[00:02:35] Shawn O’Malley: The same goes for Michael Mauboussin too. While Aswath is an academic and not necessarily a practitioner of investing in the sense of managing a hedge fund or something like that, I bet his understanding of markets and finance is as useful as many great investors. Aswath is a reminder to me that you don’t always have to be a player on the court to be widely respected in your domain.

[00:02:55] Shawn O’Malley: His focus is first and foremost on education and teaching people to think critically for themselves, which arguably means we can learn more from him than we can from studying famous investors in some cases, since oftentimes the best investors aren’t exactly keen to share their secret sauce, at least not until they’re retired.

[00:03:11] Shawn O’Malley: When it comes to the corporate life cycle, I think people unknowingly leave themselves undiversified on this front. Many value investors focus on companies that are cheaply priced based on relative valuation metrics like price to earnings which leads them to typically more mature businesses or even businesses in decline with negative growth Which is why they probably look cheaper on paper one of my biggest takeaways from as well though is that companies across the life cycle offer very different patterns of future returns and Also differ in how they generate those returns Younger companies derive much of their returns from their ability to grow revenue quickly.

[00:03:44] Shawn O’Malley: The faster they expand their business, the more wealth they’ll create along the way for shareholders usually. More established companies do not have those same growth opportunities, but instead they’re more likely to return cash to investors so they can decide how to reinvest it themselves. While these companies may only offer modest earnings growth and therefore modest share price appreciation, they may be cash cows that generate significant income for you from the dividends they distribute to shareholders.

[00:04:08] Shawn O’Malley: Classic growth and value investors then end up concentrating their portfolios and companies in one stage of the corporate life cycle or the other, which is okay, but I think that’s a decision we should make more intentionally. On the one hand, classic value investors focus on protecting their capital by looking for opportunities that provide them the most safety and the most bang for their buck, while on What that means though, is that these investors largely miss out on the biggest winners of the past decade.

[00:04:30] Shawn O’Malley: Because for most of that time, companies like Apple, Meta, Alphabet, Amazon, and Tesla all looked expensive based on traditional valuation metrics that didn’t fully account for the present value of their future growth opportunities. Yet just because growth investing has worked well recently, doesn’t mean it will work forever.

[00:04:45] Shawn O’Malley: So growth investors are taking a different set of risks by continuing to bet on the biggest winners, even at historically expensive levels. Before we go any further, let’s just set the foundation for this conversation by going over the Corporate Life Cycle 101. In Aswath’s August 19 blog post on the Corporate Life Cycle, he draws a comparison between corporate aging and human aging because, after all, companies are run by people.

[00:05:08] Shawn O’Malley: In the same way that there are so many people struggling to accept aging and getting older, the same is also true for companies, if not maybe even more so true. In part, that’s because of a mismatch in incentives. While biological aging is obviously inevitable, there are outlier cases of companies being able to reinvest in themselves and earn a second life.

[00:05:27] Shawn O’Malley: So this promise of being able to tap into the fountain of youth can really lead some companies astray. The incentives mismatch here comes from the management of declining companies winning huge financial rewards if they can indeed turn the company around, and then they are praised as heroes while having little to lose if their efforts fail and end up destroying wealth for shareholders.

[00:05:46] Shawn O’Malley: So, they basically boarded a sinking ship, and if the ship continues to sink, no one can really blame them. As a result, Damodaran found in his research that a significant percentage of aging companies wasted money on Hail Mary efforts to rejuvenate their companies rather than managing their decline gracefully and maximizing the remaining value for shareholders.

[00:06:05] Shawn O’Malley: Capitalism is built on the notion of creative destruction, which means no company can survive forever because a new competitor will eventually make it obsolete. There should be no shame in companies dying because it’s as inevitable as any living thing on earth dying. But people’s jobs and livelihoods of course depend on their employer continuing to exist, so there’s usually a lot of denial involved once decline sets in for a business.

[00:06:29] Shawn O’Malley: In his mapping of the corporate life cycle, Aswath defines six different phases that companies can journey through. It begins with startups, which is when there’s an idea for a company and maybe an effort to convert that idea into a new product or service. Once a business model has been formed and the company begins to earn revenues, it enters the young growth phase and then moves into the high growth stage as it scales up its operations to meet a larger addressable market.

[00:06:54] Shawn O’Malley: From there, revenue growth begins to plateau as the company reaches mature growth and focuses more on boosting its profitability. And then in the mature stable phase, companies become primarily focused on defending their market share and profits from competitors. And lastly comes the decline phase, where revenue and earnings can either dwindle slowly or drop off pretty quickly.

[00:07:15] Shawn O’Malley: Along the way, companies will fail and may never progress to that next stage. Most startups will probably fail before they even begin earning revenues, and then another tranche of companies will fail after generating revenues but failing to become profitable. So there’s a lot of churn at each point in the life cycle, and the life cycle itself is obviously a generalization and can either play out over several years or over several decades.

[00:07:37] Shawn O’Malley: Early stage companies are rarely profitable because so much is being invested up front to build the infrastructure of their business model, which may or may not pan out. That’s why early stage companies aren’t judged necessarily on their profitability. It just wouldn’t make sense because the business model hasn’t even really been established yet.

[00:07:53] Shawn O’Malley: Thank you. Venture capitalists investing in these young companies tend to value them based on a multiple of their revenues and factors like how large their target market is, how experienced the founding team is, whether other prominent investors are interested in the company, and other similar factors in that same vein.

