Michael Mauboussin: Why Companies Die
The most common pushback we receive from potential investors is that stocks in our portfolio trade at high PE multiples. Our response has been that given the value of a company lies in its cashflows to perpetuity, companies with high longevity of these cashflows indeed have very high intrinsic values – (see our newsletter). In this blog in The Acquirer’s Multiple, Johnny Hopkins brings up Michael Mauboussin’s research, which talks about the importance of corporate longevity. Mauboussin compares companies to ant colonies’ tendency to exploit current sources of food yet at the same time explore new sources of food for the future, that can underpin longevity.
“Imagine an ant colony with a nearby source of food. Foragers find the food source and use chemical signals to tell the other ants where to go to find the food. Call this exploitation. But some ants leave the chemical trail and wander around seemingly aimlessly. Call this exploration. Why would an ant ever leave the main trail to the food? If another rich food source appears, the colony wants to have a mechanism to find it. Ant colonies balance exploitation with exploration. But it gets even better: The rate of exploration is roughly correlated with the rate of change in the environment.
Our speculation is that a similar model can help explain why companies die. Successful companies generally have a core source of profits. For many reasons, corporate leaders tend to dedicate too many resources to exploitation of profits and not enough to exploration. Commonly, exploration requires a different structure than exploitation, causing companies to stumble. The best companies are those that can skilfully balance exploitation and exploration.
By contrast, cities and universities have less pressure to optimize, and hence are more capable of evolving and skirting failure. From a societal point of view, the rise and fall of individual companies may be healthy. But for an individual who is involved with a company on the decline, the pain is real.”
At Marcellus, we deploy what we call as ‘Lethargy tests’ to assess if management teams of our investee companies are getting lax on the exploration front that can undermine their longevity. See our newsletter here which discussed the ‘Lethargy test’ framework in detail.