A friend of mine recently explained to me how his parents survived a lifetime of farming. He said their farm tended to run on a five-year cycle. In general, over that five-year span, one of the years would be extremely profitable, two would suffer big losses and two would be about break-even.
So this is what his parents did. When they had that one great year on the farm, they would shrewdly invest the windfall into the stock market. This investment would have enough of a return to get them through the four years of breakeven and losses. Then, when the next great year came again (about five years later), they’d start over again, investing the windfall in stocks to cover the next four years.
Over time, they got to be very good at stock investing. It makes you wonder if their true occupation was really farming or investing.
This family was able to survive a lifetime in farming because they did not think in terms of individual years or growing seasons. Instead, they planned their business around the full five-year cycle. They knew there would be highs and lows across the five-year cycle which they did not have a lot of control over. For example, commodity prices would swing wildly and weather would change dramatically. You can compensate for a bit of this in the short term, but not most of it. Hence the highs and the lows in farming were pretty much a given.
Therefore, my friend’s parents needed a bigger plan—one that invested during the high points, so that they would have supplemental income to get through the low points.
Other businesses tend to be no different. Margins rise and fall based on all sorts of market pricing issues outside a business’ control. And, like weather, the external environment for businesses can also dramatically change. Fickle customers can abandon your business category for the next fad and cause as much damage as when the rain stops falling on the farm and goes somewhere else.
Hence, all businesses should consider their actions in terms of the full cycle. They need to reinvest the highs in order to be prepared for the lows. Unfortunately, as we will see below, not all businesses do this.
The principle here is that if you try to optimize individual years rather than the full multi-year cycle, you will be on a path to destroy the business. First, if good years are optimized on their own, you end handing out the profits to all the stakeholders. That will not leave any money for the lean years. So then, the only way to optimize the lean years on their own is to cut back on everything (R&D, service, quality, etc.).
This starts the death spiral. The cutbacks in lean times make the company less viable when the good times return, so the highs get progressively smaller. Debt piles up in the lean years until it is unsustainable. None of the money ever gets reinvested for the long term, so the business gets old and unfit for the changing times. Bankruptcy is almost inevitable.
I was reminded of this principle when I saw a recent article online from Fortune. It was a list of the ten largest bankruptcies in U.S. retailing over the last few years. As I thought about this list, I realized that in a majority of these cases, the retailer failed because it did not plan for the full cycle.
Bankruptcy usually came from a combination of:
1. Taking out too much money in the good times (usually via a leveraged buyout)
2. Taking on too much debt that could not be maintained when the bad times came.
3. Was not ready when “bad weather” came (a negative change in the external environment).
4. Did not invest the money from the good times into projects that would pay out in the future (adapting to the “new weather”).
Here are a few examples, which I’ve simplified for the sake of time.
Circuit City sold low margin electronics products. The margins suddenly got a lot lower when Wal-Mart and online retailers like Amazon aggressively went after the business. Circuit City did not have enough cushion to absorb the drop in prices. Then, Circuit City made matters worse in the lean times by cutting way back on sales service. It was the aggressive sales service team which was able to talk customers into buying the more profitable attachments and extended warranties for the low margin basic goods. Without the sales people to aggressively boost the margin in the shopping basket, the margins got even lower. Eventually the losses got too great to be sustainable.
Linens N Things
Linens N Things was almost identical to its competitor Bed Bath & Beyond. The only major difference was that Bed Bath and Beyond operated on a lower cost structure (a structure designed for lean times). When the lean times came, the lower cost structure allowed to Bed Bath & Beyond to still make money when Linens N Things could not. Bed Bath & Beyond became more aggressive with its coupon promotions, making it even harder for Linens N Things to compete in the lean times. Finally, Linens N Things sold out to leveraged buyout, which created a debt level that could not be maintained.
A&P is an example of a supermarket company that could not keep up with the changing weather. It had old stores, run the old way, with old union contracts. When the good times were there, A&P did not reinvest and modernize or build a lot of stores in the growing markets. Instead, it took the profits out of the stores. That left A&P with the oldest stores in the oldest neighborhoods without the changes needed for the modern grocery business. When the bad times came, A&P kept cutting back. But due to their old union contracts, they were forced to first lay off the younger, less expensive (and more productive) employees. This left them with even higher costs relative to competition. It’s hard to survive when you have a combination of the most outdated offerings and the highest cost structure.
Sbarro had most of their pizza restaurants in malls. They thrived in the good times by taking advantage of the traffic already created by the mall. Unfortunately, the weather changed. Malls became far less popular. Mall traffic dropped significantly. Eating in malls dropped significantly. Sbarro did not have a business model designed to draw its own traffic or survive on lower traffic. So when the mall traffic dried up, it was like when a farmer’s land dries up…profits evaporate. It didn’t help that Sbarro had also gone through a leveraged buyout, which drained them of the extra cash needed for lean times.
Blockbuster and Borders
Blockbuster and Borders were two retailers who sold tangible media (Blockbuster: movies; Borders: Books). The digital revolution changed their weather. When movies and books became digital, customers did not need brick and mortar stores any more. Plus, the price of digital movies and books were so low, that Blockbuster and Borders couldn’t compete on price. These company's failures wasn’t inevitable. Others invested to adapt to the new weather of the digital world. Blockbuster and Borders, however, did not make those heavy investments in a timely manner. Hence, they failed. They, like A&P, did not do like my friend’s parents and invest during the good times. You cannot live off the investments you do not make. And without investments into the new, you become obsolete.
Quicksilver is a retailer specializing in clothing and gear for the surfing culture. Teens paid a premium to shop at Quicksilver because appearing to be part of the surfing culture made you look cool. But then the weather changed. Cool transferred from surfing culture to smartphone culture. The Apple store was now the cool destination. Money that used to go to clothes went to technology. The clothes still bought tended to come from cheaper stores, like H&M, because the money you saved on clothing could be used to buy more cool technology. Quicksilver could not adapt its cost structure and merchandising for these leaner times.
Business life is not a straight line of consistency. Instead, there are periods of ups and downs. Many of the ups and downs are influenced by external factors that are not completely under your control.
Therefore, if you want your company to last over the long haul, it must be built in such a way as to survive the entire cycle of good times and bad times. That means, that in the good times, you should:
- Put some money aside for the bad times.
- Invest some money in things that will improve your relevancy as markets evolve.
- Not let your cost structure rise to levels that can only be supported in good times.
Then, in the bad times:
- Live off some of the money set aside in the good times rather than destroy your offering (and image) through overly excessive cost cutting.
- If it looks like the weather has changed permanently for the worse, be ready to make radical moves to become relevant again. Don’t just try to wait it out if it looks like business is not ever coming back to your business model. In the best case scenario, you would have started investing in these changes back when times were still good.
To be a good farmer, my friend’s parents had to know more than just how to farm. They also had to be good investors. Similarly, good businesses cannot just be managed by people who only know how to operate the current business model. They also have to know how to invest in what will replace the current business model.