[00:08:07] Shawn O’Malley: Whereas young companies burn through the cash they raise by selling equity to venture capitalists as they try to grow into their business model as quickly as possible, mature companies have far fewer opportunities for growth, and as that realization sets in over time, they tend They typically opt to pay out the remaining cash that’s been building up on their balance sheet to shareholders.

[00:08:26] Shawn O’Malley: In terms of understanding where a company is on the corporate life cycle, Damodaran makes three suggestions. Firstly, and most simply, you can just look up a company’s age relative to when it was founded. It’s sort of a blunt tool since companies may age at different rates and may go through periods of rejuvenation, but it can still provide some information on where the company might be in its lifecycle.

[00:08:46] Shawn O’Malley: Secondly, you might examine the company’s industry group and competitors. If the industry that a company competes in is comprised of mostly fast growing companies, Then the company is probably on the younger side of its lifecycle, or at least has a better chance of reversing its biological clock than a company in an aging industry would.

[00:09:04] Shawn O’Malley: Thirdly, you can look at a company’s financial metrics. Is its revenue growing by double digit percentages, or is its growth in the single digits or negative? Do this well, you need a good feel for how fast a company’s revenue and earnings growth compares to its sector and to the broader market, which can still be a fairly data intensive process to go through and calculate.

[00:09:22] Shawn O’Malley: As I’ve mentioned, the corporate lifecycle is a template that can vary widely. This variance primarily comes across three dimensions, length, that is, how long a business survives for. The height of the life cycle curve, which represents the peak point at which they can scale revenues and profits to, and the slope, which reflects how quickly the business can scale.

[00:09:42] Shawn O’Malley: There is some variance too in the life cycle depending on how capital intensive a business is. Railroads, for example, require a lot of investment and infrastructure to operate, so they’re not easily displaced. Their rise may be slower as they build out their rail networks, but their life cycle tends to last longer.

[00:09:58] Shawn O’Malley: Industrial companies like General Electric and Ford defined the 20th century and because of their capital intensity, their life cycle lasted for decades. Compare that with more capital light industries like software, where a small team of programmers could build an app that rivals your own product. The barriers to entry are inherently lower and therefore competitive advantages just fade away a lot faster.

[00:10:19] Shawn O’Malley: In the span of roughly a decade, Yahoo rose to prominence, sat at the peak of its industry briefly, and then was quickly displaced by Google. Corporate life cycles are just shorter today, at least in technology, and thus, investors have to be on the lookout for disruptive competitors, which is something I covered recently in reviewing the book The Innovator’s Dilemma.

[00:10:38] Shawn O’Malley: As Damodaran puts it, tech companies age in dog years, and the consequences for how we manage, value, and invest in them are profound. I really like the comparison there to aging dog years because it makes the point that companies not only are all at different points on the corporate life cycle, but that no two companies age at the same rate either.

[00:10:55] Shawn O’Malley: So what does this all mean for valuation? Damodaran outlines two primary ways to think about valuation. The method that great investors like Warren Buffett like to focus on is, of course, intrinsic valuation. That is the belief that the per share value of a company can differ from its share price Transcribed And that underlying value is calculated based on the cash flows the company is expected to generate in the future, how confident you are in those cash flows occurring, and the discount rate you use to convert those future cash flows into a present value.

[00:11:23] Shawn O’Malley: This method of valuation works better for mature companies though, because their future is much more predictable. You stand a far better shot at guessing how many iPhones Apple will sell next year than you do in predicting how well some random new startup will do. Because of the wider range of future outcomes for younger companies, where they could be the next Google or they could just go bankrupt, there is a degree of uncertainty that makes intrinsic valuation a lot less tenable.

[00:11:47] Shawn O’Malley: As a result, the alternative valuation method known as pricing tends to be used more often with younger companies. Rather than determining what a company is fundamentally worth today, pricing is simpler because it compares a company’s valuation relative to similar firms. For example, a venture capitalist might look at the multiple of revenue other VCs paid for similar types of startups in order to determine their valuation for a company.

[00:12:10] Shawn O’Malley: Perhaps there have been a handful of deals where B2B SaaS startups were valued at 10 times their revenue from last year. If the B2B SaaS startup you’re looking to invest in earned 50 million last year, using the pricing method of valuation, you might conclude that 500 million, which is 10 times 50 million, is a fair value for that company.

[00:12:29] Shawn O’Malley: This is essentially what investors are doing too when comparing price to earnings ratios across peer groups of companies or against a company’s history. Pricing is based on these sorts of relative comparisons and is particularly common for companies with no past history and lots of uncertainty in their future going forward.

[00:12:45] Shawn O’Malley: So your approach to valuation should differ depending on where a company is in its life cycle. If you’re building out a discounted cash flow spreadsheet to value a startup that models out revenue growth over the next decade, I think you’re just doing something wrong because it’s really impossible to know what will happen to such a young company over that kind of timeline.

[00:13:02] Shawn O’Malley: I’m being slightly tongue in cheek because I do think there are ways to do intrinsic valuation of young companies, but you can imagine why pricing is just a much more common approach for early stage firms. Whether using intrinsic value as a guide or using relative pricing, I really like how Aswath thinks about the purpose of calculating a valuation for a company.

[00:13:21] Shawn O’Malley: He says, quote, A well done valuation is a bridge between stories and numbers, with the interplay determining how defensible the valuation is, but the balance between stories and numbers will shift as you move through the life cycle. Your story for a company is the future you imagine for it, and every valuation has some sort of implied story baked into it.

