He said, “When I thought through this scenario, I thought how fitting that is also for businesses, and how a business on the surface might seem like everything is perfectly fine, that they’re going to continue to do great things, [and] are going to continue to grow market share. But fundamentally, if a person really understands what makes the business tick, the seed for their destruction or their downfall or their pullback is already embedded into that company.”

So he thought to himself, “How can I identify what that is before all this starts to unravel?” I really liked that analogy, and I think that it’s very fitting when you’re thinking about a business, because so often, management is going along their merry way thinking that everything’s fine and dandy. Then all of a sudden, it’s quickly unraveling itself faster than they could ever imagine. 

He describes this process of a company that falls from grace in five stages. The first stage is the “Hubris born of success.” The second stage is “undisciplined pursuit of more.” The third stage is “Denial of risk and peril.” The fourth stage is “Grasping for salvation,” and the fifth stage is “Capitulation to irrelevance or death.” 

So what we’re going to do through this episode is we’re going to talk about each one of these stages.. We’re going to talk about the things that kind of identify and signify whether you’re in stage one through five. Just for the progression stage one would be you’re that runner that has the seed of the cancer and you don’t even know it, versus stage five is everything is falling apart, and you’re at your death phase with the business. 

Did you have anything else you want to add for the intro and the overall summary of what we’re going to be covering, Stig?

Stig Brodersen  5:55  

No. I think the only thing I want to say is I think it’s important to have respect for why it’s easy to look back at call it, Lehman Brothers or Bear Stearns and say, “Yes, this is a very simple narrative of why things go wrong, and how difficult it can be when you are in the middle of the situation.”

I think it’s important so we don’t make this too simplistic. There are some very smart people running these companies that we’re talking about and also that failed. It’s just one of those… It’s easier to explain what has happened, than what’s going to happen, I guess.

Preston Pysh  6:32  

Yeah, that’s a great point. The other thing that I want to quickly highlight is like any Jim Collins book, there’s just a ton of research here. He backs this up with case studies, and he backs it up with research from actual companies. That’s the one thing I really like about his writing is it’s not just anecdotal. He has a lot of examples to substantiate his claims. 

So let’s go ahead and enter the stage one: hubris born of success. When we’re talking about this first stage, we’re talking about “Is that a company?” I guess the easy way to say it would probably be [that] a company has an ego problem. We’re successful because we do these specific things and they’re going around outing that. 

What Collins says they should be saying is we are successful because we understand why we do these specific things, and understand what conditions would prevent those from happening or that they wouldn’t work any longer. 

So understanding [the] why of the specific things is the important part. He provides an example with Motorola. They invented the StarTAC cell phone, which were the smallest phones in the world at the time using analog technology. 

However, at the time, this is where digital was starting to come out and you can kind of see that phrase that he was saying, “We’re successful because we do these things,” but they’re not understanding why they do the specific things. He talks about how the amount of impact that had and how that set them back.

Stig Brodersen  7:58  

Yeah, and it’s actually very interesting. Speaking about a company like Motorola, I mean for decades has been praised as one of the very best companies. You might be thinking it’s because Motorola didn’t reinvent itself, like they kept on with the analog technology and they didn’t go digital. That’s definitely a huge explanation.

However, Jim Collins talks about how complacency is really not important. I mean, it’s easy to come up with a narrative saying that the company didn’t change the way they should. It’s not a question about changing. It’s not a question about innovation if you look at the stats. That was something that also surprised the author when he was conducting this research. 

A company like Motorola, they never had as many patents as when they’re all filing for bankruptcy. They just have the wrong patent. They couldn’t understand why they were successful, and in which situations they were not successful. It’s very important just to read between the lines and he is starting out this chapter… 

Perhaps it was even in the preface about the United States Leather Company. They were once the biggest companies in America. I think [they were] like the 15th, the 17th, at the start of the 20th century, but they just didn’t reinvent [themselves]. They kept producing saddles, which was not a good investment. It turned up when the car came out. 

Basically, he’s telling that story to tell you that the stories are not as important as the data that you’re looking at. It’s all about understanding why you’re successful, not all the other, what you would call noise.

Preston Pysh  9:35  

So concluding this first stage, let’s talk about some of the indicators that help you identify whether you’re in stage one. This is the one that I really liked and this is the thing that I always say to Stig, whenever we’re thinking through our strategy with our business, and that’s neglect of the “primary flywheel.”

So going back to Collins’ first book, he talks about this thing, the flywheel. What’s that fundamental thing that the business does and does better than anybody else on the planet, and is really their competitive advantage that they’re really, really good at and they’re very efficient at? He says that when a company starts getting away from that thing, they start drifting off… Maybe focusing on other things or leaders get distracted by the exciting potential earnings that they fail to focus on. That’s when the companies set themselves up for this stage one. 

I like this point, too. He talks about refusing to attribute luck to random events. He says that the management thinks that every success that came to the company was 100% due to their actions, as opposed to, “You know what, we did this really well. But if we didn’t have this lucky circumstance over here that happened, we would have never been able to be catapulted to where we’re at.”

They’re basically attributing all success completely to their actions and that’s a dangerous thing. That’s where he goes really stepping in, and not accounting for the why. I think that’s the big word in this first stage that you got to really understand is why did we do this? So just a couple points.

