Why are Declining Businesses Difficult Investments?
Forget pizza, bruschetta, risotto and pasta. One of the best things about Italy is mortadella, a pork sausage flavored with spices and pistachios. It may not be fancy but it is loaded with flavor, and great travelling memories.
What, then, to make of Felsineo, the leading mortadella manufacturer, offering a vegan option – of a pork sausage – sold under its traditional label?
The decision could be seen as either bold or stupid but Felsineo’s had little choice. As Italy’s population ages, demand for meat is falling. Younger Italians, meanwhile, are increasingly choosing a meat-free life. Eurispes (the Institute of Political, Economic and Social Studies), estimates that 7.6% of the population is either vegetarian or vegan. And meat-eating Italians are buying higher quality cuts. Sales of cured meats like mortadella fell 5% in 2016.
Felsineo is desperately trying to fight a slump in sales, which is proving more structural than cyclical. It is a challenging task, although successfully investing in a shrinking business like Felsineo may be even harder.
Overcoming structural change is possible. Netflix, which once sent out DVDs in cardboard envelopes and now streams its own content across the Internet, proves it. But it’s a rarity. History shows that established firms struggle to reinvent themselves.
Changing what has worked for decade’s takes courage, especially if it causes sales to initially fall faster and costs to rise for years. Genuine innovation is more likely to come from newer and more agile firms with no preconceptions, no history.
An alternative path is to fight structural change through diversification. This, as in Felsineo’s case, involves expanding the product range to ‘adjacent’ categories and markets. It seldom works though, as all challenged firms end up doing the same thing and competing fiercely with each other.
A third path is to acquire businesses in unrelated industries, much like Fairfax bought Stayz, an online accommodation portal. This is risky. Successful acquisitions are generally opportunistic and not motivated by need.
None of these options are attractive. So if a firm falls victim to structural change, why not just shrink?
For investors at least, this makes sense. The best managers are those that allocate capital most efficiently, not those that try to predict future trends. After reaching maturity, often sitting back and focusing on cash flow is the low risk option. In practice though, it rarely happens.
Shrinking is preferable but hard
When sales are falling, fixed costs have a growing, adverse impact on profitability. And there is only so much that a firm can cut expenses. Again, Fairfax proves this point.
At the same time, directors and managers don’t want to oversee a contracting business, often because their fees and salaries are dependent on growth. Owner-managers, meanwhile, tend to take pride in the longevity of their companies to the point of even denying their businesses are in trouble. Gerry Harvey, the founder of white goods retailer Harvey Norman, comes to mind.
“History shows that established firms struggle to reinvent themselves”
Declining businesses tend to first resist structural change. Then, when it’s too late, they try frantically to fix things up with ill-conceived new products or foolish, overpriced acquisitions. Either way, shareholder value is destroyed. This is why declining business make for such difficult investments.
When we invest in such businesses we don’t expect them to turn around. We look for alternative sources of value unrelated to the core business that might be hidden within them.
One of the recent investments in the Forager International Shares Fund, into set-top-box manufacturer Technicolor is a good example. The stock is discussed in detail in the Forager December 2017 quarterly report. But if you can’t find a reason like this to invest in a declining business, best steer clear.
Steve Johnson, Forager Funds Management, www.foragerfunds.com