But How Did You Know? (Part 1)

February 22nd, 2007

The scenario goes like this: the owner of a firm engages us to help sort out his or her business. The impetus: its performance is not up to standard. We dig in and find the prime culprit, which is typically not the one anyone expected. This causes some heated discussions. The culprit is an asset of some standing; it has a long history of delivering efficient production. Nonetheless, those days are past, and the asset is sold.

Not long thereafter some change in the industry or economy makes it clear that however painful it was to shed that asset, to have owned it during and after the change would have been disastrous.

The owner demands of us: How did you know?

The answer is, strictly speaking, we didn’t. Such events are recurrent in Sr.’s and my combined careers, but our advice is something less than prescience. It is also more than coincidence.

It is very hard to treat this subject without writing a book—-in fact, Tom Sr. is doing just that and is nearly finished. But if I distill our experience into a few broad observations, and deal with the one measurement that exposes the economic strength or weakness of an asset or expansion (any long-term economic commitment fits the bill), I might just get something said in a couple of journals. This one is the first, and the setup.

It seems that the following things hold true:

1) Few firms, however small, can get by without making some long-term and nearly-irrevocable commitments (can’t be reneged without significant and even prohibitive losses). For our convenience here, call them assets.

2) Assets are subject to cyclical fluctuations in value. The timing of these fluctuations is not specifically predictable, although it is possible to broadly assess when they are high, or low, and likely to increase.

3) These fluctuations can make or break individual firms.

4) The vast majority of us find it hard to resist buying when prices are already high; we find buying when prices are low nearly impossible. Chalk it up to human nature, herd instinct, or “irrational exuberance.” I won’t try to explain it. Volatility would be less dramatic without these tendencies.

5) A firm’s financial performance cannot always be accounted solely by internal characteristics. External happenstance can negate excellence or mask weakness, temporarily.

To elaborate on my set of premises: once the process of production is begun it is hard to stop. The only way to recoup the costs plus some return is to see them through the production cycle that was envisioned when they were purchased. The valuation of work-in-process inventory is purely an artifice of accounting. Its market value is almost certain to be far less than the cost of the inputs invested in it. Even assets such as real estate are problematic. A fast sale demands a discount (this apart from general changes in market values).

That asset values fluctuate is readily apparent. Most people with practical knowledge in an industry can quickly assess when the relevant assets are cheap or expensive. They can point to occasions where something was bought too expensively and cite the damage done, or when it was bought cheaply and cite the unusually high speed of payback.

Regarding premise #3: the failure of businesses is conventionally attributed to the failure of the idea, the execution, or the capital. True, many ideas have no viable market. And the execution of a viable idea can fail. But the sufficiency-of-capital question is problematic. Not enough? It kind of begs the question. How much is enough? It is like blaming someone’s lack of success on his or her lack of wealth. However, the capital question does indicate, if vaguely, the impact of externally driven volatility on individual businesses. Consider another scenario:

Let’s assume that the business in this case is demonstrably well run, with a good idea, and has the track record to show it. In fact, execution is so reliable and the idea so popular that an expansion is in order. The firm has to get access to the range of assets to facilitate growth by using other people’s capital. Let’s assume also that this expansion is concurrent with a general rise of activity in this industry. For this reason, the needed additional assets are considerably more money this go-around. No matter; they have done the math, and the math is good.

Expansion is messy, and at some point or another, an expansion will stretch management beyond its immediate capacity, and execution will suffer. This firm in this scenario winds up in just such a situation. Concurrently, the general demand for their product is in a slump. Between the two, sales fall and costs rise. These events are, strictly speaking, not failures; they inevitably attend growth. Given time, this management team will adjust successfully, as they have done in the past.

However, there is no time. The conditions that slowed sales growth for this company hold true for the entire industry. People are canceling plans to expand and shedding idled assets. This has a predictable effect on the price of assets, which predictably weakens the company’s balance sheet and its standing with the bank. Add to that a period of operating losses due to growing pains and the attendant shortage of cash. The bank is demanding a solution now.

This example might read like one of the improbable moral dilemmas that television screenwriters concoct, except that it really happens. This story or any number of variations has been a staple of our careers—helping business owners to avoid, or extricate, or benefit (avoidance and benefit are nicest, but life doesn’t always work that way).

How is it that we see what other miss? The same way everyone else does. I buy into the idea expounded by the great economist Friedrich A. Hayek: all knowledge is local and personal. The beginning of every new business is essentially one person acting on knowledge that no one else will. Knowledge is by nature “asymmetrical,” although that description reads more like a guilty verdict in some circles. Oh well.

The two scenarios contrast a firm that acts in time with one that doesn’t. The second one is not past help, although getting past the crisis is certainly more stressful than avoiding it altogether. Perhaps I can add a sixth observation to the set above:

6) Every successful entrepreneur will experience at least one of each in a career.

There is a financial measure, which is economic, not just financial, in orientation. No other single measure trumps it for predictive value. That measure is return on assets. It is not unfamiliar to many people, but it surprises me how rarely it is used, at least in the realm of private, independently owned firms. Having introduced the concept, I’ll try to fit it to a journal-lengthed discussion next month.