Investors invest with the notion that companies will continue to grow and expand their revenue and profit over the years, allowing our capital to compound at a steady clip. However, with the business world being so dynamic, there are many cases of even great companies facing a deterioration in business prospects due to changes in their industry or external environment.
I believe it’s very important for investors to continually read up on companies and the industries they belong to in order to appraise themselves of the latest trends as well as identify potential red flags that may surface. Persistent red flags may render an investment thesis invalid, and you then need to make the tough decision to divest in order to reallocate the money to a more promising company.
Here are three key factors that result in business deterioration.
Industry structural change
A structural change within an industry is a common reason companies falter. Such a change may cause the industry to become much less attractive, or make it easier for new entrants to gain a foothold and survive, or reduce pricing power for all players. Whatever the nature of the change, investors need to understand its implications and whether it might render their investment thesis invalid — or at least make it much less attractive than before.
A good example of an industry structural change that negatively affected a business happened in the case of SIA Engineering Company Ltd (SGX: S59). The airline industry has seen a shift towards aircraft with a lower maintenance frequency due to the use of composite materials without aircraft. As a result, SIA Engineering has suffered a decline in revenue for airframe maintenance over the last three years, and it has also been reducing dividends since FY 2014.
Poorly executed acquisition
A poorly thought-through acquisition could also be a key factor resulting in business deterioration. This is especially so if the acquisition is supposed to be “transformative” and would shift the entire group in a different direction. A recent example of this can be seen in Singapore Post Limited (SGX: S08), which announced its decision to divest its US e-commerce businesses Jagged Peak and TradeGlobal. These two acquisitions were made in 2015 but have since dragged the group down as they have continually been loss-making.
The final factor that could result in business decline is industry disruption. This differs from the structural change as it introduces a new element into the industry — that of a new business model that threatens to up-end the old, established one. A good example of this would be the troubles faced by ComfortDelGro Corporation Ltd (SGX: C52) since the rise of ride-hailing companies such as Uber Inc (NYSE: UBER), Grab, and Gojek. These ride-hailing companies have disrupted the traditional business model for ComfortDelGro’s taxi division and caused the group to have to scramble to evolve in order to maintain market share.
Investors need to be constantly alert
Even these few examples illustrate how important it is for investors to be constantly alert for changes in their business and competitive environments. Companies periodically face threats, and investors should study the way management responds to these threats. Some of the changes and trends could be temporary, while others could have a permanent and debilitating effect on the business.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. Motley Fool Singapore contributor Royston Yang does not own shares in any of the companies mentioned.