Stig Brodersen  11:11  

It really comes back to the episode we did… I think it was Episode 108, called The Outsiders about the very best eight CEOs. They really own their mistakes, and they own everyone else’s mistakes. If something went wrong, it was always the CEO saying, “It’s my fault. What can I do about it?” Even when it was not his or her fault. It was just the approach that they have. 

Every time things went well, the author would have what he called, like, “Look outside the window principle,” or something like that. It’s basically meant that he would attribute all the good fortune to someone else, like his team, the market conditions, whatever you could come up with. That’s just such a healthy approach and really makes you humble. 

One of the best stories that Jim Collins comes up with, to exemplify this in the first days is he’s talking about Walmart versus Ames. Ames was a retail that came out four years before Walmart and they basically have the same concept and same opportunity. Though the reason why Walmart was so successful compared to Ames that was really because of Sam Walton’s humility and his willingness to learn. 

The anecdote that he attached to this story is that at some point of time in the 80s, Brazilian investors bought a discount chain. It was only going to run in Brazil. They sent out letters to 10 CEOs in the US to consult with them, and have a brainstorm meeting on how we can best serve our customers. 

Then, 9 out of 10 people ignored [it]. The one person who came to those meetings, who met them and spent the week with the Brazilian CEO was Sam Walton. He did that not just to teach them how to run retail, because he said, “I’m not sure I know why. I might just be lucky with Walmart before… What can I learn from you? What can I learn from you that is useful, so I can sustain the success that we have so we can keep on growing?” 

That just tells you the opposite side of this arrogance of being, of course, successful. We are Ames. Of course, we are supposed to be successful, because they’ve got a track record the past 10 years. While Sam Walton would say, “I don’t care about the past 10 years, what’s going to happen the next 10 years? And how can I get that?”

Preston Pysh  13:20  

And how can I own up to it? So I’ve got a funny story that I can tell you from when I was young. I got out of high school, I go off to college, and I ended up going to West Point. At West Point, they have an interesting way to introduce you to the school. 

In the very first day, when you show up, you were taught that as a freshman, you have four responses. If you’re talking to an upperclassman, the four responses are: “Yes sir/ma’am,” “No, sir/ma’am,” “I do not understand sir/ma’am,” and “Sir, no excuse sir/ma’am. No excuse.” 

I think for a person hearing that from the outside, they might be like, that is ridiculous that that’s the only thing you’re allowed to say, unless they ask you to expound on something. The last one is the one that I want to highlight, because I think it fits into this stage one, where we’re talking about taking ownership and when you are forced to say no excuse, even if in your mind, there’s an excuse and there’s a reason why something happened. Maybe your friend did something, and you got in trouble for it. The only thing that you can respond with is no excuse. 

I had no appreciation for this at the time, but looking back decades later and looking at the experience, what it forced me to do personally, after going through that for an entire year of saying, “There’s no excuse.” Sometimes the comeback would be, “Well, yeah, there is an excuse. Tell me what you failed at.” 

So then you would have to say, “Well, if I would have done this better, then that circumstance might not have played out.”

It forced me to take ownership for every single thing, even when it wasn’t my fault. Even if it was my friend’s fault. I had to take ownership for it. That was a really, really powerful thing that I learned at a young age that I still hold with me today. In that when something doesn’t go wrong, I like to feel like maybe other people in my life might argue that this is how I handle things. Though I would like to feel like I always look internally at myself first and say, “How could I have done that better?” And it comes back to that lesson that I learned as a young cadet years ago. 

So moving into the second stage, this is “undisciplined pursuit of more.” I loved his example in this stage here because he talks about Rubbermaid. He talks about Rubbermaid making so many products that they were actually making a product every single day of the year. 

They got to a point where they were making so many products and they had so many products on the shelves, that when they went back and looked at how many products they had, versus the time that they did it in, they had literally made a product for every single day in the year.

I mean, anybody looking at that, from the outside can say that does not make any sense whatsoever. Like you have to know what your market really wants: what’s going to give you 80% of the return for 20% of the effort? You got to just optimize the living heck out of it. The example he provides with Rubbermaid was quite amusing. 

Stig, I know, you’ve got some notes on this idea.

Stig Brodersen  16:24  

I think the best example I can come up with all this undisciplined pursuit for more is that would be Starbucks. Starbucks was actually not mentioned in the example. He used America as an example but it’s basically the same. So what happened with Starbucks, I want to say it was around 2005-2006, when it really took off. It was that they decided to grow but they decided to grow for the sake of growth. 

So the metrics that they started to look at were not bottom line at all. It was not expenses. It was just one of the key metrics. That was the number of stores, which is probably one of the most ridiculous metrics to look at, because you can always get a higher top line by just opening new stores. What happened was that they opened up very profitable stores. 

Another thing would be hiring X amount of people. Though I think I want to tie a bow on this long spiel about talking about Packard’s law, which was something that Jim Collins highlighted in this chapter, and that was that you can grow faster [by] finding the right people to implement that growth. Think about how it should be measured and if it is not measured on the bottom line, you should be very, very careful. 

Preston Pysh  17:36  

You see this so often with businesses that go and buy or acquire another business and it has no correlation to the underlying assets of the original business that they purchased. If a company’s doing this from a non-operational standpoint, it works kind of like the Berkshire Hathaway model where it’s kind of like a non-operational role.

