Identifying success
Success is the mirror image of these failures – the business survives and prospers.
But can we recognise businesses whose management have managed risk and
made wise decisions as a result? Can we differentiate these from those that have
just been lucky? I think it is possible to make a hypothesis, at least by categories.
It is very noticeable that pharmaceutical companies tend to have relatively
low gearing. It is also noticeable that very successful companies tend to have
low gearing compared with rivals from the same industry. Now, it could be that
there are many successful pharmaceutical companies and therefore we can’t tell
whether it is success or industry that is making the difference. But maybe phar-
maceuticals is an inherently high-risk business. Forget about beta and volatility
of market returns: those businesses are vulnerable to major product failures fol-
lowed by hugely expensive lawsuits; they are vulnerable to their best-selling
products running out of patent protection; they are vulnerable to a sudden decline
in blockbuster new drug invention because you cannot plan for inspiration. They
are particularly vulnerable to Nassim Taleb’s Black Swan
events unpredicta-
ble and rare that are not accounted for by risk measures that deal with normal
distributions of many occurrences of an event. Perhaps, because of this, their
managements accommodate operational risk by limiting financial risk.
In a different industry, Microsoft has relatively low gearing. It too could be
particularly vulnerable to Black Swan events: a sudden invention by a rival; a
dramatic product failure; crippling anti-trust action. If there are tax advantages to
debt and studies suggest there are then why operate at consistently lower
gearing than your rivals unless you are taking a view on risk and balancing it?
National Grid, an example of a utility business, does not really have to worry
about those Black Swans nor about volatility of returns because it is effectively in
a ‘cost plus’ business. As a result it can manage huge borrowings. My hypothesis
is that managers of all these businesses have thought about risk and have man-
aged it successfully.
Nassim Taleb (2008) The Black Swan: The Impact of The Highly Improbable, Penguin.

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