrity, and limp as pale shadows of their former glory.

These companies, despite being market leaders in their respective industries, see their performance take a turn for the worse.

But the question is…

Why Good Companies Go Bad?
Pick up any company’s annual report these days, and the management analysis of performance revolves around how the “global economic slowdown and uncertainty” has played spoilsport with their company’s plans.

Now, this is not unusual as managers usually draw the blame.

The CEOs offer every excuse in the book: a bad economy, market turbulence, a weak currency, competition, and other such forces that are very much outside their control.

But a close study of corporate failure suggests that, acts of God aside, most companies fall for one simple reason – managerial error, and then inaction.

Here are some interesting insights from Donald Sull, who is a Professor of Management Practice at the London Business School and a global expert on managing in turbulent markets. Sull writes in an issue of the Harvard Business Review…

Why do good companies go bad? It’s often assumed that the problem is paralysis. Confronted with a disruption in business conditions, companies freeze; they’re caught like the proverbial deer in the headlights. But that explanation doesn’t fit the facts.

In studying once-thriving companies that have struggled in the face of change, I’ve found little evidence of paralysis. Quite the contrary. The managers of besieged companies usually recognize the threat early, carefully analyze its implications for their business, and unleash a flurry of initiatives in response. For all the activity, though, the companies still falter.

The problem is not an inability to take action but an inability to take appropriate action. There can be many reasons for the problem—ranging from managerial stubbornness to sheer incompetence—but one of the most common is a condition that I call active inertia.

Inertia is usually associated with inaction—picture a billiard ball at rest on a table—but physicists also use the term to describe a moving object’s tendency to persist in its current trajectory. Active inertia is an organization’s tendency to follow established patterns of behavior—even in response to dramatic environmental shifts.

Stuck in the modes of thinking and working that brought success in the past, market leaders simply accelerate all their tried-and-true activities. In trying to dig themselves out of a hole, they just deepen it.

Effectively, what Sull is saying is that companies that go downhill often fall due to their managers’ failure to meet the challenge of change – not because they didn’t act but because they didn’t act appropriately.

The key reason this happens is that managements of these companies behave reactively instead of proactively.

The Destruction Cycle
Here’s how the “corporate destruction cycle” looks like…

  1. It starts with companies getting on a fast paced growth curve in a good economy, which their managers attribute to managerial excellence instead of the “rising pond that raises all ducks”.
  2. After a while, managers become arrogant of “their” achievements and believe they can do no wrong. As Citibank President Charles Prince uttered in July 2008, before the financial crisis deepened – “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
  3. In the high of the moment, these managers make ill-judged capital allocation decisions – expand wildly, take on unprofitable projects while compromising profits, borrow heavily to put growth in steroids,
  4. These flawed capital allocation decisions destroy return on capital and creates financial stress.
  5. Managers, while denying that there was something seriously wrong with their decisions, paddle hard under-water to get their companies. Sadly, they try to get out of trouble the same way they brought trouble in the first place. This is the phase when you hear of “business restructuring” or “balance sheet restructuring”.

Now you may say that failure is part of the natural cycle of business. Companies are born, companies die, capitalism moves forward. People call it “creative destruction”.

Yes, “creative destruction” is the appropriate term here, but what is harrowing is to see companies self-destruct themselves rather than going down fighting competitors over a number of years.

There are several examples I can think from India Inc. that have followed this cycle, and are now pale shadows of their former glory.

The route of self-destruction may be different, but the consequences have been similar.

Now, as much as their managers may try to get their companies back on survival mode, the damage has been done, and shareholders have been left holding the bag.

Here’s a partial list…

Ranbaxy – Shook minority investors’ trust during the Daiichi deal. Now facing heat from the US FDA for unethical business practices.

Bharat Forge – One amazing business that got burdened by big acquisitions, which screwed up its balance sheet.

Tata Steel – A leader in its industry that failed to see the top of the steel cycle, and made a big and pricey acquisition, for which it continue to pay even now.

GE Shipping – Got aggressive in asset building despite there being overcapacity in the market. The management that guided it so beautifully in the past could not deal with the changing market conditions so beautifully.

Sintex – Took on too much debt to fund acquisitions. Now lacks the cash flows to repay debt.

Blue Star – Got aggressive in picking up low profitability projects during good times. With new projects and order execution happening slow the business is facing bad times. The management also has a habit of laying too much emphasis on business consultants (marquee names) and altering its vision frequently.

3i Infotech – A case of a company on a treadmill of debt fuelled acquisitions, now finding it difficult to focus on the business. The ICICI parentage had to rub off!

Opto Circuits – How moats get diminished and how management silence causes investors to lose trust – a classic case study.

PTC India – A simple business with a management that wanted to focus on everything except power trading.

