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The economy’s periodic knockout punches to businesses that are unsustainable

What happened to Lehman Brothers was exactly what happens to a greedy individual when a bull market suddenly reverses. bloomberg (Photo: Bloomberg)Premium
What happened to Lehman Brothers was exactly what happens to a greedy individual when a bull market suddenly reverses. bloomberg (Photo: Bloomberg)

  • The economy has a periodic routine of delivering knockout punches to businesses that are unsustainable
  • Dealing with any crisis begins well before the crisis even sets in. Staying true to core values, and discarding some of the baggage, gives you a greater chance of success

On 15 September 2008, Lehman Brothers, a global financial services behemoth, filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code. With total assets of $639 billion and total debts of $613 billion, it was the biggest bankruptcy filing in American history. For Wall Street, and for most of the corporate world, the unthinkable happened.

Lehman Brothers was an investment bank that like any other investment bank was not subject to the regulations that regular banks, which solicited deposits, were governed under. Someone observed that over the years, it had morphed into a real estate hedge fund that was masquerading as an investment bank.

What happened to Lehman Brothers was exactly what happens to a greedy individual when a bull market suddenly reverses.

Assume a stock has been doing well and is currently trading at $85. You expect it to go up further. You buy a thousand shares. Instead of going up, it crashes to $25—you would have lost $60,000. This error in judgement is unlikely to bankrupt you. However, if you were greedy and borrowed $850,000 to buy another 10,000 shares and the stock price had dropped to $25, you would be owing someone $600,000. Now, you are certainly bankrupt!

This is what happened to Lehman. They were holding housing assets almost 30 times their capital; they had borrowed hugely to invest in the housing market.

The economy has a periodic routine of ‘spring cleaning’ during which the system is cleansed of businesses that are inherently unsustainable, and bankrupting investors who don’t respect fundamentals. These phases tend to be dubbed as ‘downturns’ by those who are sent to the cleaners.

Continuing with the Lehman story, we’ll see how someone actually saw this as an opportunity and made the best of it.

In less than a week from the collapse of Lehman Brothers, Warren Buffet’s Berkshire Hathaway invested $5 billion in investment bank Goldman Sachs’ preferred stock, with 10% per annum dividends. This investment injected the much-needed optimism into the system. The investment was made at a price ($115) that was less than half of the pre-crash Goldman stock price ($248). Berkshire Hathaway also received warrants to buy $5 billion of Goldman Sachs stock at $115 a share.

In 2011, less than three years after the investment, Berkshire Hathaway redeemed the shares and earned a profit of $3.7 billion on its investment of $5 billion. And, in 2013, they exercised the warrants and received $2 billion in cash and 13.1 million shares of Goldman Sachs in stock.

There are two lessons here. One, going against the herd often works, and two, there are no universal downturns. Because someone’s downturn could be someone else’s ‘opportunity’. When everyone was despondent and hopeless, when the markets had tanked and the bottom was not in sight, it took character to invest.

Good investing has always been about character. Similarly, building a sustainable business is also mostly about character.

Easy Money is not an answer

When the covid-19 pandemic began impacting the economy, central banks across the world responded as they always do—by increasing the money supply.

Here’s a sense of the magnitude of the increase: the US Fed printed more money in the last two years than in its entire period of existence. Part of this money was used to provide relief to those who had lost their jobs or were impacted by the pandemic in other ways. However, the biggest beneficiaries of easy money have always been the wrong ones.

They are institutions that channel this money into either stock markets or into funding unsustainable businesses and end up creating unrealistic valuations in both the public and private markets. Following the footsteps of these pied-pipers are millions of ordinary retail investors who are taken in by the ‘get-rich-quick’ stories, only to be marooned when the tide recedes.

Like a rising tide, easy money lifts all boats including the ones with holes that are not seaworthy. And the tide recedes when easy money starts fuelling inflation. In November 2021, inflation in the US touched a 40 year high of 6.8%. By January 2022, it had touched 7%. End of easy money.

Notionally poor, really poor

When asset prices drop, people who begin to measure their affluence by the net-worth of their assets suddenly start feeling ‘poor’. They cut down on expenditure. Economists call this the ‘wealth effect’. Wealth effect typically impacts spending on luxury goods. Most purchases of luxury products are either put off or substituted by products that provide value for money.

Contraction in demand is also a fallout of people losing jobs. All discretionary purchases are put off. Discretionary spend is usually of the kind that is expected to either deliver benefits in the future or is mostly just plain wasteful expenditure. If a company is selling products and services that buyers consider discretionary, there would be a dip in revenue during these downturns. The higher the percentage of discretionary products and services in the revenue stream, the sharper the dip.

Well-funded startups that have a substantial revenue stream subsidized by capital burn need to make sharp course corrections and learn their lessons. With capital scarcity here to stay, market-creation needs to be done more thoughtfully and sustainably. Some of the customers who came for discounts may disappear, but that should be good.

