Saturday, May 10, 2008

The Rise and Fall of Businesses

As I had been very busy the entire week, I have not been able to blog much at all even though I had many ideas and issues floating in my head. One of these is about the interesting aspect of the rise and fall of businesses. As readers may know, all businesses technically have an “infinite” life and can last in perpetuity as they can have different owners while retaining the same name and registration number. However, most businesses tend to fall into cycles where they start-up, grow rapidly and then fizzle out (some go out spectacularly in a big BANG like a supernova !). This follows the teachings of most marketing textbooks which state the four phases of a business: Start-up, growth, maturity and decline. I will proceed to discuss each of these phases and give some examples. Readers are free to debate or discuss whether these examples are relevant and to give more examples where applicable.

Start-Up – This is the phase where a company acquires a core business, be it in Information Technology, Oil and Gas Support or a new industry such as Bio-Fuels. Start-ups are usually fraught with risks and most of them go belly-up within 2 years due to inability to manage costs and also inability to adapt to changing consumer preferences and tastes. To be fair, sometimes the fault does not lie with the Management; it may be that the dynamics of the particular industry are not conducive for long-term sustainability and profitability. In Singapore at least, the food industry is cutthroat and extremely competitive. One example of casualties are the numerous bubble tea shops which opened in 2001 and 2002 and subsequently went out of business as the bubble burst (no pun intended !).

Growth - A company which has survived the hardships of the start-up phase can now grow rapidly by establishing a solid customer base and also decent margins. Assuming it has a competitive advantage with respect to either cost control or product differentiation, it can now build up a sizeable business and market share in order to enjoy sustained profitability. This is the phase in which the company needs to either borrow heavily to expand or root for an IPO (raising funds through equity issuance). Many of the newly listed companies on SGX are examples of start-ups which have grown to a point where they need to raise funds to grow further. An IPO is one of the methods. Some recent examples of IPO would include China Zaino, China Eratat and Hisaka Holdings. During such a phase, the company’s products/services find quick acceptance and their revenues and profits grow very rapidly, to the order of 70-100% per year. However, such rapid growth usually cannot be sustained more than 2-3 years and the company will enter the maturity phase* after this. Some examples of listed growth companies will include Wilmar, Swiber, Ezra and many China companies seeking to increase market share in a huge market (China Hongxing, Celestial and Cosco come to mind).

*Note: There are companies which still manage to grow after 10 to 20 years by diversifying their product offering, keeping up with trends and offering better value to existing customers, but these are a rare few.

Maturity – In this phase, the company’s products and business units have stable customer base and their revenues and profits no longer enjoy rapid growth. It becomes harder to get new customers and the market may get saturated with other competitors who also begin to offer the same products and services. During such a phase, the company may generate more cash than it requires and may not know how to productively employ this cash. Companies can either gun for more organic growth through internal restructuring or product innovation, or acquire other businesses to complement their existing one. These moves are key to determining if the company moves back to the growth phase, or if they push it towards the decline phase. Examples of mature companies are many of the blue chips such as Great Eastern, Fraser and Neave, Yeo Hiap Seng, the local banks, SIA and Venture Corporation. Examples of mature companies which are mature but acquire to grow are Olam International, China Fishery and OSIM. Examples of mature companies which grow organically without acquisition (thus far) will include Boustead.

Decline – This is the saddest phase of a company’s life cycle, where its products begin to fall out of fashion or become victims of commoditization or competition. A decline can be defined as the phase of a company’s life where earnings and revenues fall, with declining margins and also less operating cash inflows. Declines can be short and sharp (when a company goes bust quickly by over-extending itself of expanding too quickly), or it may be long and protracted as the company slowly bleeds itself to death. At such a stage, assuming a company is listed, it will valiantly try to shore up capital by issuing rights and more equity (as its deteriorating balance sheet will make it an unsuitable candidate for bank loans or company-issued bonds). Assuming it is able to turn around (in rare cases), then it can slowly go back to the mature phase where operating cash flows can sustain the business, or perhaps they had found a new business to go into or a new way of positioning themselves which changes consumers’ perceptions. But in the majority of cases, companies will eventually liquidate and fold, with creditors getting pittance and shareholders usually getting nothing at all. Examples of once growing companies now in decline include Creative Technology and OSIM.

These 4 phases are anything but distinct in the real world, with some companies a hybrid of both growth and mature phases, while others may be in limbo alternating between mature and decline phases. It is never really very clear-cut but a shrewd investor should at least be aware of the life cycle stage his company is in so as to avoid unpleasant surprises. A careful study of companies’ fundamentals and the industries in which they operate is necessary in order to make an informed judgement, in order to save oneself from a lot of heartache and potential loss of capital.

12 comments:

donmihaihai said...

Hi,

Saying that I do not like the teaching of business on "start up, growth, mature and decline" and there is lots of confusion on your post is quite extreme. I rather say after much reading, understanding and thinking on my part, I separate the whole thing into 2 parts.

1st is the industry. And there indeed has 4 phases. Start up(or creative destruction or innovation or whatever it call), growth, mature and decline. One of the best books on this subject that I know comes from Michael E Porter. A general looks at the industries where the company like Venture, SIA and F&N operate in say that they are not mature. I refer mature as growth track inflation and GDP growth. Industries where Creative and OSIM operate in are actually fast growing.