Even in an operational role, if you have the right people in place, and the headquarters doesn’t try to go down there and change everything, I think that’s when it gets… When they tried to really do the merge, and they try to bring their headquarters in there and start bringing some of their leadership down there and it gets messy. I see that fail so much more than it actually works that I think will get easily nested up here into this stage 2, which is an undisciplined pursuit of more. 

So some of the indicators that you’re in stage two, I really like this one. So, “Easy cash erodes the discipline that sustains the company in the first place.” How many times do you see a company that goes and does an IPO or raises a bunch of money? Maybe an early startup, they raise a bunch of money. I mean, you’re seeing this in FinTech right now, like to the extreme, all this crypto currency Bitcoin stuff. 

You’re seeing so many companies that are getting very large checks being thrown at them, and they’re just going out there and spending it. They’re trying to grow and they’re not. They’re not getting hardened is the way I like to describe it. 

When a company is strapped for cash, they have to get hard. They have to develop these protocols inside of their organization to be efficient, to be lean, to do things in the most optimal way possible to generate net income.

I think that’s a really healthy thing for a company to go through. So anytime you see a very large check being written for a company, the immediate question needs to be, so what is this for? Like, what in the world are you going to use all this money for?

Stig Brodersen  19:36  

Another thing that’s really a red flag, and this is probably not so much from the outside, but whenever you look inside an organization is if people start to think in terms of job instead of responsibility. That’s something I’ve seen so many times that people are saying, “No, that’s not me. That’s not my job that has not been delegated to me. So what can I do about it?” That’s just the wrong approach, you have a responsibility and you can always ask for more.

Preston Pysh  20:04  

One other point that I have for the indicators for the second stage is: will these activities that we’re doing right now help the organization’s economic engine? Or is it going to basically create a resource engine?

So a lot of the times when these companies grow and they expand, what they’re really doing is maybe adding more risk to the business because there’s more cogs in the wheels. There’s not really much economic benefit or margin being added on the income statement that then gets banked and can be used as retained earnings into the future to give the company that flexibility to maneuver in the market dynamically. 

Instead, they’re just adding more people to the churn, and you’re not really seeing much more net income being added to the bottom line. That’s when you’re getting yourself into this situation that I look at it like a person walking a tightrope. If you add more and more weight to that person as soon as you get a little bit out of balance, the whole thing is going to fall over. That’s, I guess the best analogy that I could use for this stage two piece.

Something that’s important that Collins talks about in the book is you could start out at stage one and recognize it and pull yourself right out of it. You could get to stage three and recognize it and pull yourself out of it. So a lot of these companies, they might start going down this path, but they can get themselves back out of it.

The ones that just continually go stage 1 to 4 and don’t do anything to mitigate or correct themselves, they’re the ones that eventually have the slow and sometimes even quick death. 

Let’s go ahead and jump into stage 3. Stage 3 is called “Denial of risk and peril.” This is where you’re really starting to see the numbers demonstrate what’s actually happening here. Instead of the company’s still growing their top line and there’s like this thing that’s kind of growing inside of the business, this mindset that’s kind of grown inside of the business… Now you’re actually starting to see it play out. You’re starting to see the maybe the Starbucks example, and this isn’t necessarily what happened…

Let’s just say they continue to add more and more stores. A lot of them are profitable, then it’s a strain on resources at the headquarters level, and it just compounds and it gets to the point where it’s not sustainable. 

You’re actually seeing the top line start to contract. Then, management’s way of handling that is it’s this outside thing or it’s the economy or it’s anything but us. It’s not us. It’s everything else. It’s the competitor that’s coming into the space. We need to just keep doing everything the way we’re doing it. We need to keep expanding. That’s what we’re talking about here in stage three. 

Stig Brodersen  22:39  

Collins actually gives some really good pointers in terms of how to read the financial statements. He found in his research that three key ratios are more important than others. He mentions gross margins, current ratio, and debt to equity.

All of the following companies that he studied in that duration, at least one of those three ratios in stage three, which will then lead them to stage four. So the gross margins, it’s basically what you see a lot of in retail right now. It’s basically just the difference between the revenue. So the price that you charge for a product, and then the cost to that product. If you ever start to see that to erode, it is a big red flag. 

Now, that’s also why retail is so cheap. I guess some people would say it might still be more sold to a higher piece of value, but it’s definitely a red flag. That’s often a good reason why companies like that are trading at a very low multiple. 

So the current ratio would be how much cash is expected to go in, and how much cash is expected to go out within the next 12 months. If you see a change in that, it’s also a red flag,

Preston Pysh  23:48  

Tell the audience what a normal current ratio would look like as far as the number.

Stig Brodersen  23:54  

I would recommend that you have a current ratio of around 1.5 or more. If it’s 1.5, it basically means that every time we have $150 coming in, we have $100 going out. This is very different from sector to sector. There are some good reasons why it is different for a company like Walmart than if you have already an *inaudible company.

Preston Pysh  24:15  

If you guys want to go do a graduate level study of the current ratio, go look up Amazon and look at their current ratio. What you’re going to find is that it’s actually under 1.0. I think we talked about this on our forum, maybe like four or five years ago. There was a big long discussion on our forum about this and it really comes down to their operational effectiveness and how they’re able to do this and their dealings with vendors.

