Pure Downside, No Silver Lining

There are no exceptions to Newton’s third law of physics. Every action has an equal and opposite reaction.

This is mostly true in business and investing too. It’s why it’s easy to underestimate how quickly things change.

Most of investing history goes like this: Something abnormally good or bad happens, and then another thing equal and opposite thing occurs to push things in the other direction.

Altria is the best-performing stock of all time, earning more than 20% a year for more than half a century. A lot of this performance was because people didn’t want to own the stock for moral reasons, or fears over new regulations. That kept the share price low, which kept the dividend yield high. And reinvesting a high dividend yield is like gasoline on a flame to compounding. So hating the stock led to stock outperformance – one action, then an equal and opposite reaction.

Same thing in reverse during bubbles. Excitement leads to high valuations, and high valuations lead to unexciting returns.

And in business. Success makes you think you’re right, and thinking you’re right encourages actions that are wrong.

Same in economics. Oil prices up, drilling up. Drilling up, oil prices down.

These offsets – often just simple supply and demand – drive the first law of economics: Nothing remains too good or too bad for forever.

But unlike Newton’s law, there are exceptions.

Pessimism is usually just extrapolating bad events without considering the offsetting reactions that push things in the other direction. That’s why it’s often wrong.

But there are things in business and investing with no offsets – bad events with no stabilizers, no equal and opposite reactions to that seed an eventual upside. They are pure downside, no silver lining. They belong in a folder labeled, “Do everything you can to avoid these.”

Three big ones:

1. Reputational damage

The underappreciated part of reputational damage is how fast and far it spreads.

It spreads fast because the risk of interacting with a terrible company surpass the gains of interacting with a great one. Tell me a restaurant is amazing and there’s maybe a 30% chance I try it, someday. Tell me it’s terrible and there’s a 90% chance I don’t. The hurdle to keep someone away from something is lower than getting someone to try something. So people are more gullible to negative reputational gossip than upside potential, and bad news spreads fast. Bank runs are a good example. It’s why pessimism outsells optimism. And it’s why reputational harm is so damaging.

It spreads far because reputation is the only common denominator between all stakeholders – customers, employees, shareholders, suppliers, regulators, etc. The more successful you are the more people want to be associated with you, which is great. But that’s equally powerful in reverse. To generalize only slightly: No one wants to shop at Sears. No one wants to work at Sears. No one wants to invest in Sears. No one wants to partner with Sears. No one wants a Sears in their neighborhood. Poor reputation is like a a debt that doesn’t show up on the balance sheet and is the only thing that can repel so many different people.

Solomon Brothers got into trouble 30 years ago. Warren Buffett, who was a big shareholder, took over as CEO and told employees: “Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.”

2. Illiquidity

“The only unforgivable sin in business is to run out of cash,” said Harold Geneen.

There’s a more innocent version of this that affects many of us.

Progress is cyclical, and if you have the cash to endure a cycle then the ugly parts of it – lower prices, less competition, etc. – become opportunities that offset the pain. It’s only when you’re out of cash that the nasty side of cycles are just nasty.

If the price of an asset falls and you can’t take advantage of it, either through an opportune purchase or as part of dollar cost averaging, then it’s fall just sucks. It is pure downside, no fun, no gain. Reinvested dividends on a declining stock price can be an offset. But that just highlights how having and using cash can counteract the pain of decline.

A cousin of this problem is underappreciating that cash isn’t just a low-yielding asset; it’s the barrier that prevents you from being forced to sell higher-yielding assets, and that makes the real return on cash higher than it appears. A miserable event with no offset, no silver lining, is when the economy stalls and asset prices fall, and because the economy stalls you lose your job, and because you lose your job you have to sell assets at low prices, all because you didn’t have enough cash. Unforgivable.

3. A toxic workplace

Many of the smartest German scientists and engineers saw what was happening to their country in the 1930s and said, “I’m out of here.” As Albert Einstein and his family fled Germany in 1932, he told his wife, “Turn around, you will never see it again!”

A journalist asked Hitler in 1931 what Germany would do when the smartest brains left the country. “I’ll be the brains,” he allegedly replied.

Scale back the stakes by endless orders of magnitude and this kind of stuff happens in companies too.

There is no offset, no upside, no silver lining to a toxic work culture because the smartest employees will always have an option to go somewhere else, which is a downward spiral for companies that’s hard to recover from. This is increasingly true as more jobs shift from commoditized physical work to niche knowledge work.

There are many forms of toxic turnoffs beyond the obvious discrimination, harassment, low pay, and maniacal bosses.

Profits that come from exploiting customers is a turnoff.

Accepting ideas based on seniority rather than merit is a turnoff.

Bureaucracy is a turnoff.

Boredom and monotony are turnoffs.

Once the best employees leave the office becomes less exciting for second-tier talent. Once they leave the third tier finds greener pastures, and on and on. Negative compounding. No offset, pure loss.

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