Thrill ride or smooth path?

The scenery in Calgary is wonderful, great for outdoor activities. Just this summer, Kara, a member of our Research team started mountain biking. She liked this adventurous form of recreation so much, she invested in new gear and jumped at the opportunity to register for a 24-hour mountain biking marathon. To our relief, Kara returned from the marathon primarily intact—albeit fairly bruised. But it is certainly hard to blame her for taking the risk. The inspiring stories that we hear from our CIO Jim, an experienced mountain bike racer, are hard to resist acting out for ourselves. I have to confess that I started biking this year, too. The difference is that I bike to the office on a smooth, safe path along the river. In comparison to Jim and Kara’s biking excursions this may seem boring, but Jim has years of biking experience under his helmet; and as for Kara, suffice it to say, I am glad she returned mostly unscathed.

In investing, it is also alluring to dive right in and try a stock picking approach that seems to work well for others. For example, one could identify a long-term trend and then invest in a company that could take a lion's share of the expected increase in sales from the trend. While this may seem easy, we have found that it takes a lot of research and due diligence for this approach to prove successful.

Companies, themselves, also actively look for such opportunities. For an effectively managed company, with excess capital to deploy and fine-tuned systems and processes in place concerning the addition or expansion of product lines, investing in a new trend can present a real opportunity to increase profitability. A good management team expands into the new area carefully, reassessing along the way to gauge if the route can indeed be traversed profitably without disrupting existing operations.
The story can be quite different for mediocre and poorly managed companies. They initially see a new trend as a saviour, an escape from their existing problems—whether this is capacity underutilziation or strained cash flow, or both—and then, ultimately, as a great profit opportunity. Their Operations team is directed to make sure there is enough capacity to meet demand, Marketing is told to bring in new business, and investors are promised a better future. Sales soon start to roll in, margins improve as capacity utilization increases, and the stock price rises. Often warning signs appear along the way, however, depicting pitfalls ahead. Inventory buildup starts to outpace sales growth, cash flow lags behind reported profits, and management turns to debt or equity investors to bridge the funding gap. Their problems typically continue to expand, impacting other parts of the business, as management shifts resources and is pressured to mitigate losses in the new product line by squeezing other segments. Around the next curve are profit warnings followed by a change in management and strategic direction—perhaps the entire business is soon restructured.
We have observed that companies with truly effective management teams are few and far between. It is too easy to misread false positives, such as rising sales and profit margins, which could mean that the company is indeed doing well, but they could also indicate it is on the brink of a profit warning. Finding able riders on the management circuit takes time and effort. We often trace a company’s performance promises back 10 – 15 years to see how they have delivered.

The bottom line in the investment marathon is that we prefer to arrive at our destination safely. This doesn’t mean that we won’t invest in companies that follow the new trend approach. We just don’t throw caution to the wind and invest before following a diligent, systematic investment approach—which can often be seen as the long, smooth path.