Stig Brodersen  24:40  

Yeah, I think it’s less than one, that it’s something about like the credit terms that they can negotiate because sighs and it’s more like a math thing. It’s not like we’re not saying that Walmart is going bankrupt. We’re not saying that at all. If you look up the numbers, it’s a different type of business. 

But yes, it is a general concern if you have more cash going out than coming in. It’s a trend that you should definitely look into. 

Then the last thing, that’s debt to equity, which is also a metric we talked about multiple times here on the show. The easiest way to think about this metric is basically that a company would slowly build equity whenever they have a profit, but then we look at how much they have to the head in comparison, basically, we just don’t want the company to have too much debt compared to the wealth that they accumulated. 

The other side that he’s pointing to that’s not like a key ratio. That would be multiple reorganizations. There was another thing that he pointed to, and for me, it has been very relevant. So with Preston and I talked about *inaudible* here a few weeks back, and that is a very interesting stock pick. I picked up some and I think, Preston, correct me if I’m wrong, but I think he also picked up a little?

It was a very good price and it showed some very good numbers. One thing that was concerning for me when I was going through the financial statements was that they are doing some restructuring right now. 

They had some things going on in the UK and they’re going to write that off. I’m not saying it’s a huge issue, even though whenever I look back at some of the previous financial statements, I can see very little, but a few restructuring. 

This boils down to how you present your data, because if something is restructured, it doesn’t appear as your normal operating income. The way that *inaudible and a lot of other companies are reporting operating income is that they have something called adjusted EBIT. 

Whenever they’re doing their adjusted EBIT, it’s a different number than the profit that they’re actually making because that will include all the costs that they’re basically just running off. So whenever I see something like that, it’s not so severe that I will never invest in that company. That’s not what I’m saying, especially if I get good value and it’s not like a big position. However, it is something I definitely plan to monitor closely also for this company.

Preston Pysh  27:02  

Anybody that’s listening to this, and they’re interested in how something like the current ratio is calculated, this is all on the balance sheet. When you go on to the balance sheet, there’s current assets listed, and there’s current liabilities, those are items that are going to be either paid out or collected within 12 months. So all you do is you just take the current assets, and you divide it by the number for the current liabilities. That’s how you come up with that ratio of a 1.5 or whatever number is that Stig and I were talking about. 

Let’s talk about the indicators that you get when you’re in stage three. Just listen to some of these and you guys are just going to be nodding your head and be like wow, this is what my company I’m working for right now. 

Okay, listen to these, amplify the position and discount the negative. So if you go into a meeting and all they’re talking about is how awesome they are, and any negative is just kind of washed away. That’s a stage three sign.

Bet big on new goals without empirical evidence or validation of previous small wins. I love this one. Like if you’re going out there and you’re putting all the chips down on something that you have no idea what it’s actually going to do, that’s a sign of stage three. 

Here’s another one: debate and dialogue is replaced with consensus. If the boss is sitting at the head of the table, and he’s not saying, “So what’s wrong with this idea? Shoot some holes through this idea, tell me why I’m wrong.” Instead, all you hear is people just kind of nodding their heads and saying, “Oh, sir, that’s a great idea. We love that idea.” Those are some signs. 

Here’s another one: externalizing blame rather than accepting failures. That one’s obvious. 

Here’s one more obsessive reorganization within the company. So all of these I think everyone has seen in their days in the workplace, but whenever you’re seeing these just permeate your workplace, you’re in stage three.

Stig Brodersen  28:57  

I don’t want to talk too much about stock investing, necessarily. However, here it goes anyway, whenever you’re listening and reading through the reports, of course, its natural tendency to emphasise good news, but it just can be so, so dangerous. I just need to bring up this one example. 

So I called Preston last night, and we talked about just business [in] general, and then I said that the stock pick that he pitched… I think it was like 2 or 3 Mastermind meetings ago. [It] was GameStop. I don’t think you ended up buying that buy. I bought some stock in that. 

They were sending out new quarterly results and the market was like trading at 8% or 10% pre-market up. Everyone was just so happy, and I was kind of thrilled too, because I’m used to never write about my stock picks. 

Then I read through the statement and they have two growth drivers. I don’t want to talk too much about this stock pick. It’s more for the example. They have something called Technology Brands. Technology Brands is very important to them. That’s one of the primary drivers of growth and already like a really important business unit. I was actually very surprised to learn that the earnings or the gross profit has decreased on that. I was because they actually took off at [a] sizable depth to buy a lot of AT&T outlets and to really grow that. I mean, that was definitely the expectations. They were asked into that twice and the response went something like this, “Yeah, there’s a delay in iPhone X. So that’s just why. Next question.”

They didn’t talk about that at all. However, they had another business unit that is also growing. It is called Collectibles, and this is significantly less severe. They just talk 60% of that earnings call or wherever there was all about the growth that they have in the collectibles. Complete neglecting the problems they had with the Technology Brand that was actually an even more important business unit. 

I haven’t sold my positions since I read that. [That] is probably, I don’t know, two or three hours ago since I read that. I was just so taken back about what I felt was a very insincere handling of problems with the management. They might have some good reasons for why that has been the case. But nonetheless, they need to own that mistake. They cannot blame it on Apple because they’re delaying one of their releases. That’s for me as an investor, that’s not good enough. So for me, that was definitely a flag. So perhaps Preston was right, after all, who knows?