[00:13:40] Shawn O’Malley: Either the company will maintain steady market share and sales, or it’ll bounce back to its past levels of growth and profitability, or maybe your valuation is implying that a company is in some sort of terminal decline. The world is a dynamic place, it’s not black and white, and it won’t always conform to a spreadsheet.

[00:13:57] Shawn O’Malley: That’s why storytelling and a bit of creativity can be so important in the evaluation process. The one thing we know is that things are always changing, so evaluation that suggested companies prospects will remain the same over several years, especially as it ages across the corporate life cycle, is just unrealistic.

[00:14:13] Shawn O’Malley: In a way, different types of investors are all telling different stories about where markets make mistakes and how that enables them to earn their market beating returns. As he puts it in value investing, you focus on finding bargains and misvalued companies based on their existing assets, where you believe that you have the data to estimate value more precisely than the market averages.

[00:14:32] Shawn O’Malley: In growth investing, you focus on finding bargains and misvalued companies based on their future prospects and less so based on their current businesses. Growth investors inherently believe that while there is imprecision and uncertainty about predicting the future for young companies, they have an opportunity for market beating returns in doing so because market averages tend to be a lot worse at valuing broad ranges of future outcomes.

[00:14:54] Shawn O’Malley: The point is that growth investors and value investors, as defined in the most general sense, look at companies at different stages in the corporate life cycle and rationalize why markets have failed to accurately value a company based on either their existing operations or their future prospects.

[00:15:09] Shawn O’Malley: However, both value and growth investors are hoping to buy at a low price relative to what they deem the company to be worth, And they’re hoping that gap will close over time. The investment philosophy you choose then can lead you to over invest in companies in certain phases of the life cycle, which as Watt says, isn’t inherently bad, but again, it’s important to be aware of the decisions you’re implicitly making with the strategies you follow companies at different stages and the corporate life cycle offer very different expected returns and risks.

[00:15:37] Shawn O’Malley: That’s why I think most investors should be diversified across the corporate life cycle spectrum, owning a blend of early stage companies, high growth companies, mature companies, and even a set of declining companies that may be excessively cheap relative to the dividends they’re still able to pay out to investors.

[00:15:52] Shawn O’Malley: Another point I want to make about the corporate life cycle is that the type of management team running a company can change drastically over time. A visionary founder might have been the perfect person to dream up the next Apple and begin to bring that vision into reality. But after a certain point, that company has aged into becoming something completely different after it has reached that more mature status.

[00:16:11] Shawn O’Malley: Apple today, for example, is far less focused on dreaming up visionary products than it was in its early days with Steve Jobs. It’s just a lot more concerned with operational matters like quality control, supply chain management, marketing, and customer service. In other words, companies, priorities change as they go from trying to change the world and grow at all costs to trying to defend their market share and satisfy their existing customers.

[00:16:34] Shawn O’Malley: And it’s rare that a single person is the best CEO to manage the company at each stage of that life cycle. The visionary dreamer is probably not impeccable at managing logistics, and logistics tend to matter far more to mature companies than to early stage ones. Aswath actually calls it a myth that there’s a prototype for universally great CEOs.

[00:16:53] Shawn O’Malley: The CEO of IBM is probably not the best person to run a young company on the cusp of innovation like OpenAI with its Chassis BT product, and that’s okay. Especially in the decline phase of a company where a company’s purpose for existence is fading away, the founder of the company is probably the worst person to run things.

[00:17:12] Shawn O’Malley: They’re very emotionally biased and are probably the type of person who would rather build empires than manage decline well. These people are great, but as Aswath argues, they’re more likely to make reckless bets trying to keep a dying company alive rather than accepting the inevitable aging process and focusing on returning as much capital as possible to investors.

[00:17:30] Shawn O’Malley: Who can then allocate those resources to new business models that will benefit society. That is a nutshell capitalism and as painful as it is for those associated with companies in the decline stage, that is just reality. Companies being generally bad at accepting decline and therefore destroying capital in their dying breath is actually one of my biggest takeaways from studying the corporate life cycle.

[00:17:51] Shawn O’Malley: Mark Zuckerberg is one of those rare examples of someone running a business from its start to maturity and doing a pretty good job all along the way. Bye. Depending on what you think of the metaverse, you may or may not agree with that statement. One of the key ideas that Damodaran keeps returning to is this concept of aging gracefully.

[00:18:08] Shawn O’Malley: As he suggests, quote, The healthiest response to aging is acceptance, when a business accepts where it is in the life cycle and behaves accordingly. In the same way that a young company with tons of opportunities for growth should spend its cash on chasing that growth rather than buying back a ton of stock or paying out dividends, a mature company with stable profits shouldn’t risk it all on acquisitions and new business lines meant to reignite growth.

[00:18:31] Shawn O’Malley: But making peace with that decline is not easy, especially for a company’s management team and investors who are all human and have egos that sort of distort their incentives. I’ll just add here that acceptance of decline doesn’t mean some passive or defeatist attitude either. Instead, this is about navigating decline well with the least amount of pain possible and extracting the most possible value for stakeholders, which can include everybody from investors and the employees of the company.

[00:18:56] Shawn O’Malley: While management may think they’re trying to save everyone’s jobs by investing billions into some unproven endeavor meant to restore growth, in reality, they’re probably just hastening the decline in the date at which people lose their jobs. So you can see why it’s not an easy pill to swallow. It’s very tempting to try and show that you’re doing everything possible to reverse decline, rather than recognizing that, historically speaking, decline is inevitable for every company.

