Shareholders in Thomas Cook – a company that traces its roots back to 1841 – face being wiped out. This contains lessons for all investors, especially those who think they are stockpickers for the long term.
Thomas Cook’s troubles arise in part from the same thing that made it successful for decades. This thing is organisational capital. This is the set of systems, know-how and goodwill that make companies more valuable than just a collection of machines and contracts. For some companies, such as WalMart or Ocado, this capital consists in large part of the ability to run efficient supply chains. For others, it is brand loyalty or patents. And for others it is the good use of IT: Boston University’s James Bessen has shown that differences in the ability to do this are a big reason why some companies thrive and others don’t.
For decades, Thomas Cook had great organisational capital. Millions of people trusted it to organise their holidays well. But then technology changed. Websites such as Airbnb and booking.com mean we no longer need Thomas Cook’s expertise to book flights and accommodation. We can do so ourselves. Thomas Cook failed to respond to this, and so has been on the wrong side of what Joseph Schumpeter called creative destruction.
In this sense, Thomas Cook follows a long line. Kodak and Polaroid were destroyed by the rise of digital photography; Xerox by email; record shops by file-sharing; Nokia by smartphones; and so on. In fact, it’s not just isolated stocks that can suffer due to technical change. The whole market can. Boyan Jovanovic at New York University and Vanderbilt University’s Peter Rousseau have argued that the great bear market of the 1970s was caused by anticipations of the IT revolution: it devalued incumbent companies while the beneficiaries of that revolution, including Apple and Microsoft, had not yet arrived on the market.
Even strong companies, then, can sometimes see their organisational capital become almost worthless because they fail to anticipate or adapt to technical change. Organisational capital is often inflexible. Worse still, it can even become a liability.
Why? One reason lies in the very success of such companies. The fact that they do so much right for so long leads them to overvalue their own expertise. This can lead to hubristic overexpansion, such as in Thomas Cook’s merger with MyTravel. It can also lead to underestimating the threats from different technologies; this is the 'not invented here' syndrome. And large companies contain lots of senior people in cushy jobs who are loath to change. “In a centralised bureaucracy there is a built-in tendency for conservatism,” writes Northwestern University’s Joel Mokyr in his superb book, The Gifts of Athena.
Yet another reason is that managers know less than they pretend. Paul Ormerod and Bridget Rosewell at Volterra Consulting have shown that the statistical distribution of companies’ deaths is very similar to that of species’ extinctions. This, they say, implies that companies have no more ability to foresee change and adapt to it than have species. In the same spirit, Sussex University’s Alex Coad has shown that company growth is largely random. Kenneth Boulding, a former president of the American Economic Association, famously said in 1966 that bosses of large organisations will often “be operating in purely imaginary worlds”.
Because of this lack of foresight and adaptation, corporate deaths are common. Of the top 100 employers in 1907, only two are independent stock-market-listed companies today: WH Smith (SMWH) and Prudential (PRU). And Hendrik Bessembinder at Arizona State University has estimated that most of the shares ever to be listed on the US market since 1926 actually underperformed cash during their lifetimes because they were crushed by competition and technical change.
The late Andrew Grove, formerly chief executive of Intel, said that “only the paranoid survive”. Many companies are not paranoid enough.
For investors, there are important lessons here. One is that Warren Buffett was right to say we should look for companies with “economic moats” – defences against competition. But future competition doesn’t come only from other companies: Thomas Cook had decent defences against other tour operators, but not so much against new technologies. It also comes from as-yet-unfounded ones or from as-yet-unknown technologies. Personally, I doubt that investors have the foresight to see these new challenges coming and therefore to know whether companies have adequate moats.
Equity investors are often accused of short-termism. I think the allegation is wrong. Given that companies face big but unquantifiable threats from future technologies, investors should discount their future prospects very heavily.
For this reason, it is unwise to be a long-term buy-and hold stockpicker. If you are, you risk ending up like The Simpsons’ Montgomery Burns, holding shares in Transatlantic Zeppelin, Amalgamated Spats and Congreve’s Inflammable Powders – stocks destroyed by creative destruction.
Herein lies an underappreciated virtue of tracker funds. In effect, they back the field rather than particular horses. And if we don’t know which horses will lose the long race that is the process of creative destruction, we should indeed back the field. Professor Bessembinder estimates that “the best-performing 4 per cent of listed companies explain the net gain for the entire US stock market since 1926”. Tracker funds give us at least some exposure to this 4 per cent. Active management risks missing out.
Tracker funds, though, are not perfect. They diversify the threat that competition will come from other quoted companies. But they don’t protect us from competition from as-yet-unlisted ones. This is one reason why private equity funds should also have a place in the portfolios of genuine long-term investors.