Preston Pysh  31:23  

Yeah, I did not buy it. Like I said, when we recorded that numbers were just so interesting. When you bring up this point, Stig, about how they’re not owning up to the failures, and really kind of making those the focus. 

When you go to a Berkshire meeting, and you watch Buffett and Munger talk about their decisions, they are so comfortable talking about their failures. In fact, I think that they almost prefer to talk about their mistakes and their failures because you can see them trying to learn and also teach people how to not make that same mistake. 

They’re almost obsessive about focusing on that area, as opposed to talking about all their wins, which they just have so many of them. So it’s quite interesting to see the dynamic between what he just described and what we see every May when we go out to their Shareholders Meeting. 

Alright, so stage four, “grasping for salvation.” So this is the point where things start getting a little scary. The business is not only seeing financial decay, but they’re also seeing talent decay. They’re seeing a flight of investors that have been around for a while. They’re seeing all sorts of things that are happening here and they’re reaching for straws. They’re getting desperate. They’re trying anything and everything. 

They’re firing people that have been there for a long time because they think that they’re the reason that they’re underperforming. Really this is just the mindset of kicking in even deeper and pointing more fingers. So for the example in the book for stage four, Collins talks about HP and IBM. Stig is going to cover the recap of this.

Stig Brodersen  33:01  

For HP, they had the problems at the end of 1998. What they came up with was that they needed a bold new leader. Not only did they want a new leader, they wanted a different expression, especially in the media. 

One of the reasons also to attract talent, at least that was a narrative. So they wanted a new leader, and they found one. They found a really charismatic woman. She was featured on Oprah. I think she was even on the front page of Vogue. I think they actually paid $3 million for that front page. She was very determined, “We need to do these 2 or 3 things or whatever it was.” And when we do that, we have turned this company around, and this just needs to go like this. 

She was definitely in a hurry and obviously what happened after that a short period of time, these initiatives didn’t pan out, and she was let go. Then he compares that to the previous IBM CEO that almost went underground after he was appointed. He didn’t go public at all because whenever he was asked, he actually said that he did not have a grand plan because how could he? 

He didn’t know the company well enough. So he spent nothing less than three months before he made the first public statement terms of where they were heading. He still said, “I am just really trying to understand what we need to do.” And that was how IBM and perhaps they could use a CEO like that today. Who knows? 

That was really how they turned it around and this really comes down to some of the markers in terms of when this is happening. Are you seeing someone who is in a hurry to implement solutions?

For instance, like HP, then that’s probably a bad thing, and vice versa. Do they look at big acquisitions like the silver bullet solution? You see a lot of that whenever you see a new management focus on *inaudible* is usually not the best thing. 

You should focus on the core competency company. Do they have good stories and good narratives in terms of how to go out of the crisis? Or are they performance fact-based whenever they make an offer arguments both internally and externally? That’s really what you should be looking for to turn around a stage four company.

Preston Pysh  35:08  

So the behaviors that exemplify and perpetuate stage four, listen to this one: seek a big game changing acquisition based on hope for that has yet unproven synergies to transform the company in a single stroke. That would be something that would exemplify stage four. Here’s another one, embark on a program of radical change, a revolution, the transformer up and nearly every aspect of the company jeopardizing or abandoning the core strengths. 

So if those are things that you’re hearing inside of a company, then you know you’re in stage four, but Collins recommends something that could get you out of stage four would be gaining clarity about what is core and should be held firm, and what needs to change building upon proven strengths and eliminating weaknesses. 

So whenever I read that, the thing that immediately comes into my mind if anyone’s read the Steve Jobs book. I distinctly remember when Jobs came back to Apple, this was after he had started next he had come back to Apple. He comes in and they’ve got all these odd-end projects going on. It was just kind of like a mess. 

It was exactly what would be a classic stage for [a] company. So Jobs is sitting there with a whiteboard and he’s jotting down all the different products, the assets within the company. He’s asking them about the competitive advantage of this. What’s the competitive advantage of that? Well, what’s the technology? How long is this technology good for? Je’s like mapping this all out on the whiteboard. 

After he’s done hearing all these different people show up and he’s like, it seemed like there was just yet another department that came out of another department and as he’s writing this stuff down. After he was done, he heard everything, he took out his marker on the whiteboard and he circled four things, and then he wiped everything else away. 

He said, these are the four things we’re going to do and we’re going to do them better than anybody on the planet. If anyone comes to me with anything else, we’re not going to do it. We are doing these four things. That’s what set Apple on the trajectory that it’s at today and that is exactly what Collins is getting at with how to recognize what is stage four. 

What a company needs to do to get through stage four and start coming back out is what are those core assets that are bringing home the bacon? How can we optimize those? How can we refine those? How can we be really, really, really good at that and cut all the excess fat off of this company, because if we keep running around at 300 pounds, we are going to die. So we’ve got to figure out how to save this thing and focus on those things that will save the company. 

I found that to be a really profound chapter and I really found it profound, the insights that he gives on how to self correct at this point because this is your next to the last phase and if you don’t self correct here, you’re done. 

Alright, so the last stage is “capitulation to irrelevance or death.” In this section, he doesn’t have any companies that he provides that reach stage five. Most of the companies that he studied throughout the book got to stage four and then they started to self correct. Some of them did in a great fashion and some of them just continued to stumble around at the bottom.