[00:19:19] Shawn O’Malley: Based on ASWA studies, turnaround stories are the exception, not the rule. Recognizing that is pragmatic. There’s usually an entire ecosystem of bankers and consultants though, happy to collect fees as they pitch companies on some magic potion that will give them a second life. There are some examples of this that get studied endlessly in business schools like IBM in 1992, Apple in 2000, and Microsoft in 2013, but they are few and far between in reality.

[00:19:46] Shawn O’Malley: He gives us a pretty compelling quote on this too. Damodaran says, Like the Egyptian pharaohs who sought immortality by wrapping their bodies in bandages and being buried with their favorite possessions, companies that seek to live forever will become mummies, and sometimes zombies, sucking up resources that could be better used elsewhere.

[00:20:02] Shawn O’Malley: I want to make this conversation a bit more tangible. Let’s look at a few case studies on aging from Aswat Damodaran’s September 9th article. The three companies he references paint very different portraits of decline. The three are Intel, Starbucks, and Walgreens, Intel was, as he puts it, a tech superstar not that long ago.

[00:20:20] Shawn O’Malley: It was founded in 1968 and built the computers that underpinned the computing revolution. Walgreens is the oldest on paper, having been founded in 1901, and today exists as one of the country’s biggest and best known pharmacy chains. And then there is of course Starbucks, which got its start in 1971 as a coffee bean wholesaler, until Howard Schultz came in and turned the company around and converted it into a global coffee shop chain.

[00:20:43] Shawn O’Malley: And What these distinct businesses have in common is that they’re all in the later portion of the corporate life cycle and their stock prices have been feeling the pressure from that lately. Walgreens is closing hundreds of stores while Intel stock has collapsed 60 percent this year. And Starbucks recently ousted its CEO due to underperformance.

[00:21:01] Shawn O’Malley: Market perceptions have turned against each of them, though Starbucks has had some positive momentum again after announcing that they poached Chipotle’s CEO to now lead the company. All three were superstar companies at one point though, and all three have seen that luster fade. Whether that decline is permanent remains to be seen.

[00:21:19] Shawn O’Malley: Walgreens is likely the furthest along in its decline, where the odds of reversal are the lowest and the prognosis is the most severe. All kinds of new competitors are disrupting the pharmacy space, from Amazon to Mark Cuban’s Cost Plus Drugs company. After going public in 1927, Walgreens has aged slowly over time, with pockets of growth spurts along the way, before more recently falling into a pattern that is hard to label as anything besides decline.

[00:21:46] Shawn O’Malley: Where annual revenue growth was in the double digits from 1994 through 2011, growth got cut in half over the next decade, and over the last three years, its revenues have only risen 3 percent per year. Meanwhile, over those three decades, its gross margins have declined 8 percentage points, and its operating margins have fallen from over 5 percent to under 2%.

[00:22:06] Shawn O’Malley: Those slim operating margins make it almost impossible for there to be really any meat left on the bone for shareholders after paying interest expenses and taxes. What’s worse for Walgreens is their competition isn’t doing much better either. While CVS has outperformed Walgreens, it’s market value is still down since mid-2022.

[00:22:23] Shawn O’Malley: Walgreens collapse has been more precipitous though, in 2016, Walgreens was worth more than CVS, and today it’s market cap is about 1 tenth of CVS’s valuation. Despite the clear signs of decline setting in, Walgreens brought in a new CEO in 2021 who promptly made a 5. 2 billion acquisition of VillageMD, which is a chain of doctor’s offices and clinics.

[00:22:46] Shawn O’Malley: As Aswath explains, Walgreens options are just simply dwindling. To survive, it’ll need to shrink its presence down to only its most productive stores and shed the rest to reduce costs. But the company is potentially one big macroeconomic shock away from slipping into bankruptcy if it is unable to refinance its debts.

[00:23:05] Shawn O’Malley: For each of the three companies, he prepares a scenario analysis showing a rough estimate of intrinsic value based on changes to their operating profit margins and revenue growth rates. For Walgreens, he projects that the company’s shares will be worthless unless it can double its profit margins. Yet, that is probably unrealistic given the rise in competition that Walgreens faces.

[00:23:25] Shawn O’Malley: Of the three, Walgreens is by far the best candidate for gracefully accepting decline and allowing the company to shrink in a way that preserves as much capital as possible for shareholders. When it comes to Intel, the picture has looked pretty bleak as well. While the company stayed at the top of its industry far longer than most of its tech focused peers, it’s seemingly safe to say that its best days of growth are about three decades behind in the rear view mirror.

[00:23:49] Shawn O’Malley: In the world of computer chips, Taiwan Semiconductor is by far the leader in producing them, and NVIDIA is the leader in designing the most valuable high end chips for artificial intelligence in gaming. Rather than specializing in manufacturing or design, as Taiwan Semiconductor and NVIDIA have done, respectively, Intel has tried to compete with both of them.

[00:24:08] Shawn O’Malley: Over the past year though, investors have only realized that doing so has left them far behind both. Whereas revenue grew at almost 15 percent a year from 1994 to 2001, it declined 11. 31 percent per year over the past 3 years. The company is quite literally contracting, and even worse is that its margins are falling too.

[00:24:28] Shawn O’Malley: Gross margins are down from 55 percent to 41 percent over the last three decades, and its operating profit margin fell from a very healthy 31 percent to an anemic 1. 69 percent more recently Damodaran describes this as essentially a textbook example of the corporate life cycle. It went from clear periods of growth to stability, to a very clear and sharp decline.