The 2nd part is actually on individual company, the management that lead the company. After start up, the future of the company depend on the management, even if the company operate in a declining industry and how they ran the business(example on decline industry TPV CRT segment)make a different. A company that in growing industry can decline due to mismanagement. One recent article on this subject comes from Jim Collins in fortune Mag. I like his last sentence the best

"That most do fall - and we cannot deny this fact - does not mean you have to be one of them. "

Here is the link if you are interested.
http://money.cnn.com/2008/04/18/news/companies/enduring_greatness.fortune/index.htm

Market Uncle said...

Hi Musicwhiz,

I came across a concept called regression to the mean in the book called Competition Mystified by Bruce Greenwald.

Unless a company have genuine competitive advantages, technology, brand etc, it is very difficult to fight its ultimate decline. Profitability attracts competition, failure to fend off competitors just result in mediocre returns on cost of capital.

Thus, in a hot industry, there's a lot of money to be made, only the best managed companies ultimately survived the expected intense competition. But these 'good ones' probably still see a slowly declining profitability.

On the other extreme, cold and forgotten industries see many companies leaving the market, either going bankrupt or leaving for other markets. This ultimately leave a void for better managed companies to rise from the ashes and many money again.

Hence it still boils down to management. Unfortunately, I am still learning how to sieve out better managed companies.

la papillion said...

Hi market uncle,

I've heard of regression to the mean. It's prevalent everywhere e.g. a parent who are very short will have kids which are taller than them, and vice versa.

I read it from a Fooled by randomness too :)

PanzerGrenadier said...

Hi Musicwhiz

Off-topic, but no problem to using a couple of my posts now and then as a guest post/article on your blog!

Let's grow the personal finance readership collaboratively!

Be well and prosper.

musicwhiz said...

Hi donmihaihai,

Yes, I agree with you that it can be split into 2 parts - industry and company. I had failed to mention this in my post as it would make it way too lengthy. I did mention that some industries were "new" like palm oil (biofuels) while others were mature (commoditized) though I did not give examples. However, I do not totally agree that industries where growth = inflation rate are mature. Some may be more on the brink of decline but as I said, it's never easy to separate distinct phases. I also do not agree that Creative and OSIM are in fast growing industries. Unless a new technology appears to revolutionize the industry (e.g. walkman), making sound components and massage chairs has already become an established industry in itself and it more likely mature as the number of players has grown significantly and players compete mainly on price (OSIM's branding itself as "premium" has failed to gain it market share thus far).

The second part about Management and companies is very true. Companies in the "right" industry can certainly decline due to poor management. Conversely, strong management may not be able to grow a company which is in a weak industry. Thus, strong management needs to be coupled with a growing industry in order to make a company "great".

Regards,
Musicwhiz

musicwhiz said...

Hi Market Uncle,

Regression to the mean - that's a good teaching indeed and thanks for mentioning it here ! A company will eventually see growth slowing and profit growth declining. However, only very exceptional companies can make it grow for 20-30 years consistently. As you pointed out, competition tends to eventually erode profits and a growing company will eventually stabilize and turn into a cash cow.

Management is an important aspect but it's not always easy to judge them. Sometimes (as in the case of JEL Corp), there can be a lot of hidden dirt or skeletons in the closet which will fool even sophisticated investors. Hence, investing always carries a risk.

Regards,
Musicwhiz

musicwhiz said...

Hi LP,

So eventually all childrens' heights will "regress to the mean" ? Haha then you need a sample size of 30 for it to be statistically important. Which means a couple needs to have 30 children to prove "regression to the mean" ? Hehe....kidding.

Cheers,
Musicwhiz

musicwhiz said...

Hello Panzer,

Thanks for dropping by. Ok, I will choose some of your posts as a guest post in future. Thanks for allowing me to spread your personal finance teachings ! Keep up the good work on your blog !

Regards,
Musicwhiz

donmihaihai said...

Hi,

Ya it is difficult to separate distinct phases. Same like if one put OSIM into a branding in consumer healthy lifestyle products and Creative into consumer electronic gadgets rather than massage chair and sound component(?), the possibilities are endless.

8percentpa said...

Hi all

If both parents are tall, it is likely that their kids will be shorter, and their grandchildren even shorter until they become average height (it will not overshoot and become dwarfs, not like stock markets)

Consider if this does not happen, shouldnt we see people around that are 5m tall, bcos the kids keep getting taller than the parents. And of course we also have pple that are like 50cm or something.

The fact that human heights follow a normal distribution around a mean height lends evidence to the fact that it is more likely that taller parents will have shorter children. (The children will likely still be taller than the average population, it takes a few generation to revert to the mean)

Incidentally, this also happens with intelligence. If two smart people get married, chances are the kid will be dumber than the parents (although still likely to be smarter than the general population.)

In fact smartness usually do not last long. We never hear of Einstein's kids or Newton's kids right? Well Newton is gay though... Hehe.

So eugenics actually doesnt work! And better marry somebody who is not at the same intellect level as you are! Food for thought huh!

Read this from "Against the Gods" by Peter Berstein. Sorry for the long post.

musicwhiz said...

Hi donmihaihai,

Yep, I fully agree that it is difficult to separate distinct phases in a company's "life cycle". Aiyah, anyway it's just all theories; in real-life things are seldom black and white, most of the time they are a hazy shade of gray. :P

Regards,
Musicwhiz

musicwhiz said...

Hi 8percentpa,

Thanks for the long post, a pleasure to read. :)

Well, I don't really believe smart parents make smart children. There is probably some element of nature + nurture and other factors as well. Human beings are a lot more complex than we think, thus it is probably a myriad of factors which contribute to a person's development.

I guess the same can be said of companies as well - they are affected by all manner of stakeholders and it will be hard to predict the combined effects of such interactions.

Regards,
Musicwhiz