The worst situation an investor can ever find themselves in is a business failure. Unfortunately, this does happen. Businesses fail all the time for numerous reasons.
Investors should be well aware of this risk. After all, if investing was risk-free, the returns would be much lower. Investors will always have to deal with the risk of failure. However, while it is impossible to eliminate this risk, it is possible to skew the odds in your favor.
The best way to do this is to seek out failed businesses and learn from them. Learn what went wrong, why they failed, what could have been done differently and what markers (red flags) investors could have used to establish the company's problems.
This process may be the best way of building a failure checklist, which can then be used repeatedly and refined where necessary.
Mounting debt
Several common factors link struggling and failing businesses. First off, the most prominent business killer is debt. Taking on too much debt is always catastrophic for corporations, no matter how large they are. It can strangle cash flows and reduce investment. If a company is not investing, it can lose customers. This makes it harder to repay the debt, and the company has to cut costs. This deadly cycle can quickly erode a business's strengths, alienate its customer base, and put it on the fast-road to failure.
Overconfidence
Secondly, overconfidence is a typical red flag. Companies and managers can be overconfident about their abilities and overlook the big picture. This may lead them to ignore a competitor's new product or think the organization is more robust than it is.
Companies can and do lose their competitive edge by taking their customer base or product line up for granted. On the other hand, firms that are always striving for better performance, new customers or improved outcomes have the edge.
A classic example is Amazon.com (AMZN, Financial) vs. any other traditional retailer. No company is immune to competition, regulation or poor employee relations.
Growth at any cost
Thirdly, growth at any cost can be a killer. Moving back to the retailer example, over the past few decades, brick-and-mortar retailers have expanded across the country rapidly. Still, as we are discovering now, many of these companies expanded too far without investing enough in staying ahead of the competition.
Warren Buffett (Trades, Portfolio)'s See's Candy is a great counter-example to this. The company has tried to expand outside of its core market, but every attempt failed. So, rather than waste money on growing, Buffett decided to keep the business small and reinvest its profits elsewhere. The results of this strategy have been impressive.
Growth at any cost should not be a company's prerogative. Suppose a business cannot earn a reasonable return on invested capital from expansion. In that case, the money should be used to reduce debt and then returned to investors, who may be able to deploy the capital elsewhere more effectively.
Markets they don't understand
Companies can often fail after trying to expand into markets they don't understand. Following on from the above point, companies should not pursue growth at any cost, including in terms of acquisitions or expansions into new areas.
Suppose business managers cannot turn a suitable return on capital by reinvesting in existing operations or expanding in the same sector in a different market. In most cases, they should not try to enter a new sector. This can result in the same problems noted above.
A costly expansion into a market the company does not understand can cause irreparable damage to the balance sheet and its reputation. The company should return this excess capital to investors instead, who can then deploy it as they see fit. They might have experience in other industries, which would mean they are more suited to deploying capital in these industries than the company itself.
Disclosure: The author owns shares in See's Candy parent Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
Read more here:
- Why Aren't There More Warren Buffetts in the World?
- Mohnish Pabrai Buys Seritage, Sells Chrysler
- Warren Buffett: The Best Way to Learn About Business
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