A company that I would like to talk about today that in my personal opinion, that’s in stage five is Sears. The reason I feel like Sears is in stage five is because the company has set themselves up for a situation where they have structured the way that they compensate their employees in such a manner that no outside investor is going to have a lot of interest in buying or merging or taking on the responsibilities of that company. There are laws in place that if you have all these obligations, and I’m talking about basically retirement obligations to a lot of the employees that you have at Sears, that is not something that you can just swipe away and make those disappear. 

Those are obligations that must be paid at a certain order. If the company would liquidate or if the company would be purchased, those obligations are going to be carried over. I think that’s a big, big concern. That was very bad and poor decision making by the management of this company years ago. 

Think of it like this. If you’re going to structure something inside of your company, you know what that means financially. So if I offer somebody a retirement package that’s going to be paid if they work for the company for 30 years, and it’s going to be X number of dollars, I have to value that in today’s terms. 

So these managers, they would have structured all these deals with all their employees. They were making promises that they knew could not be held, or at least I would suspect they had no idea that they could be held. That was the death of this company. Not to mention many, many other things. 

However, the reason that I think that company’s going to go into stage five is for all those reasons. Like I said, he didn’t provide an example in the book of a company that got there, but I think if you’re studying this book, and you’re looking at real world examples, I personally think that that’s a company that will get there. Maybe I’m wrong, maybe somebody will come in and happily pay all those benefits out. But I think it’s a big concern and I think that it’s a great example.

Stig Brodersen  40:29  

Stage five is really where the company’s leader, perhaps even the founder, typically just sells out, and it might be to a competitor might even file bankruptcy. It’s not a good state to be in but I think the best way, at least for me to talk about this stage is how to avoid it. I know that we gave a lot of pointers so far in the first four stages. However, if there’s one thing I really wanted to point out that’s the sense of urgency.

I mean, it’s easy to feel the sense of urgency if you’re just about to go bankrupt, but obviously, you need to feel that a lot sooner than that. If you feel urgency both in good and bad times, and if that is ingrained in your culture, that’s really the roadmap to success. 

Whenever I read about a company that might be stage 4 or 5, and they talk about how they will now improve the bottom line by starting a cost cutting program, that’s some of the worst things I can ever read. It’s kind of like me telling my wife, “I want to be a good spouse in the next two weeks. I’m going to put a really great effort into being a good spouse.”

You should not do that just over the next two weeks. You should just be a good spouse. You should not have a cost cutting program. You should just always cut costs. I know this comes out like a rant, I guess of some sort, but that’s the best way of not getting there to stage five, I guess.

Preston Pysh  41:55  

You know, it reminds me of dieting. A person that gains a bunch of weight and now I’m going to go on a diet and it lasts for two or three weeks, and then it’s just right back to square one. It’s not based on some fundamental change of the person’s lifestyle, or the habit and the person’s lifestyle that allows them to keep the fitness or the diet or whatever it might be into perpetuity. Trust me, folks, I’m not some beacon of excellence when it comes to health, but I’m using that as an example that a person could tie back to a company. 

What Stig’s point is, is if you’re just saying, “Hey, we got to start a cost cutting program,” that means that it’s temporary in nature. That it’s something that you got too fat, if you’re getting too fat, the problem is why are you getting too fat? In the company, why are you not developing very optimized flywheels as Collins would call them, before expanding those and growing them out into bulk and into volume throughout your organization? 

I think that that’s the really critical part when you’re building the company and also as you’re trying to optimize it if you’re in a decline.

Alright, in general, we highly recommend this book, this is a really quick read. All five of these stages are so critical. I think it’s something that a person should probably read often to try to remind themselves and think about these things. I thoroughly enjoyed this book. It was fantastic.

Stig Brodersen  43:15  

We actually read quite a few books that we don’t talk about on the show. So we want to ensure that you’re actually getting the very best book. That’s why sometimes we sound over enthusiastic.

Preston Pysh  43:27  

We probably only do like two of every four books that we read.

Stig Brodersen  43:32  

Usually.

Preston Pysh  43:35  

Alright, so at this point in the show, we’re going to play a question from the audience, and this question comes from Antonio.

Antonio  43:41  

Hey, guys, thank you for taking your time and answering my question. I’m a huge fan of the show. Recently, there has been some speculation that China is looking to replace the Petrodollar by convincing oil supply in countries such as Russia or Saudi Arabia to accept payments in yuan backed by gold. Is [it] the death of the Petrodollar as we know it? How will this affect the American economy? And can Bitcoin profit from such a scenario? Thank you.

Preston Pysh  44:07  

All right, Antonio, fantastic question. Stig is going to take this first stab at this one.

Stig Brodersen  44:13  

Thank you for asking this question. First of all, without trying to put on my tweet jacket and talking to you about the petrodollar and history, like in a professor kind of way, please allow me to just provide the foundation for the concept that you introduce here. 

Petrodollar really was something that came up after the collapse of Bretton Woods gold standards in the early 1970s. What happened at the time was the US struck a deal with Saudi Arabia to standardize all prices in dollar terms, and it had a lot of impact. The dollar was already the main currency, the world’s reserve currency actually. 

It really became even more important after that. That’s also one of the reasons why the US is able to endure persistent trade deficits and it also provides the US with financial markets with a very impressive source of liquidity and foreign capital outflows. 

