Wednesday, April 27, 2016

Thoughts About Failing Businesses

I was just looking at the list of companies we've blogged about as potential failures that either did fail or else essentially wiped out shareholders in a restructuring:

First I looked at them in terms of industry categories. The biggest category was coal/mining, with 7 companies. Molycorp was what you call a science project stock, funded with expensive debt, not too hard to see poor equity returns coming there. But the six coal companies were on top of the world in 2011. Much cheaper natural gas came out of nowhere and destroyed them.

To have rationally invested in those coal companies, you needed to know what coal prices would be many years in the future. But that means knowing about the prices of coal's competition for electrical generation (natural gas, solar, etc.) which is tough.

The next category is oil & gas, where there were six failed companies. This is pretty similar to the thoughts on the coal companies; in fact the oil & gas glut is in a sense what caused all the coal failures. Once again, there were very explicit oil price assumptions that were necessary for the success of the companies' capital expenditures and for the success of equity investments in those companies.

Financials had six failed companies but they were all 2007-2009, there haven't been any recently obviously thanks to reflation. Maybe what's noteworthy is that they were extremely levered, which magnified the effect of bad investment decisions.

Next category is solar and alternative energy, with five failed companies. The alternative energy ones were once again science project stocks. Maybe it's a bad idea to invest in public companies with 9+ figure enterprise values that don't yet have a product that they can sell for more than it costs to make. And then the photovoltaic solar companies were dealing with a product where the underlying technology was rapidly improving but they had sunk huge capital into manufacturing plants. Also, there's the theory that the Chinese PV solar firms were a deliberate bust-out to take advantage of naive American investors.

Two of the firms were pharma - those fit the science project category again. Then two were shipping and two were building materials: firms that run with a lot of leverage to make up for low margins that come from undifferentiated products.

One thing that would be interesting to look at is how much these companies spent on capex in the final years of their lives when the businesses should've been in runoff mode. For example, Radio Shack was remodeling stores and buying "Super Bowl" ads right up until the end.

It's also remarkable how quickly the change from extreme best-ever success to failure can happen. In fact, it's almost as though those extreme levels of success can signal big change ahead.

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