Now, I am not saying that any of these firms cannot recover from the situation they have brought them into. But then, the task on hand is extreme difficult, especially given that the economic growth that caused them to confuse luck with skill in the past, isn’t coming back to support them anytime soon.

Plus, these managements will have to continue to focus on fire-fighting even as opportunities may slip past.

What is more, the destructive capital allocation some of these have made over these years may not bring investors’ trust back to them.

Back to the Future
Now, you may accuse me of doing a “post mortem” of companies that have already gone from good to bad – and instead want to know which of the current good ones may turn bad in the future – and for reasons similar to those mentioned above (like hubris, aggressiveness, invincibility etc.).

Well, to show you my sadistic side again, let me tell you that there are no easy answers here.

But there’s definitely a process to identify such companies. All you need to do is identify the leaders of today…

  • Businesses that can do no wrong (or so it seems)
  • Businesses that most investors around you own (and display their pride on stock forums)
  • Businesses that have made a lot of money for you (or others) in the past
  • Businesses that seem invincible – High return on equity
  • Businesses growing fast – High sales and profit growth
  • Businesses expanding fast – too many acquisitions, high capex

…and search within them for factors that caused the above-mentioned companies’s downfall.

A few businesses – today’s stars – you may want to study may be Bajaj Auto, HDFC, SBI, Titan, Asian Paints, TTK Prestige, Page Industries, TCS, HUL, and ITC.

In other words, look for businesses that seem to suggest, like Jim Collins writes in How the Mighty Fall – “We’re so great we can do anything!”

I believe, and like I mentioned above, when companies rise to excellence, they often unwittingly develop self-destructive habits that eventually undermine their success.

This is very much like how we behave in our personal lives. We develop self-destructive habits as we get successful in our lives.

Often these habits get worse over time and become, in effect, addictions. Then, they cause our downfall.

Now, while we can overcome our self-destructive habits and can come back on the road to improved living, it’s difficult for companies to do so in the harsh, cruel world of capitalism.

So watch out for today’s skyscraper-like companies – and especially among the ones that lie in your portfolio. A few may be built on packs of cards.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Yogesh Kumar Gupta says:

    Once again a very insightful post. interestingly you linked it to cycles in ones’ personal life, which I truly believe. Thanks a lot. I am keen to meet you in person whenever you travel to Delhi. Regards.

  2. Gaurav Bhagwat says:

    Good article Vishal.

    External threats are overrated and internal mistakes are almost ignored. No management will say (ideally it should) – i sucked in the past. And bigger they become, bigger it becomes to handle expectations.. Look at Infosys… They couldnt pass the test – because assessors set 100% as passing grade…

    Keep doing great work…

  3. Reni George says:

    Dear Vishal
    Good Morning to you

    As Jim Collins has said,for the mighty the obvious problem is the static inertia of the management to look beyond and analyze their decision,when the tide is strong it does not take much pressure to row in that direction….

    I have seen how company’s go in mindless expansion,when as a common investor who looks beyond the glasses,I could not understand how the the management missed the correlative factor of expansion and growth.One of the major problem is that somehow most of the management of the company is aloof to the ground realities.So obviously there are just watching at the 90 degree angle.where they miss out what is present at the acute range.

    One such example which I have studied carefully and which helped me in desisting investment in these type of companies was the “GOLD LOAN ” companies.A couple of years back this was one of the hottest sectors….every tom dick and harry in this space,with the continuous rise in the price of gold were opening Gold pawn shops in every nook and corner of the cities on india…(Crappy Mindless expansion)..The companies were Muhtoot Fincorp,Mannapuram Genral finance to name a few.

    Static Inertia Stage : Now expansion has taken place…that means to recover the rental,employee cost and other costs and above that to manage profit margin,business needed to grow at a frantic pace,so what was the solution.Give the maximum loan that could be given on gold.So all the doubtful scenarios were kept in the back burner and loans were given on 80 to 90 % of the gold value and even the making charges of the jewellery was calculated in the value of the gold determined.

    So the end result was that the mighty were to fall, and indeed they fell.So more than the success it is the failure of the companies that teach us a lot about investment,as i have said in one of the post in Facebook on Equity Desk.

    “Before Investing in a business…..always “INVERT”…..why it would not be prudent to invest in that business….After this process,in 95 % of the business,you will drop the Idea of investing…”Invert” a tool to remove most of the biases generated while taking a investment decision.”

    Thanks and Regards
    Happy and Safe Investing

    Reni George

    • Good morning Reni…and thanks for sharing your thoughts!

      “Short-termism” is I think to be blamed here – managements, analysts, investors – all are eyeing the next quarter’s performance and thus the managements work the hardest to achieve the same….long term be damned.

      Your example of gold loan companies is important here. I have seen a lot of people lose massive savings betting on the rise of gold, and the invincibility of these companies.

      Yes, inversion is the key here. Know where you are going to die, so that you don’t go there. Regards.