Actually, the latest number I could find on this just to talk to you about the magnitude was back in 2013 where 87% of international deals were settled in USD on one side. So basically what you’re talking about is, is this changing now? And what will then happen? The answer is, yes, it is changing now. 

Now, that’s not the same as saying that the US probably won’t be the world’s premier reserve currency. They have been that since 1945, where they replaced the British pound. So first of all, I think that’s actually fascinating that it’s not longer than 1945 that the US dollar was not the reserve currency in the world. Think about how fast that has basically changed. So if you’re asking can that change one way or the other, is *inaudible going to be China, the answer is obviously yes. Time is infinite and yes, it will happen at some point of time. 

Will this happen with China, for instance? If we look at a list of the biggest all importers in the world, aside from the US, you have China. Yes, China, they probably would like to sell things in their own currency if they could. You have India too, and China’s actually prevailing important terms of export for them, but the total trade with China is actually slightly more than is the case for the US.

It’s the same with Japan. That’s three on the list, and with South Korea, where I want to say China is even 2.5 or 3 times as important in terms of trading partners. 

You can come up with many good reasons why in the future, a commodity like oil will not be sellable in USD and why would be another currency. Now, will this dramatically change? We talked about having the Chinese currency as a primary source of currency multiple times before. It’s just now being included in IMF, the International Monetary Fund’s basket of currencies, and it’s very, very little. I don’t see that happening anytime soon, despite the facts that I just gave to you. 

The second most important currency in the world after the dollar that will be the Euro. Being European and seeing everything that’s going on in my wildest dreams, I can’t see how the Euro can overtake the US dollar, with the membership countries being so inconsistent with what they say and what they do and the goals they have with the monetary policy. 

So I guess my response to the first part of the question would be the US dollar in the current system we have. It’s not perfect, but it’s the system we’ve got. I guess I have a hard time seeing how that’s going to change dramatically, at least over the next decade or two. That being said, your points about China, definitely you will see a shift but perhaps not to the extent that one might argue.

Preston Pysh  47:58  

I agree with what Stig [is] saying to the extent that I don’t think that you’re going to see any kind of drastic change in the next couple years. I think when you get out to 10 years from now, I’d say 7 to 10 years from now, you might start to see things start to change around a little bit. However, I think, in the near term within the next five years, I don’t see too much changing. 

I do find this very interesting, though, what you’re talking about. I think that it’s more representing the frustration that a lot of countries in the world have, with everything being priced in dollars. I think that that is probably maybe more important than anything else, because I think that that might be what drives the big shift. Maybe 10 years from now, some other type of currency [will] emerge as maybe a global reserve currency. 

I guess that leads us to the Bitcoin conversation. So you look at Bitcoin just this past summer. I want to say in like June, you looked at the market cap of Bitcoin and it was around maybe $80 billion was the market cap of Bitcoin today? 

The market cap of Bitcoin is $137 billion. So that’s just a couple months ago, that was like four or five months ago that you’ve seen that much growth in it. But let’s call this with this is $137 billion of a market cap on a currency is very small, like insignificant as far as how small it is. 

Though I will say watch the trend on this thing because this trend is like something I have personally never seen in my entire life. I don’t know that we’d ever see it again, if this trend persists. 

So when we look at the market cap of various currencies, so let’s just start off with gold, 7 trillion for gold. When you start talking about the US dollar, I have no idea how big the market cap is on the US dollar, but if I had to guess… I mean, you’re talking 10s of trillions of dollars, it’s way up there.

Stig Brodersen  49:49  

It also depends on how much you include the money cap of the US dollar. I mean, we’re not just talking about  notes and coins here. It really depends on what kind of… You have all these fancy terms called M1, M2, whatever you want to include as a currency, and how much is credit and how much is not. If we start seeing a currency backing commodity, whatever it is, it’s a different world. I mean, I know that $137 billion sounds like a lot. Obviously, that’s a lot, but as Preston said, for a currency, it’s next to nothing.

Preston Pysh  50:23  

I don’t want people to hear us say that right there and say, “Oh, well, Preston and Stig didn’t think that Bitcoin can be a really big deal in the next 5 or 10 years,” because we definitely think it can be a very big thing in the next f5 or 10 years. We just think that where it’s at today, as far as market cap, that’s not going to happen in the next couple years where Bitcoin is now going to be what oil and things are pricing in the next three years. That’s not happening, even at the pace the Bitcoin is going out, it’s not going to be there in three years. 

But give it 10 years, and it keeps trending the way it is, and you see all this money that’s stuffed up into fixed Income with a zero percent return starts flowing out and a lot of people are selling out of that and they start chasing the 300% or 500% return that Bitcoin has been returning every single year for like the last seven years. Yeah, you might start to see some interesting things happen if that trend continues. 

I think that’s our best advice for people when they’re thinking about Bitcoin is if you’re not studying it, and you’re not aware of it, there’s some interesting things happening here. We’re not saying it’s gonna replace or become the world reserve currency. It’s something that I think people need to be aware of.

Stig Brodersen  51:32  

I think, Antonio, if your question is more in the direction of, “Will countries use, call [it] a Bitcoin or another cryptocurrency to sell transactions?” I think that is highly unlikely because all nations really have an incentive to use their own currency… at least not use a cryptocurrency, so that’s probably not it right now. 

You see a lot of individuals settling transactions with cryptocurrencies. You will probably also see companies starting to do that, but you will probably not see government institutions doing that for a very long time. 

