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…
- 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”.
- 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.”
- 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,
- These flawed capital allocation decisions destroy return on capital and creates financial stress.
- 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.