“Failure is central to engineering. Every single calculation that an engineer makes is a failure calculation. Successful engineering is all about understanding how things break or fail.”
- Henry Petroski
During the 1890s, the 3rd Marquess of Salisbury was debating whether to electrify his house. His country estate, Hatfield, was (and still is) one of the most famous houses in England (Queen Elizabeth I grew up there) and considered a national treasure. No one wanted to see it go up in flames. In fact, his grandmother – dressed in those enormous dresses of the early 1800s – caught fire and burned to death shortly after the 3rd Marquess’ birth.
But, Lord Salisbury’s great interest in science overcame all these fears. He eventually installed some of first residential electric lights through the house. His children could remember throwing pillows at the wires in some rooms as they sparked and smoked to prevent fires from breaking out and burning down the house. There was even a servant who had the rather unfortunate – and fatal – experience of stepping on one of the uninsulated power lines in the gardens. Asked whether he thought the “Great Experiment” (as it was laughingly known to the family) was worth it, Salisbury is remembered as saying, “Sometimes advancement in science isn’t perfect. But if you plan for things to go wrong, it’s much easier to eventually make them go right,”[1]
I bring all this ghoulish history up in relation to a conversation I was having with a fellow value investor who asked me, “If you were allowed just one, what would be the most important lesson would you give to somebody starting out in their investing career?” Since that conversation I’ve given a lot of thought to what that one piece of wisdom might be. I might suggest “margin of safety.” That certainly is critical to any value-based investor. Another might be the power of compounding. Or, perhaps, the development and practice of patience. All of these are extraordinarily powerful concepts, but when I really thought about what has made the greatest impact on my investment theory and results, it would be this one thing: Think like an engineer and always plan for failure.
Most investors I know don’t like to dwell on potentially horrific results – the sudden and sickening drop of a holding’s stock price by 15%, the reporting of accounting fraud or the infamous “death spiral” one hears about as revenue slows, the balance sheet weakens and bonds sell at a 40% discount to par. But the startling fact is that this happens all too often to individual and institutional investors. With all the suddenness of a bridge collapsing or airplane crashing, the best laid plans of the investor suddenly have to take into account serious – and sometimes catastrophic – losses in their portfolio. When these events happen, it is all too common to blame the events on bad management, flawed corporate strategy or the amorphous “market forces” at play.
I find that most of the time (note I don’t say all the time), events such as these could have been headed off by applying Petroski’s thought: “Successful engineering is all about understanding how things break or fail.” I say this because I think most successful value investors also happen to be successful engineers (at least by Petroski’s measures). These investors can take almost any business case and find a way to break it. That doesn’t mean that particular scenario will play out, but rather they have thought about it and planned accordingly. Forewarned is forearmed as they say.
I was talking to an investor who had a 30-year run of great returns and I asked him the key to his success. He told me he saw every company as sum of its parts that – when engineered properly – create a machine that works seamlessly at generating revenue and free cash flow. Maintenance of course is required, in the form of research and development, capital spending, and sales and marketing.
He imagined taking apart this machine – piece by piece – and looking at each component to see how it might fail. As we discussed this method, we agreed there are several major components that need to be reverse engineered to better understand their design, function, weaknesses and possible improvements. As an investor, if you see no improvement (or worse, no acknowledgement of a problem), then it’s probably best to simply move on. The most important parts of an investment that require great engineering are the following.
Management
The first and most vital piece of a business is its management. Are they capable of surrounding themselves with strong leaders? Does management see itself as allocator of capital there to maximize shareholder returns? Are they compensated in a way they feel is good for them, the company and its shareholders? Finally — and most importantly — is this a group of people who will provide moral and ethical leadership to the company's employees, its board and its community? Can they convey and demonstrate that moral leadership is good corporate leadership?
Understanding how good management works and what bad leadership looks like is one of the first steps in avoiding investing in a company with a limited future. As an investor, consistently low returns in capital, equity and assets demonstrate a management team just not up to snuff. Additionally, outrageous pay packages, stock option grants and so forth show that management work for themselves, not you as a shareholder.
Operational issues
You frequently read about bad execution or operational issues as a weight on corporate profitability and investment returns. Every company will at some point have glitches in execution. Companies with chronically low margins or increasing SG&A, combined with decreasing revenue, can tell an investor that operations-level managers and systems personnel simply haven’t figured out the best operational processes.
Competition
Some of the worst investments I’ve made in my career have been where either me, my team or my holding's management misjudged the competition. This can be anything from launching a new product, creating a great marketing campaign or misjudging the marketplace’s future demands.
When I look to deconstruct this piece of the business, I look to see ratio of SG&A to sales, advertising awards, market share, along with other numbers to see how the company is doing relative to its competitors. I remember one holding that saw its sales and marketing budget triple over three years and market share drop by 25% in the same time. Knowing beforehand that competition and the company’s lack of customer knowledge would destroy a great franchise could have saved me a lot of time and money.
Regulations
Some businesses – like pharmaceuticals or tobacco – you know will be impacted by different political regimes and their views on regulatory affairs. There are occasionally some – like the recent Boeing 737 Max – where a series of events can lead to regulatory action, leading to some truly horrendous results for investors (obviously this is nothing compared to the passengers, flight crews and their families).
Investors should always be thinking about how regulators – either from a legacy standpoint or new transactional event) might impact their potential holding. One might not think much about railroad regulations (instead focusing on capital expenditures) until a car derailment leads to a large toxic cloud requiring an entire town to be evacuated.
All of these categories require an investor to use an engineering approach to think about failure – how and what conditions can lead to permanent capital impairment. At Nintai Investments, this engineering process is coupled with the financial “breaking the case” – the process in which we find what type of financial stress can lead to bankruptcy.
Conclusions
Most engineers will tell you the time to find, isolate and solve the problem is in the design process. As an investor, the research phase of your investment process is the equivalent to the engineer’s design phase. By preventing yourself from buying into a potential corporate failure (defined as permanent capital loss), you avoid all the work necessary to breaking the corporation down to its integral parts and trying to find out if the problems can be resolved.
As Petroski said, “Every single calculation that an engineer makes is a failure calculation.” Every decision to invest or not invest should be a similar calculation – is this a company that will be a success or failure in my long-term portfolio returns? You might not be an engineer by training, but thinking like one can certainly help you in the long run.
As always, I look forward to your thoughts and comments.
Disclosures: None.
[1] These words of wisdom were unlikely to be much solace to the unfortunate servant’s family.
