10-K Diver @10kdiver:
1/
Get a cup of coffee.
In this thread, I'll walk you through how businesses die.
As Charlie Munger says: All I want to know is where I'm going to die, so I'll never go there.
In that spirit, we want to know how companies typically die, so we never take our portfolios there.
10-K Diver @10kdiver:
2/
I can think of 5 common ways companies die:
(1) Competition,
(2) Concentration,
(3) Leverage,
(4) Reputational Damage/Fraud, and
(5) Government Intervention.
Let's examine these one by one.
10-K Diver @10kdiver:
3/
COMPETITION
Every year, many thousands of businesses fall prey to their competitors.
Capitalism is brutal.
Whenever a business makes big profits, competitors attack it -- to try and steal these profits for themselves.
Sooner or later, some competitor succeeds.
10-K Diver @10kdiver:
4/
There are 2 common ways for this to happen:
(i) An *existing* competitor launches a superior product or slashes prices, OR
(ii) A *new* entrant muscles in to steal market share with a competing product, a substitute product, or a new way of doing things.
Some examples:
10-K Diver @10kdiver:
5/
To learn more about the nature of competition and how it shakes up different industries, I recommend studying the work of Michael Porter.
For example, "Porter's 5 Forces" is a great way to think about competitive dynamics:
10-K Diver @10kdiver:
6/
Moving on to the next cause of death:
CONCENTRATION
This happens when businesses "bet the farm" on one thing. And that thing goes wrong.
For example, relying overly on a single customer.
Or a single supplier.
Or a single product.
Or a single key employee.
10-K Diver @10kdiver:
7/
Here are some examples of this kind of "concentration risk":
10-K Diver @10kdiver:
8/
The antidote to "concentration" is, of course, "diversification".
That is, as far as possible, we should seek to invest in companies that DON'T have a *single* point of failure that may one day bring down the whole ship.
10-K Diver @10kdiver:
9/
After competition and concentration, LEVERAGE is the 3'rd big thing that kills companies.
This usually happens when companies take on too much debt.
This makes them vulnerable to even a small drop in their cash flows -- eg, because of a recession, or inflation.
10-K Diver @10kdiver:
10/
Debt-laden companies tend to be fragile.
The slightest disruption can cause them to default on their principal/interest obligations.
Pretty soon, they're forced to sell assets at fire-sale prices, raise equity at unfavorable terms, or file for bankruptcy.
Some examples:
10-K Diver @10kdiver:
11/
Then there's REPUTATIONAL DAMAGE and FRAUD.
For example, if a serious safety issue is discovered with a company's product, customers may leave en masse.
Or if the company is caught cooking its books, it may be ostracized out of existence.
10-K Diver @10kdiver:
12/
Once *trust* is lost, it can be very hard to regain.
And amidst product recalls, criminal investigations, and legal battles, the company may well die before it regains its lost reputation.
Some examples:
10-K Diver @10kdiver:
13/
Finally, we have GOVERNMENT INTERVENTION.
Sometimes, the government may ban a company's products.
Or, through the courts, take anti-trust action -- breaking the company into smaller pieces, forcing it to exit some lines of business, imposing hefty fines on it, etc.
10-K Diver @10kdiver:
14/
Such government action can drastically reduce a company's profits -- and perhaps even kill it.
Some examples:
10-K Diver @10kdiver:
15/
So, there you have it -- 5 of the most common ways companies die.
To recap, they are:
(1) Falling prey to competition,
(2) Succumbing to concentration risk,
(3) Using too much leverage,
(4) Losing reputation or being a fraud, and
(5) Being limited by government action.
10-K Diver @10kdiver:
16/
These are NOT the only ways a company can die.
But these are "the usual suspects".
So, now the question is: how do we identify and steer clear of companies that can die from these risks?
10-K Diver @10kdiver:
17/
I think it may be impossible to *entirely* eliminate these risks.
For example, it's hard to be 100% sure that a company is NOT cooking its books.
Also, it's hard to know for certain that a company's products are 100% safe to use. Think Boeing 737 MAX.
10-K Diver @10kdiver:
18/
But there are 3 ways we can protect our portfolios to a "reasonable" extent:
(1) Adequate Diversification,
(2) Price Discipline, and
(3) Betting on Survival.
Let's take them one by one.
10-K Diver @10kdiver:
19/
First, Adequate Diversification.
We can't be 100% sure that NO company in our portfolio has these risks.
But we CAN size our positions so that EVEN IF 1 or 2 companies succumb to such risks and die, they don't take down our whole portfolio.
That's why we diversify!
10-K Diver @10kdiver:
20/
Second, Price Discipline.
We should only pay "sensible" prices for the companies in our portfolio.
Why? Because if we pay too fancy a price, it may be a while before we see ANY return. And the longer we wait, the higher the chance that one of these risks kills our company.
10-K Diver @10kdiver:
21/
Finally, Betting on Survival.
Sometimes, it may *look* like a company is about to die from one of these risks.
As a result, the company's stock may be beaten down.
But the company's *actual* probability of death may be fairly low.
The stock may eventually recover.
10-K Diver @10kdiver:
22/
Like an American Express that eventually put the Salad Oil Crisis behind it.
Or a Chipotle that eventually fixed its contamination problems and again became popular.
IF we can identify a few such opportunities, and bet sensibly on them, chances are we'll do well over time.