Where's the Risk?
Imagine Ivan Drago testing various pieces of your company to see when it crumbles - how to be better than unbreakable
“It is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it.” – Nassim Nicholas Taleb
“The inability to adapt brings destruction.” – Bruce Lee
“You see the old way wasn’t working, so it’s on us to do what we gotta do to survive.” – Tupac
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After last month’s post re: 2023 being a “reset year”, one question that came up was, “so…does this mean we’re past all the supply chain disruptions?” Yes, things have calmed back down from the chaos of 2020-2022, system velocity has improved from a very low level, and today, things appear “normal” for the time being. They’re relatively better, and as they say, “progress = happiness.” Demand has softened and supply has increased. Shippers, carriers, and 3PLs can and should be more strategic this year. But the system is still fragile and sensitive to shocks - so, “no” - supply chain disruptions are not over. Some future shocks will be seen coming (e.g., large scale shifts in sourcing, manufacturing, and major trade lanes) and some will not (e.g., wars). Some shocks will be direct and some indirect. And when these events unfold, analyzing the supply/demand balance across the many links in the chain will determine the degree of stress and impact on various parties.
Certain system stress is cyclical and related to the macro environment. This generally affects everyone. Kind of like winter. You can feel demand cooling off, it’s a tough period, but then the economy picks up again. Some winters are long and hard; others relatively mild. Since demand usually moves quicker than supply, freight volumes are a good indicator of the direction of the economy and lead pricing and margin cycles.
In my years as an analyst, I remember hearing companies talking about weathering the cycle or “hunkering down” to make it through the dips. But management teams never really talked about getting stronger during these periods of stress. Survival - to fight another day - was the broad objective. Some, like Expeditors and Old Dominion Freight Line, were able to outperform their peers by not cutting as much during the “winters,” which required a clear strategy (and adequate financial cushion) before the dip. You could see they were more resilient (or not hurt as much as others) coming off the trough - but rarely were they “better” as a result of an exogenous shock.
Well, what if one could be better after chaos, disruption, stress, and disorder?
That idea never came up. It was always assumed that the best you could do under attack was to cover up and block — avoid damage. In martial arts, though, there’s also opportunity in chaos. If you know what you’re doing, an opponent’s attack often leaves them exposed somewhere. Still, at a minimum, you want to shore up any holes and not be easy to break.
Nassim Nicholas Taleb has authored several books that have significantly influenced my thinking, starting with “Fooled By Randomness” — a book I have gifted often. They all start with the basic premise that life and the future are uncertain, even if paths seem logical (bordering on predetermined) after the fact — and surprises along the way are the rule, not the exception. He wrestles with how to operate not only in a complex world we don’t understand but in a world where luck, chance, and the unknowable play a significant role.
Most are more familiar with his second book, “The Black Swan,” as he popularized the term (even if it is often misused), referring to events that a) are unpredictable, b) have a big impact, and c) are explained away after the fact as something more foreseeable than it was. Anything you would name now, for example, that is likely to disrupt the economy or supply chains, by definition, would NOT be a Black Swan event.
To look at the risk to Black Swan events in the broader transportation & logistics industry (or any industry), we have to start with two basic claims.
What we do not believe we can know —> what major unpredictable events will change the landscape. The industry will be impacted by things we see coming, like economic upturns and downturns, excess supply building, inventory swings, and government regulations. In addition, there will be unexpected events that have a large impact on the competitive landscape, freight volumes, capacity, pricing, and margins.
What we believe we can know —> which companies and industries have more to lose or to gain from volatility/chaos/stress. And while we’re uncertain where stress will hit, by examining industry sectors and then individual companies, we do believe you can see who’s in poor shape, who’s not wearing their vest, and who’s ready to walk through fire. You can know who hates volatility and surprises.
When analyzing complex systems (e.g., the global economy, global trade, and global supply chains), there is benefit to understanding how industries and companies are structured to deal with significant events (good and bad) that change the landscape. There are many interdependencies in these systems that are often hidden/unknown but have significant consequences (e.g., who knew the real importance of chassis availability before 2021?).
While we do not know what large events might or will happen ahead of time (most don’t, which is why stocks often gap up or down big in response to these events), we do believe it is useful and possible to identify which companies and industries are inherently carrying more risk around and therefore more exposed to crippling injuries from negative events and less able to capitalize on positive ones. If one were to look at how companies sort themselves out along a spectrum, it would go from Fragile (hates volatility/stress) to Robust (indifferent to volatility/stress) to Antifragile (benefits from volatility/stress, up to a point).
It is important to note that prior to Taleb’s book, “Antifragile,” there was no such word for the opposite of something that is fragile. Most would think it to be “resilient” or “robust,” but using those words is akin to saying “neutral” is the opposite of “negative.”
To illustrate the concept with a transport example: if one were to FedEx a package with delicate, breakable contents, the box may be marked “Fragile,” as mishandling could easily damage what’s inside. At best, one hopes the contents arrive in tact, unharmed. But what if dropping, kicking, tossing, or running over the box actually improved the contents – made them more valuable? That is what is meant by antifragile – something that benefits from disorder, randomness, chaos, volatility.