[00:24:49] Shawn O’Malley: The bottom has fallen out of Intel’s business, with its revenue and margins falling off a cliff. Although you might think Intel is further along in its decline than Walgreens, Intel’s advantage is that its industry is still quite vibrant. Its direct competitors like Nvidia are doing phenomenally well, which provides at least some hope that Intel can rejuvenate itself and maybe slow its decline.

[00:25:09] Shawn O’Malley: With Walgreens, its peers CBS and Rite Aid aren’t doing well though, and the retail pharmacy model seems really destined to be disrupted. So, even though Intel has seen an even sharper decline than Walgreens, there’s at least more reason for optimism that Intel can have a longer runway remaining in its corporate lifecycle.

[00:25:26] Shawn O’Malley: That could even present a good buying opportunity if the market thinks the company is doomed for imminent death and it can, in fact, hold on profitably for longer than expected. Meanwhile, like so many declining companies, Intel is resisting its decline aggressively. Arguably too aggressively, according to Damodaran.

[00:25:43] Shawn O’Malley: Intel has splurged on its chip manufacturing business with its Intel foundry in hopes of competing with Taiwan Semiconductor while also trying to launch a new generation of AI chips to compete with NVIDIA. As he puts it, Intel’s problems stem largely from aspiring for growth levels that they cannot reach.

[00:25:59] Shawn O’Malley: It’s competitors have clear leads, yet the industry is big enough that, if it can accept its subordinate role to its peers, Intel could find enough growth to stay alive. Because sentiment is so poor for Intel and the bar has been set so low with its stock price, Damodaran’s scenario analysis paints a considerably rosier picture than Walgreens, because even just modest improvements in profit margins and revenue growth would mean the stock is undervalued today at less than 20 per share.

[00:26:24] Shawn O’Malley: Damodaran actually discloses that the stock is so attractively priced that he’s buying Intel, so clearly, he believes the company can have some success in managing its decline, especially relative to the market’s current perceptions of it. And at the time of recording, it does appear that there are some rumors floating around that Qualcomm may be interested in acquiring Intel, which has given the stock a modest boost.

[00:26:45] Shawn O’Malley: Still, nothing has been made formal, at least not yet. The third case study is on Starbucks, the company where a double shot Venti caramel macchiato isn’t only a normal thing to order, but the staple of many people’s morning routines. Howard Schultz nursed the company from a single store to its worldwide presence after taking over as CEO in 1986.

[00:27:05] Shawn O’Malley: He retired in 2000, only to return again between 2008 and 2017 to guide the company after the great financial crisis and return again briefly as an interim CEO for a year in 2022. Starbucks is the least clearly declining company of the three, I’d say. Yes, it’s not growing at the 40 percent annual revenue growth rates it saw in the 90s, but it still has seen very solid revenue growth of 8 percent per year over the last three years.

[00:27:29] Shawn O’Malley: Meanwhile, its operating profit margins have actually grown over the past three decades from 9 percent to 15%. So its revenues are still growing meaningfully, and for every additional dollar of revenue, it’s converting a higher percentage into profits than it did in the past. Based on the numbers, you might argue that Starbucks isn’t even a company in the decline phase of its corporate life cycle at all.

[00:27:49] Shawn O’Malley: Instead, these numbers probably better resemble a late stage growth company or a mature company. But the reason Aswath argues that Starbucks could be considered a decline is because it has no story underpinning its valuation. There is no compelling narrative that’s exciting investors and giving them something to latch onto to justify optimistic projections about the future.

[00:28:08] Shawn O’Malley: Investors who had been hoping the company would return to double digit growth rates by expanding internationally, particularly in China and India, are probably poised for disappointment, according to Damodaran. Lower priced competitors and governmental restrictions in both markets have handicapped Starbucks growth.

[00:28:24] Shawn O’Malley: Additionally, inflation and input costs and demands for higher employee compensation are a real threat to its profit margins going forward. So there’s just not a clear storyline to be told for how Starbucks can not only preserve its profitability, but also grow aggressively enough to justify a rising stock price.

[00:28:40] Shawn O’Malley: Storytelling requires vision, not just from investors, but from management too. The stock has jumped on hopes that Brian Nichol, Chipotle’s ex CEO, who recently joined Starbucks, can provide that magic, but I’m skeptical because, well, Nichol is planning to be at the corporate headquarters only part time as he commutes back and forth between California and Seattle on a private jet paid for by the company, It doesn’t really sound like the type of person devoted to cutting costs and turning the company around with an imaginative vision for the future, so you might say Starbucks is in decline in a different way than Walgreens and Intel are, with a younger biological clock but it’s sitting at a key inflection point in its life cycle.

[00:29:17] Shawn O’Malley: It will either get a second wind, or in a decade from now, we’ll point to this moment as when it’s slow decline began. Going through these case studies here, I found it immensely helpful to think through where a company is in its life cycle and whether it’s at a key inflection point. That alone wouldn’t tell you whether or not to invest in a stock since a declining company like Intel can still offer good value, while a healthier company like Starbucks may look expensively priced relative to the range of likely possible outcomes before it.

[00:29:43] Shawn O’Malley: But it enables you to build a framework for your valuation, especially as you compare your perception of where a company is and its life cycle versus what the market seems to think. With Intel, the market seems to be saying that Intel’s expiration date is quickly approaching, and if that’s not true, as government subsidy programs like the CHIPS Act funnel money to the company that helps keep it alive, then its shares might actually offer good value.

