Bet on dominant player, don't predict

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I recently read a very good article, the purpose of this post is “Bet on dominant player, don’t predict”. I’m sharing it with investors here.

Media: The Daily Telegraph, June 19, 2015
Author: Terry Smith

Software Companies

In 1984, the top 10 software companies in the UK. Except for Microsoft, the rest are basically no longer around:

Microsoft
VisiCorp
DRI
Micropro
Lotus
Ashton-Tate
Peachtree
SPC
CAR/Sorcim
Perfect

Biotechnology Drug Development

A 2012 study published by KMR used drug success and failure data submitted by 13 of the world’s largest pharmaceutical companies between 2007 and 2011. The study found that 97% of drugs failed in preclinical trials, 95% in Phase I clinical trials, and 88% in Phase II clinical trials. The outlook only improved after Phase III clinical trials—of the drugs that have succeeded so far, 54% have been approved.

The probability of a drug succeeding in the preclinical stage is one in ten thousand (if you’re interested in math, the calculation is (1-0.97) × (1-0.95) × (1-0.88) × (1-0.46) ≈ 0.0001). Trying to pick winners in the early stages of drug trials—this way of investing in biotech companies is clearly like finding a needle in a haystack.

Just like in football, you can also glean insights into a company’s prospects from changes in management.

Sir Alex Ferguson managed Manchester United for 27 years, during which time the team won 13 Premier League titles, 5 FA Cups, 4 League Cups, 10 Community Shields, 2 Champions League titles, 1 UEFA Super Cup, 1 Intercontinental Cup, and 1 Club World Cup. What about the team’s future?

His brief successor, David Moyes, managed only one Community Shield during his less than one-year tenure.

Two business examples

Sir Terry Leahy’s retirement and resignation as CEO of Tesco shares a similar story. After 14 years in the role, he was replaced by Philip Clark, who served only three years – a period rife with profit warnings, food contamination fears, and accounting scandals.

I’m not saying it was all Mr. Clark’s fault. In my view, the root of the problem lies in the Leahy era, but it only becomes apparent after a charismatic leader leaves.

Similarly, McDonald’s CEO Jim Skinner, hailed as the man who turned the company around and named CEO of the Year during his eight years at the helm, left in 2012. His future was not difficult to predict. His successor, Don Thompson, conceded defeat after only three years and stepped down as CEO.

Conclusion

The key issue isn’t who should be held responsible for the decline of McDonald’s, Manchester United, or Tesco, but rather that investors should be wary, like football fans, when a long-serving and highly successful CEO leaves.

Bet on dominant player, don’t predict. Just as predicting long-term winners in the software industry is extremely difficult, predicting whether established companies will remain long-term winners is equally challenging. If you’re investing in startups and early-stage investments, the odds of accurate predictions are predictably low.

Don’t try to predict which horse will win; instead, find ways to bet on the horse that has already won. A key factor in success in sports and investing is narrowing the odds of success.

I am the author of the original text, the abridged version of this article was originally published in Smart monthly magazine.

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