So, let’s look at some of the key themes of “Antifragile” related to the transportation & logistics industry and areas of company-specific risks.
Industry fragility
Global supply chains are extremely fragile, as they are long with many links, many parties involved, and many possible points of failure due to disruption. However, at the industry level, transportation is one of the least fragile industries, as it has been around for centuries and is critical to domestic and global economies. And a big reason the transportation industry as a whole is strong is because most of its parts are fragile (with general non-contagion). To put it another way, what kills some companies makes the others stronger, and one company’s failure doesn’t take the system down. Still, within the industry, there are segments you can identify as more fragile than others. The average asset-based truckload carrier, for example, is more fragile than the average truck broker.
A few interesting ideas from the book related to fragility
Redundancy – many think of lean as efficient, but it’s not robust and certainly not antifragile. A little fat can help you survive the winter. A lack of cushion is dangerous in a world where things don’t go as planned. The idea here is that if you have more than one of something (or more than you need), you’re harmed less by the loss of that something than if it’s your only one. In the military, they often say with respect to comms, “two is one, one is none.” We view capital as important here, for if a company has excess cash or excess borrowing availability, it will not find itself in as much of a pickle as a company levered to the gills, in a period where income falls, interest rates rise, and/or more money is needed.
Agency Problem – this is the difference between the owners and the CEO/executives of the business. The story of a company is always a bullish one, as we know of no founder or CEO who aims to reduce the value of the enterprise over time. Specifically related to publicly-traded companies, management teams (typically) create lengthy presentations, speak at conferences, and hold quarterly analyst calls to convince investors that their stock (a piece of ownership in the business) will be worth more next year than it is today and, over time, will be an investment worthy of their (clients’) money.
In fact, everything an executive team does, in theory, is an attempt to increase shareholder value. We say, “in theory,” because it has been discovered that more than just a few executives have prioritized maximizing their own personal wealth to those of employees or shareholders. If the business does well, the executives get big bonuses, whereas if the business underperforms, they still get paid, and others pay the price. This is a significant source of fragility in companies, which is why executive ownership is important an incentives should be well thought out.
Unfortunately, some boards just allow incompetent-but-well-meaning CEOs to stay in office long past the initial walk down Shareholder Value Destruction Lane, often because the CEO placed the directors on the board in the first place. As most should know, stocks don’t only go up – they go down, and some (a significant amount) even go to zero. The same goes for companies (e.g., Circuit City, Blockbuster, Consolidated Freightways, Kozmo.com, Bird Scooter? TuSimple?). This can be helped by aligning the executive leadership and owners.
The Turkey Problem* – just because it hasn’t broken before doesn’t mean it’s not prone to break (or even more likely to break) under future stress (sometimes it is because things have changed – like deregulation), while other times it’s a straw breaking the camel’s back type of thing (like how we’ve seen the driver shortage playing out with long-term demographic shifts). The “turkey” is one who is both surprised and harmed by significant events.
*Think of a turkey’s confidence in living another day - it grows from May to June to July to August, as every day seems further confirmation that they’ll see tomorrow. Until late November. Wow - imagine the surprise. Not at all what they expected, as they were more confident they’d see the day after Thanksgiving than any other day up to that point.
Neomania – falling in love with the “new thing” leads to fragility. This is where the “disruptors” come in, as everyone has been in love with digital/tech companies in recent years (the second tech bubble of my career). Similar to 1999-2001 when “investors” wanted to throw money at any company with a “.com” in its name, more recently (beginning ~2015), stories of Uber’s valuation led VCs to want to back “the next Uber for __” or the next “unicorn.” Now, we agree that technology is still advancing and that it will change how supply chains function and companies interact with one another. But it shouldn’t change as much how supply chains look, as freight still has to move from point A to point B by land, air, or water. In fact, I believe the biggest trend with respect to supply chains for the next 20 years is nearshoring/reshoring, which has more to do with costs, demographics, e-commerce, and geopolitical issues.
Specific places to look for fragility at the company level - most can be fixed
Labor. Labor is culture, and culture is a key asset for any company. The stronger the culture, which is often tied to strong leadership, the more a company tilts toward robust and antifragile. Unions are fragilizing, as inflexibility in labor costs and work rules can lead to significant margin compression and losses in downturns/market shifts. Independent contractors, given all the current legal issues and state political trends, are also a risk. We would include management here, as leadership will either strengthen or weaken the culture. Management also sets the tone for how the company responds to volatility and disruption.
Incentives. The gets into “the agency problem” again - where the manager of the business is not the true owner. Do your best to make sure incentives are aligned across the organization to encourage long-term success and minimize outsized risk taking.
Redundancy. We’ve already discussed the benefits of redundancy, but of course we should point out that companies don’t need two of everything, just some extra resources in key areas in case of surprises or emergencies. For example, in its large acquisition, it didn’t make sense for DSV to keep Panalpina senior management or many of its other mid-level managers, as they already had individuals performing those functions. Two branch managers were not needed in Houston, so redundancy in some areas increases fragility, in our view. But a company that keeps extra cash on hand, or has a backup server, or has excess facility capacity — those are smart redundancies, allowing it to operate through disruption and capitalize on positive opportunities that may present themselves.