[00:30:05] Shawn O’Malley: Meanwhile, the market is quite optimistic that Brian Nichol will lead a turnaround for Starbucks, yet he has articulated no clear story for how he will do that, which should at least raise some skepticism for you as an investor as you consider where Starbucks is in its life cycle. Thinking about corporate life cycles more broadly, Damodaran says, quote, A healthy economy will encourage entrepreneurship, providing risk capital, and not tilting the playing field towards established players.

[00:30:29] Shawn O’Malley: It remains the strongest advantage that the United States has over much of the rest of the world. He adds, quote, If capitalism is all about creative destruction, it follows that companies, which are after all legal entities that operate businesses, should fade away as the reasons for their existence fade.

[00:30:44] Shawn O’Malley: That is one reason I critique the entire notion of corporate sustainability as opposed to planet sustainability since keeping declining companies alive and supplying them with additional capital redirects capital away from firms that could do far more good with that capital. The subtext here is that we need a healthier framing of corporate decline in society.

[00:31:03] Shawn O’Malley: All companies will face decline, even once great ones like Starbucks, Intel, and Walgreens, and we ought to celebrate the CEOs who can preside over declining firms in a way that preserves order and value for shareholders. So much attention goes to companies in the first half of their life cycle since this is where the most exciting ideas and growth are But that leads to declining companies being overlooked.

[00:31:23] Shawn O’Malley: For investors, value often comes relative to expectations and using Intel as an example again Damodaran thinks the company offers great value despite being in decline To invest in a declining company, you’d want to be confident that not only is the stock priced attractively relative to current overly pessimistic expectations about the future, but also that the right management team is in place to gracefully embrace the company’s decline, or if there is an opportunity to rejuvenate it, do so effectively, which I’ll say again is rare.

[00:31:51] Shawn O’Malley: Decline is arguably the most difficult phase in a company’s life cycle because it leaves management with just no good choices. Bootstrapping a young business is incredibly hard, but at least promising opportunities can be found there. Declining companies are really left with a menu of unappetizing choices.

[00:32:07] Shawn O’Malley: Declining companies decision making becomes destructive when decline leaves management in denial, desperation, or in a survive at all costs mode. More constructively, the signs of a declining business that won’t handle its aging well are acceptance from management, which may mean divesting poorly performing assets and spinning off better performing ones, Renewals and revamps, which might mean sprucing up existing product lines to reach broader markets, or rebirths, where a new market or product can be found that resets its corporate life cycle.

[00:32:36] Shawn O’Malley: Rebirths are the most uncommon and typically involve a strong element of luck. Between that range of destructive and constructive outcomes for declining companies is a more middle of the road response that Damodaran calls MeTooism. That is, management begins by acknowledging that their existing business model is running out of fuel.

[00:32:54] Shawn O’Malley: But they believe that a pathway exists to bring the company back to health and even growth. They end up chasing strategies that have worked for competitors, but this rarely works since they’re late to the party and earlier companies have already built up moats. Only for a few companies will Imitation offer a pathway back to growth.

[00:33:11] Shawn O’Malley: So a company may have strengths that can signal how it should manage its decline. Intel still has technological advantages from its experienced employees and patents that may be underutilized, which if used more effectively could create value. And with Starbucks, given its ubiquitous brand recognition, even without a story to tell going forward, there are plenty of advantages it can lean on during this transition period.

[00:33:32] Shawn O’Malley: Walgreens, however, has almost no differentiating advantages, making it an ideal candidate for embracing decline rather than resisting it. Intel may not be far off from reaching a similar point, but for the moment at least, there is reason for optimism that it can renew and revamp itself, though a total rebirth is unlikely.

[00:33:50] Shawn O’Malley: Starbucks is not only best positioned to be renewed and revamped, but it has more flexibility to explore rebirthing itself too. This is also why stock is the most expensively priced of the three, because there is that optimism about the future that can still be really spun into an attractive narrative, though as we’ve discussed, that narrative remains to really be clearly articulated.

[00:34:11] Shawn O’Malley: I hope these examples were helpful in thinking through how decline can look differently for different companies and in understanding why it is so hard for companies to age constructively. Decline is a misunderstood and ignored part of the corporate life cycle, which is why I wanted to spend some extra time looking at it.

[00:34:27] Shawn O’Malley: But there’s certainly more to be said about the corporate life cycle that we can continue to build on here. To dive even deeper, I want to return to a recent paper from Michael Mauboussin and Dan Callahan of Morgan Stanley. As they put it, understanding where a company is and its life cycle is helpful for addressing capital allocation, costs of financing, governance, and valuation.

[00:34:46] Shawn O’Malley: The way to manage and evaluate a new company that is expanding rapidly is very different than it is for an old company that serves a mature and saturated market. In their paper, they lead off with an alternative portrayal of the corporate life cycle based on companies returns on capital relative to their weighted average cost of capital.

[00:35:03] Shawn O’Malley: If you’re not familiar with the term weighted average cost of capital, in short, it’s a measure of how much it costs a company to raise financing from either debt or equity based on the company’s mix of debt and equity in its capital structure. Debt costs are easy to estimate, but equity costs are more subjective and reflect the returns a company needs to generate for shareholders to justify keeping their equity capital in the business.

[00:35:23] Shawn O’Malley: So, if a company has a blend of 50 percent debt and 50 percent equity and can borrow at 8 percent per year, while the cost of issuing equity is estimated at roughly 12 percent per year, Then the weighted average cost of capital would be 10%. If the company had more equity on its balance sheet, the WAC, which is an acronym for weighted average cost of capital would be higher.