    • Inversion is a great tool. I agree it should be one of the final tests before frankly not just investing but many other important decisions in one’s life.
      Which college, which job, which life partner, which house, which car (and cellphone) and a host of others to which INVERT must be applied.
      Thank you for reminding.

  4. Joseph Jude says:

    All scenarios described here don’t fall into the same bucket. What Ranbaxy did was unethical but others were a failure in business operation / execution. Investors should stay away from ‘cockroaches in the kitchen’ but no one can predict the failure of the risks these CEOs take. Sorry to take Steve Jobs example, but it illustrates the point. When he introduced iPod and the other i-Series, most of the analysts and pundits wrote him off. Coming to think of it, he was nuts to get into a crowded smartphone market with telling customers ‘this is what you want’ and ‘this you don’t want’ (keypad). But his risk paid off.

    Take the case of iGate buying Patni — as was reported that time ‘they bought a ferrari with a credit card’ but the integration went well and it looks like a success, for which Phaneesh should be credited and appreciated but he got into a scandal, which is a no-no for investor.

    Another point: I’ve a problem with the academics who study and write about success & failure of companies. The companies that Collins mentioned in an earlier book all folded up (ex: Freddy & Fannie). What does he do? He goes to write another book. These guys can’t make a single company work in the long term. Take case of Porter. That is why I prefer to read Buffet and other CEOs who ran successful companies or people like Ram Charan who have skin-in-the-game.

    Cheers,
    Joseph

    • Thanks for sharing your thoughts Joseph!

      Unethical practices also stem from hubris on the part of the management, and the roots are sown when the times are good.

      Yes, I agree with you about the point on learning from Buffett and Ram Charan. Regards.

    • Whether academic or hands on or whatever (say a theorist) I think we should give credit to the various observations and theories because it all helps to learn concepts and challenges. what I look for is logical and critical thinking.

  5. That is why humility is required, however successful one is. And once one has had a prolonged period of success, it is very hard to return to true humility. As I am discovering! 🙂 And its harder for companies, since a company is now a collection of highly successful people. The wise have said that life is a great leveller, and eventually things revert to the mean. If one figures out how to stay humble, thanks one’s good fortune, and keeps being present to what is rather than what one thinks it should be, one can probably maintain a certain grace, calm, and steadiness amidst the ever changing situations in life.

    Practising humility is very difficult, as I am discovering! So it is better to teach our kids humility from early days. And humility is not about subversion, humility is about knowing that one has been luckier that the others, and that one needs to be graceful since it is the community and society that allows one to live one’s life well. And when things are not going well, humility is also about knowing its not about oneself, and that if things are unfavourable, they can turn around and be favourable too.

    Regards,
    Rajaram

    • Very much, Rajaram! Humility – that stems from integrity – is one of the cornerstones of long term success. It is difficult to practice, and that’s why we see so few businesses that have sustained over decades. Regards.

    • Rajaram, Thank You for your comments! You have succinctly summarizes the importance of humility. I read your comment twice and thoroughly enjoyed it.

      A management that truly practices humility would treat minority shareholders as partners and take decisions that are in everyone’s interest.

      Cheers!

  6. Sanjeev Bhatia says:

    Hi VIshal.

    The post and the accompanying comments have brought a very important aspect to the front. The Management’s arrogance and the superiority complex due to “their” success, makes them place themselves so high up the pedestal that they become oblivious of ground realities. That’s why Lynch laid much more emphasis on “hitting the tyres” rather than plain number crunching in his wonderful book “One Up…”.

    Coming to Lynch, I am reminded of his Corporate Piss theory. The more a CEO accumulates cash, more the tendency to Piss it away. We see it so often in the form of pricey and senseless acquisitions, more to feed the ego of CEO. 🙂

    Happy Investing

    • Piss theory is hilarious and repeated again and again, each one with equally convincing and dumb reasons. Mr Lynch is an articulate writer with lots of clarity. I loved his book “:One up on the wall street”. Regret that I read it rather late but happy that I did.

  7. Surya Kanth says:

    Very good Article!!!!
    As I always feel, One of the biggest and toghest things to overcome is commitment bias… As reni has mentioned about ‘Gold Loan’ companies… It is very easy to reject an investment before it is committed… But once you are committed, it becomes very tough unless you have a very detached viewpoint….
    If we are talking about making or not making mistakes… then the first thing i preferably do is study my portfolio…. Ranbaxy lost because of some reasons but our stocks may lose because of some other reasons…. we always have to keep an open eye…

  8. I am yet to read the book by Jim Collins.
    Only yesterday I was discussing that I need to.
    I do remember seeing a presentation somewhere of the 7 phases a typical company foes through growth, euphoria etc.
    Reminds me I have a rather long reading list pending !

  9. Great post. There are very few knowledgeable bloggers in India with respect to value investing, macroeconomics etc. I am glad i found your site.

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