Others places to look
Customer concentration - the more diversified, the less fragile. A 30% customer goes out of business - ouch. A 3% customer goes away, it hurts - but it’s not fatal.
Focus on the customer - is there one? The companies closest to understanding their customers’ needs are best equipped to ride out the cycles and become stronger over time. If you never hear a company’s management talk about how they’re solving problems for their customers and want to provide and excellent product and/or service, run the other way.
Decentralized vs centralized operations - decentralized ops can respond quicker to volatility and is generally more robust.
Financial leverage - less debt is less fragile. And fixed debt is more robust than floating debt.
Skin in the game - increased ownership from execs down to front line workers improves decision-making and reduces fragility.
Fixed costs/operating leverage - The old “make it up with volume” story, often told in good times, is dangerous. Understand the leverage in the business, as revenues and margins usually don’t move in a 1:1 manner. If you don’t understand how truly fixed/variable your cost structure (most companies overestimate the variability of costs in the short-term), it can lead to a false understanding of costs that can lead to improper incentives and long-term underperformance. And can be deadly in a downturn.
Contract writing – this is important to limiting downside, as many contracts (especially long-term agreements, like in contract logistics) are written as if everything will generally stay the same for a multi-year period. Well, time increases volatility, so a longer-term contract needs to be more flexible and think about more things than an annual contract. A lot of 3PLs have gotten in trouble here over the years.
Size - it can be a source of strength but also a vulnerability (see David vs. Goliath by Malcolm Gladwell)
Data - do you have good data? is it timely? accurate? can you easily analyze it to make better decisions? More data is neither good nor bad - it’s how you use it. Lack of data, low data quality, and/or delay in data are all sources of fragility. High-quality, fast, and meaningful data, on the other hand, can move a company towards anti-fragility.
M&A - this is both a source of risk and potential return. But they tend to fragilize. Risks of acquisitions – integration (physical, labor/cultural, tech), financing (pay too much and/or borrow too much?), accounting (did you get the numbers right?), and management distraction (how much attention is this taking away from your current business and existing customers?)
Recommendations for companies
The key concept here is that bad things happen, the unknowable happens, things different from what you expect happen, and companies that are fragile are poorly asymmetric in that they have more to lose than to gain from random events and specific stressors. Companies that are antifragile have more upside than downside from random events and certain stressors. You at least want to be in between and lean toward antifragility where possible.
“The use of money is all the advantage there is in having money.” – Benjamin Franklin
In a cyclical business, like transportation & logistics, I always advise companies to build a cash war chest during good times and then use it when the cycle turns down to 1) continue operating with little, if any, interruption to service during the softer times (if an asset-based business, this means still refleeting on schedule to maintain your average fleet age), 2) increase long-term value via a) share buybacks, if public, and b) making strategic investments at a discount. These steps should not only preserve margins but should improve relative service and enhance market positioning for when the cycle turns up again.
Unfortunately, too many shareholders and managements believe that when a company has excess cash, especially during a bull market, it should either a) grow (via acquisition at a high multiple) or b) buyback stock (at a high valuation). But I think this just shows a blatant ignorance of the cyclicality of the business and dismisses the long-term value of being able to invest through the downturn (where both M&A and share buybacks are actually more attractive).
Of course, the above recommendations are most applicable to larger, more established companies. What about those just starting up? How do they operate through the cycle and become less fragile? One of the advantages of being a start-up is that you’re not yet fully formed, and therefore you can pivot easier in openings that may be created during periods of disruption. You’re not as locked in yet with the ups and downs of a cycle. Still, cash preservation is key (so, raise a little more than you think you need to during good times), and focus on the customer to gain support in whatever direction you choose.
And on a personal level, if you can breathe and smile and move forward no matter what comes your way, you’re antifragile.
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Past Posts
Beyond Logistics post #1 re: Trucking 101 —> here
Beyond Logistics post #2 re: Life —> here
Beyond Logistics post #3 re: Pricing —> here
Beyond Logistics post #4 re: Communication —> here
Beyond Logistics post #5 re: Technology —> here
Beyond Logistics post #6 re: 3PL trends —> here
Beyond Logistics post #7 re: Lessons from Comics —> here
Beyond Logistics post #8 re: Cleaning Up Inside —> here
Beyond Logistics post #9 re: All Bad Things Must End —> here
Beyond Logistics post #10 re: Better Questions —> here
Beyond Logistics post #11 re: 2023 —> here
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About the author: Dave Ross currently serves as Chief Strategy Officer at Ascent and EVP at Roadrunner. Prior to his current roles, he was Managing Director and Group Head of Stifel’s Transportation & Logistics Equity Research practice, where he spent >20 years researching and writing on the freight transportation & logistics industry. Based in Miami, FL, he’s also an artist, connector, advisor, investor, dog dad, and serves on a few select non-profit boards (CTAOP, Humane Society, and Fountainhead).
** All opinions in this piece are solely those of the author and not intended to represent those of Ascent Global Logistics or Roadrunner or other affiliated entities.
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Always a great read!