5 red flags that may suggest a company in decline
Great companies can become merely good or even below average. Here is how I'd go about avoiding situations like this.
In 2001, Jim Collins released his bestselling book, "Good to Great: Why Some Companies Make the Leap ... and Others Don't."
In the book, Collins set out to identify the universal distinguishing characteristics that cause a company to go from good to great. He found characteristics such as Level 5 leadership, a culture of discipline, the hedgehog concept, and the flywheel.
If these concepts sound like corporate gobbledygook, that’s because they are. A former business consultant, Collins couldn’t resist vague consultant-speak and trying to fit backward-looking data and themes into a coherent, or in this case, not so coherent whole.
The book came to mind after recent revelations of Warren Buffett’s sell-down of Apple (NAS: AAPL), which I wrote about here. Buffett identified a great company in Apple in 2016 and bought it at a low valuation. The valuation is much steeper now though I suspect that’s not the only reason why Buffett is selling. I think Apple has gone from a great business to a good business, and could turn into a mediocre one, and Buffett knows it.
Why? Because Apple has built several great growth businesses, first with the iPod and iPhone and then the iPad. If it can’t build another growth business from here, revenue growth is likely to be anaemic and current valuations don’t reflect that. And it means returns from the stock could be below-average or even miserable over the next decade.
It got me thinking about other businesses which may be turning from great to good, or perhaps average. I’m going to suggest the big four banks, CSL (ASX: CSL), and Mineral Resources (ASX: MIN) are heading that way, and that there are five tell-tale signs which show why.
The decline of the big 4 banks
It’s been bizarre to witness soaring bank stocks over the past year, despite recent trading updates showing that their earnings are going backwards. The future looks bleak too.
Credit growth is mediocre after a four decade binge driven by Australia’s housing bubble. Recent data shows that most bank loans are going to the wealthy, and the remainder of the population is being shut out. Combine this with greater competition in the mortgage space, and it’s hard to see how this gets better.
It's true that the banks’ deposit base looks as solid as ever. Though online banks and fintechs are nibbling away at this as well. Cost cutting will get harder too. Yes, the banks can shut down more of their branches, yet a lot of that work has already been done. Technology could help, however progress will probably be slow.
All up, the earnings picture for the Big 4 banks looks poor, and that’s without assuming any rise in bad debts, which remain at historically low levels. The banks’ big advantage is that they operate in an oligopoly backed by government. But that won’t stop them going from good, or even great businesses, to average ones.
Figure 2: CBA share chart. Source: Morningstar
CSL: a big boat proving harder to move
After IPO’ing at $2.40 in 1994, CSL (ASX: CSL) has been a wonderful Australian success story. It’s one of the few Australian companies that’s become a global leader in its field. And shareholders have benefited mightily, with the stock price up around 375x (split-adjusted) over the past 30 years (excluding dividends).
Figure 3: CSL share chart. Source: Morningstar
With a market capitalization of $148 billion, though, size is becoming more of an issue. Growth is proving more difficult to come by, and acquisitions harder to find. This is best illustrated by the following chart.
Figure 4: CSL returns on capital. Source: Morningstar
The chart shows that returns of capital have plummeted since 2015. In that year, CSL acquired the flu vaccine business of Novartis. Despite the success of this business, returns have declined. That trend has accelerated following the 2022 purchase of Vifor.
This doesn’t rule out that returns may improve from here, but I’d suggest that the glory days of CSL are behind it, and tougher times may lay ahead.
Mineral Resources’ red flags
Mineral Resources (ASX: MIN) has been another fantastic success story. It IPO’ed in 2006 at 90 cents and peaked above $96 early last year, before plummeting back to today’s price of close to $35.
The company owns a great mining services businesses that generates prodigious and relatively steady cashflow. It also has solid iron ore assets. However, the company piled into lithium mining at exactly the wrong time and piled on debt too. That’s left a company vulnerable to two things it can’t control: commodity prices and interest rates.
Chris Ellison is a successful entrepreneur who may have taken one too many risks. His recent erratic behaviour isn’t reassuring.
5 tell-tale signs of great companies going bad
Here is my list of some of the tell-tale signs when wonderful businesses may be turning into mediocre ones:
- Long growth runways get shorter. It could be a technology that’s maturing as with Apple, or a cyclical trend such as credit growth that’s running out of steam a la Australian banks.
- Size limits growth. It’s much harder to grow when you’re a huge company versus being a minnow. CSL is the latest example of this.
- Acquisitions go bad. Many companies will reach for acquisitions to kickstart growth. Research suggests that most M&A is value destructive, and there’s been a long history of Australian companies making bad acquisitions, especially overseas.
- Management turns awry. Buffett loved that Apple was buying back stock when the share price was cheap several years ago. He’s likely less enamoured with recent purchases when the stock is arguably expensive. Bad management can turn a great company into a mediocre one.
- New competition bites. Wonderful businesses and sectors attract competition. That competition can eventually make headway and destroy companies which fail to adapt. Look at traditional department stores, television operators, phone companies, and the list goes on.
