Several years ago, Michael Mauboussin and his colleagues wrote a great paper titled – Corporate Longevity – Index Turnover and Corporate Performance, which provides some great insights on why some companies manage to successfully survive over time while others capitulate. Here’s an excerpt from the paper:
Why Companies Die
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.24
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.
Corporate longevity is important for investors for a handful of reasons. First, if longevity is contracting then investors need to rethink valuation, position sizing within a portfolio, and the magnitude of sustainable competitive advantage. Our analysis shows that while turnover in the S&P 500, a proxy for longevity, is reasonably well correlated to an index of innovation, the turnover is even better correlated to M&A activity.
That innovation and M&A are linked makes sense, but we also know that other factors, including capital availability, stock prices, and the institutional imperative, influence M&A waves. On balance, turnover for the S&P 500 and Fortune 500 is rising, but not at a dramatic rate. A better description is that turnover comes in waves. Further, changes in criteria contaminate the turnover results.
Another reason that investors need to understand longevity is to assess the risk of failure for stocks within their portfolio. This is especially pertinent for investors in value and small capitalization stocks. About one-third of the removals from the S&P 500 over time have been companies we categorize as failures. These companies have poor TSRs and below-average CFROIs. Since these stocks are often inexpensive, they can represent value traps. The data also show that young companies, which are generally small and private, tend to have a higher mortality rate than companies that make it to adolescence.
Finally, investors who have their results compared to a benchmark need to appreciate how that benchmark changes. While most investors consider index funds to be passive, the indexes themselves change quite a bit over time. Note that the S&P beats roughly 60 percent of active managers in an average year and does so without any trading, macro forecasting, or limits on position or sector size.
The S&P 500 committee presents a very attractive trading strategy. Using historical numbers, investors who bought the stocks that the committee removed from the S&P 500 (that still traded) and who sold short the stocks entering the S&P 500 would have earned a tidy excess return. It appears the S&P 500 committee behaves in a way that many investors do: It buys high and sells low.
You can read the entire paper here:
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