Do businesses always have to grow?
Business life cycle. Source: Aswath Damodoran
The short answer of course is no. There’s lots of businesses that have falling revenues. In fact, one classic way to turn around an unprofitable enterprise is to shrink it to profitability. There’s a life-cycle to most companies and industries: start-up, growth, maturity, and decline. It’s happened in technology (PCs), newspapers, transportation (trains), and other areas. It may be happening to brick-and-mortar retailers today.
But we don’t like to think about shrinking businesses. It seems unnatural to assume that a firm will see diminishing sales and declining margins. We lionize Steve Jobs, not Larry the Liquidator. CEOs that grow their companies get put on a pedestal, with books written by and about them. Leaders that preside over mature corporations don’t get as much attention.
That’s what can make value investing so tricky. The fair market value of a company in decline is a lot lower than one that’s early in its life cycle. Declining firms distribute more cash to shareholders as well, because there are fewer opportunities to deploy it profitably within the company. Taken in aggregate, value stocks are cheaper—but often, they are cheap for a reason. Blindly purchasing low PE stocks and high dividend yields can lead to disappointment—a “value trap.”
In sports, defense is just as important as offense. But people like to score goals more than they like preventing them. This cognitive bias can create opportunities. Declining firms aren’t worthless. When irrational gloom sets in, investors can profit—if they’re careful. As always, valuation—and values—matter.
Douglas R. Tengdin, CFA
Chief Investment Officer