Betting on Halos

Betting on Halos

by Mark Chussil

It’s easy to tell if a business was profitable after the fact. Unfortunately, we have to place our investment bets before the fact.

Even highly motivated professionals have difficulty consistently placing bets that win. John Bogle founded The Vanguard Group (currently managing over $5 trillion) in 1974 on the idea that actively managed mutual funds will not beat a well-run index fund over time.

But regardless of difficulty, we still must place bets. We bet not only when we buy a share of stock. We bet also when we decide where to work and what business to start.

How would you know if a company is worth investing in? How would you know if a business is likely to be profitable and long-lived? Make a list of the characteristics that you believe would separate good businesses from bad.

The good-business list

Perhaps your good-business list looks like this:

  • Strong market share.
  • Well-differentiated products.
  • Slightly paranoid management.
  • Innovative R&D and marketing.
  • Loyal customers.

And so on. A company might not have, or even have access to, all of those characteristics. For example, a new entrant to an existing market must start from zero market share. You enjoy com­petitive advantage if you have those characteristics in greater number and to a great­er de­gree than your competitors. You struggle against competitive disadvantage if they have the edge on those characteristics. Competitive advantage is better than competitive disadvantage. (Re­member, you heard that here.)

As you compose your characteristics-of-good-businesses list of course you are wary of halo ef­fects. (See The Halo Effect by Phil Rosenzweig.) A halo effect causes people to imbue a success­ful company with favorable charac­ter­istics because of its success. Not unlike the way rich people sure are attractive.

Some items may or may not be on your list. For instance, sheer size. (Would you rather be Gen­eral Motors or Porsche?) For another instance, fame or charisma. (Do you know what company makes Tabasco brand pepper sauce?) For yet another, track record. (Perhaps what we call a track record reflects creating or destroying good-business characteristics.)

Your good-business list might include having competitors who are ineffective, distracted, or de­luded. Imagine, for example, a big competitor that doesn’t leverage its size to gain lower costs or shut you out of distribution. That’s good luck for you. But by definition you cannot manage, pursue, create, or depend on luck, so I balk at suggesting that what separates good businesses from bad is that the former are luckier than the latter. Being lucky isn’t the same as being good.

The bad-business list

What’s not on your good-business list? Surely items better suited for a bad-business list, such as complacency, denial, bureaucracy, and resistance to change. The people who like such busi­nesses are those who specialize in fire sales and turnarounds… that is, people who want to turn a (bad) business into a different (good) business.

Your bad-business list might include having unusually effective competitors. That’s bad luck for you. And those ineffective, distracted, or deluded competitors can be bad luck too. They could, for example, damage the reputation of your industry through shoddy products or slimy prac­tices. I recommend distinguishing unlucky from bad just as I recommend distinguishing lucky from good. I know it’s not simple but it can be done. As one of my teachers told me: “I didn’t say it would be easy. I said it would be worth it.”

Placing your bets

Time to play investment roulette!

You can choose to invest in (or work in or start up) only one of these two businesses.

  1. Business A has most of the characteristics on your good-business list. However, it is re­porting poor results.
  2. Business B has most of the characteristics on your bad-business list. Even so, it is enjoy­ing great performance.

Which one would you choose?

If you chose Business A, the good business with poor performance, you are implicitly asserting a belief in principles. You are saying that its results will improve because its strengths, its competi­tive-strategy funda­mentals, are strong.

If you chose Business B, the bad business with good performance, you are implicitly asserting that its lucky performance will persist or that you’ll time your exit per­fectly. You are gambling.

Pay attention to how you, your colleagues, and even the media gauge the attractiveness of a busi­ness. Do you and they use good- and bad-business lists and think in terms of principles? Or are you and they swayed by current performance, the halo effect that the business must be strong because its perfor­mance is good?

Of course a business’ fundamentals can and do change over time. Changing them deliberately, for the better, is what competing as a skill is about. And when they change, for better or worse, we expect that the business’ performance will change. At least that’s what the people who chose Business A would expect.

One more question. A recent article about Blackberry and its struggles (“Blackberry to Ex­plore Its Strategic Alternatives, Including a Sale”) contains this intriguing statement: “Taking Black­Berry private would remove the distraction of having to manage quarterly financial results to protect the company’s share price…” On which of your lists would you place “manage[s] quar­terly financial results”?

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