However, if you ask in the sense that what will happen if the market loses faith in the US dollar, whether it’s gradually, it’s just slightly or is it if it’s more significant? Yes, it will have an impact on other currencies. 

So remember, what is $1 worth? One way you can price that would be in other currency. I can tell you what it’s worth in euros or I can tell you what it’s worth in yen. If people start to lose faith in the US dollar for whatever reason, less money will be flowing into the US dollar and basically a currency is no no different than the price of a stock. You have demand, you have supply, and if you have less demand for the US dollar, and that money is going elsewhere, you will see a soar in that type of currency instead. 

Now, whether or not that would be Bitcoin, which is what you’re saying. I don’t know. I mean, I think a lot of money would potentially flow out of the US dollar. I think it will go to the other major currencies definitely first, but you’re right in the sense that you don’t need a large percentage of funds, call it from fixed income or whatever it might be, to pump up something that’s only $137 billion and thinly traded. 

Preston Pysh  53:10  

This is where Stig and I see things a little differently. So he said that if money flows out of the US dollar into other currencies, he thinks that they’re going to go into other currencies before cryptocurrencies. I would agree with that up until probably the next year. Then I think that that’s going to start to change. 

I think when you look at the price action of Bitcoin specifically, it is following Metcalfe’s law, almost to a tee. Metcalfe’s law is how when you look at the growth of Facebook, you look at the growth of Google, Alibaba, 100% correlated [with] Metcalfe’s law. Since the start of Bitcoin, it has been following Metcalfe’s law, almost to a tee.

Stig Brodersen  53:54  

Could you elaborate more on the law and what it means?

Preston Pysh  53:56  

Yeah, so the law is if you’ve ever taken a business class. You’ve seen a chart that shows a network effect, where the pricing of something looks like a hockey stick where it starts off slow, then all of a sudden, it’s almost completely parabolic and it goes almost like a rocket straight up. When you look at the price, and you need a logarithmic scale to plot something on a chart to do this, that’s what’s happening with Bitcoin today. 

So I think once you start getting past the market cap of $100 billion, you got some people really raising their eyes saying, “What the hell is this thing over here?” Then if that continues, if that trend continues, which it is, this has not subsided at all, if this trend continues, and we see this go for another year, guess what? You’re not talking $100 billion, you’re talking like $500 billion. You’re talking some real numbers here. Then once it hits a trillion dollars, watch out. I mean, the network effect of this is going to only compound on itself. 

So I really think there’s something here. I think that it’s something that people need to pay attention to. I’m not saying that, I guess I’m not saying anything. I’m just describing what has happened over the last seven years. I think that the trend…the perfect example I saw, and we’re here in November of 2017. 

Coinbase, which is the exchange that does cryptocurrencies here in the United States. Coinbase had something like I want to say 12 million users from the last seven years. In the month of November alone, they had something like 1.2 million people sign up for Coinbase, just this month, in just a month. 

So when you have that many influx of buyers versus sellers, there’s some interesting things happening. I think it should really grab a person’s attention and I think they need to study what the heck’s happening.

Stig Brodersen  55:48  

I’m glad that we disagree. Unfortunately, it’s not about stocks, but about the economy, I guess. I guess we can live with that. I think what I see now whenever you bring up numbers like that, yes, there are definitely a lot of individuals who are signing up and going into Bitcoins, perhaps to buy for a 1000 bucks or 500 bucks or whatever it is. I’m really curious to see what happens with institutions. 

We talked about CME before and what they’re doing with futures with this. To me, a lot more breakthroughs in many ways than for instance, Japan saying that now you can start paying for things with Bitcoin even though it sounds a lot bigger. 

The market for Bitcoin, it’s very thinly traded compared to many other markets. That also means that if you take out $10 trillion from the US dollar, and then you put $9.8 trillion worth in other currencies. [It’s] only $0.2 trillion, which will be $200 billion. You don’t see a market cap going from 137 to 337. That’s not what you’re seeing. You’re seeing the number of Bitcoin multiplied with the last traded price. 

So the market price might go to trillions of dollars suddenly. Also what you see now is that the circulation of Bitcoin is not that much, in the sense that you have a lot of people who are using it as an investment or storing value or whatever you want to say. So you have a lot of buyers going in but not too many sellers going in. So if you see a huge influx of money, you would see a very interesting pattern in price setting.

Preston Pysh  57:18  

Yeah, meaning that it will go up more. Interesting, interesting stuff. I think that when we look back at this, and 20 years from now, we’re going to be quite amazed, maybe [with] what transpired, what happened. What didn’t happen is just this stuff is crazy. This is absolutely crazy. It’s very exciting. 

I guess that’s probably why I have so much emotion in some of this is because it’s really exciting stuff to see what’s happening here through the technology and what people are coming up with to try to take all these global currencies, domestic currencies. It’s quite fascinating. 

All right, fantastic question. So, Antonio, we went way longer than we had ever expected on that question, but because you submitted this, we’re going to give you a free course on our website on the TIP Academy website. It’s our intrinsic value course. 

For anybody else out there if you want to get a free course on our academy webpage, go to asktheinvestors.com. You can record your question if it gets played on the show, you get a free course. We just really appreciate everything our community does for us and offering up these questions. So thanks for doing that.

Stig Brodersen  58:21  

Alright guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  58:27  

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