How to Protect Your Portfolio From Self-Destructive Companieshttp://www.fool.com/investing/general/2013/10/28/how-to-protect-your-portfolio-from-self-destructiv.aspx Isaac Pino, CPA
October 28, 2013
One of our favorite quotes at the Motley Fool is from Warren Buffett's 1988 letter to shareholders of Berkshire Hathaway: "When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever."
The emphasized portion (mine) is inscribed on a wall at our headquarters, and this philosophy of investing over the long, long haul exemplifies our stock-picking approach as much as any other.
But in reality, it's a mind-set more than anything. Even great companies will fade, and many will self-destruct. As the late Steve Jobs noted: "Death is the destination we all share. No one has ever escaped it, and that is how it should be. ... It clears out the old to make way for the new."
For investors, how do you recognize the symptoms of self-destruction? While even the seemingly impenetrable "blue chips" will eventually meet their demise, there are three key questions you can ask to help protect your portfolio from the wreckage.
Does management prioritize the product?
For Steve Jobs and Apple (NASDAQ: AAPL), the product always came first. Apple followed many different paths over the past 37 years, but it only prospered when the company focused on creating the right products. Jobs describes how great organizations lose their way in his Walter Isaacson's biography of him:
If you consider the alternate paths taken by Apple and many of its competitors, this concept crystallizes. Computer companies like Dell, Gateway, HP, and IBM managed to deliver PCs for the masses during the 1990s, which was a tremendous feat. But the PC itself became a commodity, an undifferentiated product for customers.
More often than not, marketing the PC's numerous features became more important than the PC itself. Second, a race to rock-bottom prices began. In either scenario, the engineers were relegated to the sidelines, and the marketers and accountants took over. The products are no longer the focal point, and as Jobs points out, this causes the engineers to "turn off."
This problem, incidentally, seems to occur less often at would-be competitor start-ups, but emerges when complexity increases within organizations and various parties vie for resources. As David Karp, CEO of the highly successful blog platform Tumblr (now owned by Yahoo!), stated recently: "My philosophy toward [profitability] has always been, like, the guy on the corner selling fruit is running a profitable business. There are many profitable businesses out there. There are only so many very large networks."
At start-ups, it's a little easier to place the product on a pedestal. Hopefully, the rest -- profits, lenders, and stock bonuses -- will take care of itself down the road.
For larger companies with highly vocal stakeholders, the marketers, accountants, and financiers can end up running the show. Which is exactly what can lead a great company astray.
Has the company protected its blind side?
Harvard business professor Clayton Christensen dubbed this management challenge the "innovator's dilemma" in the mid-1990s, and he continues to refine the following theory:
Disruptive innovation occurs when upstart competitors attack an existing market by targeting a different set of values for customers.
The airline industry is a classic example, where Southwest Airlines (NYSE: LUV) was able to lure customers away from big carriers by offering frequent, low-priced trips to underserved markets. In this scenario, it can be hard to blame the big carriers for initially ignoring a threat like Southwest. In order to boost the bottom line, legacy airlines realized they needed to offer more long-haul flights where they catered to first- or business-class customers and provided a differentiated service. After all, these were the most profitable routes and frequent fliers were their most valuable customers.
The industry giants, insistent on capturing the low-hanging fruit, allowed dirt cheap carriers like Southwest to pick up the scraps. So Southwest did, and it built a loyal, dedicated following in the process. Christensen sums up the dilemma as follows:
From Christensen's perspective, the only solution is to "develop a disruption of your own before it's too late." Accommodate all levels of the food chain in your industry, and seek out the next big thing before someone else introduces it to the marketplace.
For investors, that means identifying whether a company's leadership has their finger on the pulse of the industry's future, not the present. Are they investing in niche, up-and-coming markets or products? While these investments will consume resources and hamper profit margins today, they just might save the business in the long run.
Who's safeguarding the company culture?
The evolution of the investment banking industry illustrates how culture can take a backseat at one of the world's most-revered banks, Goldman Sachs (NYSE: GS). Steven Mandis, a former employee, documents the shift in his recent book, What Happened to Goldman Sachs. Mandis describes the Goldman of years past as a tight-knit family, where tenure and teamwork took precedence over rainmakers and where IPO fundraising was reserved for proven, profitable businesses. Over time, all of that changed as Goldman "drifted" away from its roots.
Instead of it happening overnight, a steady stream of pressures -- regulatory, organizational, and technological -- nudged Goldman's leadership in a certain direction. Today, Goldman remains a preeminent bank, but the transformation, from Mandis' perspective, could "[I]ncrease the probability of some sort of organizational failure, when you drift from the original principles."
The banking industry stands on more solid ground today than it did a few years ago, but the culture on Wall Street leaves a lot to be desired. As Tony Hsieh of Zappos points out, "Corporate culture is every bit as important as