[00:35:43] Shawn O’Malley: And if it had more debt, then the WAC would be lower. At the beginning of the company life cycle returns in capital net of WAC are negative because early stage companies need to raise outside financing to sustain their yet to be profitable businesses. As the company grows and matures, the chart rises and then plateaus.

[00:36:01] Shawn O’Malley: Rising as young growth companies scale and build up advantages that allow them to earn returns above their cost of capital. Then, as the business matures, its ability to earn these abnormal profits diminishes. Again, debt costs are relatively easy to estimate because they’re based on interest rates and are contractually fixed.

[00:36:18] Shawn O’Malley: In contrast, the cost of equity is more subjective and reflects the returns investors expect to justify their ongoing investment in the company. If a company’s cost of capital is 8 percent and it only returns 6 percent per year, then that 2 percent gap in financing costs versus returns reflects a destruction of value for shareholders.

[00:36:36] Shawn O’Malley: Value is a bit of an intangible thing in this case, but the takeaway is that as companies age, they lose their competitive advantages and with that they lose the ability to earn returns above their cost of capital. Declining companies that can’t earn returns above their cost of capital are not worthwhile given the opportunity costs and therefore should wind down their operations.

[00:36:56] Shawn O’Malley: How they define competitive advantage is also interesting here. Mauboussin and Callahan say that the magnitude and sustainability of the spread between returns on capital and costs of capital are the defining features of what makes a competitive advantage. So you can assess where a company is in its lifecycle by calculating the spread and mapping it out over time.

[00:37:14] Shawn O’Malley: You should be able to determine whether it is roughly trending upwards, plateauing, or declining. They also identify some flaws in pinpointing where companies are in the life cycle. As we talked about when going over Aswath Damodaran’s work, a company’s age in years does correlate with its biological age in terms of its trajectory in earning returns above the cost of capital, but it’s not perfect since companies age differently.

[00:37:37] Shawn O’Malley: Additionally, we cannot simply say that all small companies are earlier in their life cycle while bigger ones are older. Relatively small companies can be mature and relatively big companies can be young because they simply have addressable markets of vastly different sizes. They measure age based on a company’s spread between its returns and cost of capital.

[00:37:55] Shawn O’Malley: Tracking companies that had IPO’d from 1990 to 2022 in the Russell 3000 index, excluding those in the financial and real estate sectors, they were expecting the full life cycle to play out where companies started with negative spreads that rose, peaked, and declined back down over time. Instead, they actually found the opposite.

[00:38:13] Shawn O’Malley: Companies tended to have the highest spreads at the time they IPO’d, which declined and then stabilized at around year 5. My first conclusion here, which you may or may not find surprising, is that companies that list on public stock markets are considerably far along in their life cycle. Rather than truly being early stage, many companies that are being listed in the stock market tend to be much closer to the middle of their biological clock.

[00:38:35] Shawn O’Malley: Secondly, the process of decline isn’t completely smooth either. Rather than going in a straight line from peak to trough, companies can endure long periods where they’re still earning returns above their cost of capital, but that spread remains mostly flat after the company has exited its growth phase.

[00:38:50] Shawn O’Malley: Modest competitive advantages can seemingly remain intact for longer periods of time than might be theoretically expected. Pulling the thread a little more on the Morgan Stanley study’s findings, the median company had a negative 7. 6 percent return in its earliest phases, with a peak median return of 11.

[00:39:07] Shawn O’Malley: 2 percent per year in its growth stage. Also interesting, the median publicly traded US company that IPO’d from 1990 to 2022 entered decline just 10 years after its first listing. If you’re surprised by that, I’ll say that the median is brought down here because many relatively young companies transition quickly into decline, especially in the tech sector.

[00:39:26] Shawn O’Malley: We mentioned it a bit before, but companies are not guaranteed to progress through each stage incrementally either. They may skip phases straight to decline or failure. For example, Mauboussin ‘s research with Morgan Stanley suggests that only 38 percent of companies in the growth stage in a given year end up in the maturity stage 3 years later.

[00:39:43] Shawn O’Malley: And as we’ve discussed, the progression isn’t perfectly linear. 5 companies in the shakeout stage, as Mauboussin refers to it, which is between maturity and decline, move backward in the life cycle to re-enter the maturity stage rather than sinking further into decline. Using Amazon as an example, from 1998 to 2022, the company has spent most of its time in the growth phase but has at various points slipped into maturity and even briefly into decline before returning back to growth.

[00:40:10] Shawn O’Malley: Netflix’s journey has been similarly Starting in 2002, it has gone from growth to maturity, back to growth, to even earlier stages of growth, and then back to maturity again. These are somewhat biased examples since they’re arguably among the most dynamic companies and markets, but the point remains. My takeaway is that Mauboussin and his colleague Dan Callahan really did find that the corporate lifecycle can be quite dynamic.

[00:40:33] Shawn O’Malley: Broadly speaking, the lifecycle is a helpful framework, but companies like Amazon show that it is by no means rigid either. Thank you. There can be a lot of back and forth between what resembles growth and what resembles maturity and that’s to be expected since these are sort of arbitrarily defined.

[00:40:47] Shawn O’Malley: Obviously there isn’t some objective law of nature that draws a line between growth stages and maturity. To make the point on why diversification is necessary across the corporate life cycle, I’ll just share the study’s findings on how total returns to shareholders vary at each point in the life cycle.