If this is the first downturn a startup is facing, it could be quite intimidating. But it helps to stay focused and do whatever it takes to survive. The lessons that one learns, and the influence it has on how one builds the business, going forward, last a lifetime. New habits take shape and old ones hopefully don’t return, and that’s the reason why founders who have seen downturns don’t pay too much attention to vanity metrics, and are focused on building a business that is sustainable and somewhat recession proof.

Downturns have also sparked innovation, and as they say ‘necessity is the mother of invention’. Microsoft developed the idea of easy-to-use computing for homes and offices as a response to challenges created by the recession of the early 1970s.Apple and Netflix reinvented themselves to who they are now during the dotcom bust.

Stanford economist Paul Romer had once made an interesting observation: ‘a crisis is a terrible thing to waste’.

Separating wheat from chaff

A downturn also creates conditions that are particularly conducive for separating the wheat from the chaff.

In the last cycle of correction, Flipkart raced ahead and Snapdeal slipped, settling at a new level that reflected the inherent value of the business. Some other start-ups like Jabong and ShopClues ended up being acquired at values that reflected their true worth, which was just a fraction of their peak valuations. Many other startups simply shut.

This does not mean that it is a bad idea to load up on capital when it is available in abundance and strive to build cash guzzling businesses. It is just a part of the natural law of evolution that when a crisis strikes, businesses that happen to be on the wrong side of the cycle could be hurt fatally. However, it is a bad idea to knowingly build businesses that break all norms on what constitutes reasonable risk, like what Lehman Brothers did. It is also a bad idea to push for and seek valuations that don’t reflect the inherent value of a business because overvalued businesses would see the maximum correction in bad times. Besides the correction, it creates a permanent loss of brand and reputation.

Betting on the downturn

If you are an investor, selling in panic is the worst thing you could do. The reason dumb investors end up ‘buying high and selling low’ is because they don’t have the courage to go against the flow of majority opinion and behaviour. This is true of poor leadership in general. Good investing, as I pointed out early on, has very little to do with an in-depth understanding of markets but is mostly about character.

This is the time to buy underrated stocks. Remember that just as a high tide lifts all boats including the leaky ones, a low tide tends to knock out all boats including the sturdy ones. Spot these metaphorical sturdy boats and invest in them.

Products that are seen to offer value for money could even see growth in a so called downturn because they end up as substitutes for premium products. This is also probably a good time for a lesser-known brand, with a sound underlying business, to go out in the market and make a splash. When most companies have curtailed their marketing and ad spends, the rates and noise would both be down and any new campaign is likely to receive eyeballs.

Resilience story

Downturns could be triggered by a range of macro-economic events. The biggest one by far in independent India was the forced dismantling of protectionist policies in 1991 and the launch of reforms. Many companies perished in the aftermath. The story of one company that survived against all odds is an inspiring one. It is of Tata Steel. And this is all the more relevant because this year, under the leadership of T.V. Narendran, Tata Steel emerged as India’s most profitable company.

In the book, The Greatest Business Decisions of All Time, which Fortune editors led by Verne Harnish put together, the decision of J.J. Irani (former Tata Steel managing director) to cut the workforce from 78,000 to a little over 40,000 finds a place alongside Apple’s decision to bring back Steve Jobs that transformed Apple completely. It was not the decision to cut the workforce, but the way it was structured and executed that made it worthy of a place in the book.

Overnight in 1991, the steel market changed from a sellers-market to a buyers-market. On the back of India’s protectionist policies, the industry in general and the steel industry in particular, had grown sluggish, unenterprising and obsolete over the decades. Customers suddenly had choices and their choices mattered. Golf and dinners no longer worked and the sales teams of steel companies had to learn to ‘sell’.

Irani was the right leader for a crisis like this. The management team members who excelled at golf, lunches and dinners, suddenly found themselves at the wrong place at the wrong time.

Irani quickly assembled a new management team that could lead from the front and modernized the steel works on a war footing. The manpower productivity at Tata Steel was among the lowest in the world. You could never be fired for non-performance—the Tatas had been proud of this culture, and until then, used every opportunity to reinforce pride in this. This had to change.

Irani succeeded in creating a survival anxiety that exceeded the learning anxiety, a condition critical for change to occur. Quite understandably, the unions were very upset. He had, after all, shaken some power structures and cozy relationships. Soon though, everyone understood the gravity of the situation and the imminent threats to survival. In the Tata tradition of labour-management consultation, the rightsizing of the workforce too was accomplished through a consultative process. The separation package was win-win for both the company and the terminated employees. When Irani’s term ended in 2001, Tata Steel was one of the most profitable steel companies in the world.

In conclusion, crises are as inevitable as day and night. Dealing with any crisis begins well before the crisis even sets in. However, irrespective of the degree of preparation, you could end up being engulfed. Acknowledging the new reality with a sense of honesty, staying true to core values, and discarding some of the baggage, gives you a greater chance of success.

(T.N Hari is the author of Pony to Unicorn and an advisor at The Fundamentum Partnership)

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