Companies must be allowed to fail

Michael Skinner

Renaissance Asset Management

Michael Jordan famously said: “I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. Twenty-six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.”

Steve Jobs failed when he was fired from Apple (he was eventually rehired as CEO). Before his death Jobs spoke of how repeated failure underpinned his own personal drive. His multiple failings (personal and professional) are arguably the cornerstone of Apple’s success to this very day.

And when starting out, Walt Disney was told that he lacked creativity. His first cartoon business went bankrupt.

Nassim Taleb (of Black Swan fame) and John Carmac (of Doom fame) both explore the field of system failure. They pose that when an idea or premise fails, associated systems can learn and ultimately strengthen. 

Extending this thinking, by distancing yourself from failure, you are restricting learning and preventing growth. Even more destructively, by delaying failure, you may very well be compounding its severity in the future.

Many central banks and governments around the world are yet to grasp this fundamental concept.

Government and central bank bailouts that save businesses from bankruptcy, act to increase the probability and likely severity of system collapse in the future. 

Taleb emphases again and again that error and failure are the essential components for the prevention of large-scale negative events.

“Every plane crash brings us closer to safety,” he writes.

If central banks don’t allow bad companies to fail and asset prices to fall, economic risk become null and void.  Dangerously, we are all incentivised to borrow more and chase higher-risk returns. 

At the same time, inefficiency skyrockets as low-quality (often perpetually loss-making) companies are kept alive. “Zombie” companies are born.

A prime example of rampant risk-taking bordering on madness is the case of Hertz, the car rental company. Burdened with debt and with revenues tumbling amid the pandemic, the company filed for bankruptcy on May 22. In this scenario, debt holders are favoured and stock (equity) holders are wiped out. Hertz essentially becomes worthless.

However, in recent months retail investors have piled into the Hertz stock chasing the “reopening trade” and an ever-increasing return. Remember, this is while the company is in bankruptcy! The share price jumped 475 per cent in barely a month.

Then something even more amazing occurred. Hertz’s management, realising the almost insatiable demand for its bankrupt stock, decided to raise $US1bn ($1.4bn) worth of new money. A company raising money in bankruptcy is unprecedented, ludicrous.

This is because in nearly every scenario, the shares of Hertz are still virtually worthless. The company itself even warned potential buyers that the value of the new stock may ultimately be worthless.

Make no mistake, companies need to fail.  Zombie companies and the resulting economic inefficiency hurt us all. Productivity is reduced and a county’s GDP diminished, subsequently wage growth suffers.

Nations are strengthened, enhanced and improved by controlled economic failure.

  • The failure of the airline Ansett benefited all Australians with the entry of Virgin Blue and lower ticket prices.
  • The failure of Enron in 2001 led to an improved banking system with greater checks and balances.
  • The failure of Bear Sterns in 2008 resulted in an improvement to liquidity and risk assessment.
  • And the 1000 failures of Thomas Edison benefited us all with illumination.

The airline Virgin Australia needed to fail. Like Hertz, Virgin was burdened with debt, stretched too far and operating inefficiently. 

The decision by the Australian government to allow Virgin fail was the right one.

In the coming months, Bain Capital will likely resurrect Virgin as a leaner, competitive and more efficient organisation. All Australians should benefit from this outcome.

The federal government did not support Virgin during this recapitalisation phase.  Industry provided the solution, and this was the correct course of action.

Australians need the government to focus its time and resources on job preservation and creation, not on saving companies that failed to protect themselves with too much debt, flying too close to the sun.

Let’s hope we all keep failing, and moreover that our representatives in government realise the value and importance of such.

Failure is necessary.

*This article was originally published by The Australian Newspaper.

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Michael Skinner
Portfolio Manager
Renaissance Asset Management

Michael is a Portfolio Manager at Renaissance overseeing Australian equity investments. He also is a Finance Lecturer at UNSW and a Honours Supervisor at the University of Adelaide. Michael holds a BEng, GDipLaw, MBA and a MLaw.

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