[00:41:03] Shawn O’Malley: Thank you. Whereas early stage companies had the highest mortality rates, leading to average annualized returns of almost negative 10 percent over 3 years, companies in the maturity stage in any given year delivered returns of about 9 percent per year over the subsequent 3 year period. Mature companies are the most likely to deliver positive returns to shareholders in any given year, but they also have a more limited lifespan ahead of them.

[00:41:26] Shawn O’Malley: While many younger companies will fail and destroy investors capital, they have the potential to turn to growth and mature companies that deliver solid returns for many more years to come. So, the risks and returns looking forward differ meaningfully at different stages in the life cycle. One particularly effective but difficult investing strategy that the report identifies is to seek companies that are transitioning to growth and maturity, either moving forward as a young company or backward as a declining company in the life cycle.

[00:41:52] Shawn O’Malley: That is to say, the best returns came from companies at transition points, specifically companies transitioning into periods of growth or maturity. For instance, a portfolio of stocks of companies that started in the decline stage but ended up in the growth stage 3 years later would generate an average annual total return of 20 percent and 16 percent for those that returned to the maturity stage, while companies that moved into the decline stage generated returns ranging from 17 percent to 3 percent depending on which stage they started in.

[00:42:22] Shawn O’Malley: A simpler way to say that is investing in companies with rising returns in capital over a 3 year period is conducive to learning better returns. And investing in companies with declining returns on capital is likely to result in worse returns. Similar to the example with Starbucks and Intel, both of these companies are at transition points and if you think they can rejuvenate their businesses and increase their returns on capital over the next three years, then they should make for great investments as they reverse their biological age.

[00:42:49] Shawn O’Malley: If you don’t have a credible story in mind for how they might do this, then you’d want to avoid them of course. It is easier said than done to identify companies that will increase their returns on capital over a multiyear period and move toward the most profitable stages of the business lifecycle, but that begins with finding companies at clear transition points, as I made the case for with Intel and Starbucks, and determining for yourself whether that transition will mark a return to growth and increasing profitability, or an advance into further decline, similar to where Walgreens is in its corporate lifecycle.

[00:43:19] Shawn O’Malley: Another point to consider about valuation and the corporate lifecycle is on duration. Duration, simply put, measures the weighted average time investors expect to wait before they receive cash flows. It’s a concept primarily used in fixed income investing, and as an example, if a bond is set to be repaid in 30 years, and it pays no coupons in the meantime, and repays the entire bond at the end of those 30 years, then the bond’s duration is pretty straightforward, it’s just 30 years.

[00:43:44] Shawn O’Malley: If it made payments monthly over that 30 year period, instead then, the duration would be much shorter. However, The concept applies to stocks too. Earlier stage companies have longer durations because the payoffs they generate for investors are further into the future, while companies in decline have shorter durations since they’re more likely to be liquidating their assets to repay investors today.

[00:44:05] Shawn O’Malley: Higher duration assets then tend to fluctuate more because they’re more sensitive to opportunity costs, as measured usually by changes in interest rates, since their payouts are much more in the distant future. So, by buying a portfolio of earlier stage companies, you’re taking on more volatility with your portfolio, as the valuations for these companies swing more dramatically thanks to changes in interest rates.

[00:44:26] Shawn O’Malley: When valuing early stage companies, Mauboussin and Callahan suggest zooming in on the company’s basic unit economics for expansion. With brick and mortar retailers, you try to determine the return on investment for building a new store. With a subscription business, you try to estimate the lifetime value of a customer based on the present value of their future subscription payments.

[00:44:45] Shawn O’Malley: And if a company has favorable unit economics, then short term losses are both palatable and to be expected as they invest in building the business. In the conclusion of Mauboussin’s and Callahan’s paper, which I think also wraps up things for today’s episode well, they remark that firms don’t age linearly, but rather transition between stages according to the strength of their advantages and competition.

[00:45:06] Shawn O’Malley: We’ve talked a lot about the corporate life cycle today, and to understand it even more deeply, I’d recommend reading Aswath’s book and blog posts, as well as Morgan Stanley’s study on investing across the corporate life cycle. I have links to those resources and more in the show notes below for this episode.

[00:45:21] Shawn O’Malley: Damodaran’s primary insight, at least for me, is to critique how decline is managed in corporate America today. To understand his point, we went over the corporate life cycle more generally, and then narrowed in on three case studies of companies that are arguably in different stages of decline, to understand what decline looks like in practice, how it can and should be managed, and in what circumstances it may present attractive opportunities to investors.

[00:45:43] Shawn O’Malley: We also reviewed Michael Mauboussin and Dan Callahan’s research published through Morgan Stanley on using excess returns on capital over costs of capital to measure companies age and the strength of their competitive advantages. On top of that, we discussed the risks and rewards associated with companies at different stages of the life cycle, examples of companies transitioning between various stages and how that can be done non linearly, and how key transition points, especially for companies transitioning into growth or maturity, represents an opportunity to earn superior returns, assuming you can identify which companies are best positioned to increase their returns on capital in the coming years.

[00:46:17] Shawn O’Malley: I hope you enjoyed digging into these topics as much as I did. I’d like to end today’s discussion with a quote from the legendary investor, Peter Lynch. And I think his quote here fits our topic perfectly. He says, this is the way the capitalist ecology works. Industries decline, old companies wither away, and young companies rise up to replace them. The process is hard on many, but ultimately it is healthy. That’s all for today, folks. I’ll see you again next week.

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