Much has been written - mostly after it’s been needed - about tail risk in financial markets. But the troubles at Toyota and EMI suggest that tail risk also matters for non-financial companies.
Take, for example, Guy Hands’ business model. In essence, this consists of buying apparently under-priced businesses with borrowed money and then cutting costs. On average, this yields steady profits, plus some big pay-offs as those businesses are sold on. But there’s the small chance of disaster; the combination of leverage plus over-paying for a bad business has horrible consequences. This seems to have happened with EMI.
Or take Toyota’s policy of using common parts across its product range. On average, this has the virtue of cutting costs by being able to reap economies of scale. But it means that if something goes wrong with those parts, the entire company suffers.
Or take a third example. Lord Browne earned a stellar reputation at BP for cutting costs. But then the Texas City refinery blew up, revealing that his cuts were not so much well-judged efficiencies as taking low-probability, high-impact safety risks. Yes, BP survived that disaster - but Lord Browne’s reputation didn’t.
In all three cases, we have a form of picking up pennies in front of a steam-roller. These strategies yielded steady small profits - even over many years - but then big trouble.
Which leads me to my question. If we look at a business from outside - and most businesses are black boxes to outsiders - it will be very hard, maybe impossible, to distinguish between a truly successful manager and one who’s gotten lucky with tail risk. Could it be, therefore, that many high businessmen’s high reputation rests not so much upon genuine skill as upon luck? Could it be that , like Bertrand Russell's chicken, we are too quick to infer, even from long runs of success, that there is a sustainable, successful strategy?
Take, for example, Guy Hands’ business model. In essence, this consists of buying apparently under-priced businesses with borrowed money and then cutting costs. On average, this yields steady profits, plus some big pay-offs as those businesses are sold on. But there’s the small chance of disaster; the combination of leverage plus over-paying for a bad business has horrible consequences. This seems to have happened with EMI.
Or take Toyota’s policy of using common parts across its product range. On average, this has the virtue of cutting costs by being able to reap economies of scale. But it means that if something goes wrong with those parts, the entire company suffers.
Or take a third example. Lord Browne earned a stellar reputation at BP for cutting costs. But then the Texas City refinery blew up, revealing that his cuts were not so much well-judged efficiencies as taking low-probability, high-impact safety risks. Yes, BP survived that disaster - but Lord Browne’s reputation didn’t.
In all three cases, we have a form of picking up pennies in front of a steam-roller. These strategies yielded steady small profits - even over many years - but then big trouble.
Which leads me to my question. If we look at a business from outside - and most businesses are black boxes to outsiders - it will be very hard, maybe impossible, to distinguish between a truly successful manager and one who’s gotten lucky with tail risk. Could it be, therefore, that many high businessmen’s high reputation rests not so much upon genuine skill as upon luck? Could it be that , like Bertrand Russell's chicken, we are too quick to infer, even from long runs of success, that there is a sustainable, successful strategy?
Chris: your quip about Toyota using common parts leads to the wrong conclusion. Sharing of components is as old as serial automobile production. In 1910 and 1920, small manufacturers couldn't build their own engine so they bought one from Anzani or Meadows. In mass production cars of the 1930s onwards, you'll find electrics from Lucas, Bosch, Magneti Marelli; carburettors from SU, Weber, Stromberg, Solex; gear boxes from ZF, Borg Warner; and many more examples.
Aside from economies of scale, this was good because if a mechanic was familiar with the component in one car, skill and knowledge was transferrable. Design deficiencies were also spotted. If the team at Morris failed to identify a problem, perhaps a smaller company might be more critical.
What went wrong at Toyota was that an accelerator component was designed for/by the company; it wasn't a shared component; it was a Toyota component, further used in a couple of cars based on a Toyota design. When the component demonstrated deficiencies, Toyota succumbed to bias and blamed consumers.
Posted by: charlieman | February 10, 2010 at 10:03 PM
Could it be, therefore, that many high businessmen’s high reputation rests not so much upon genuine skill as upon luck?
That and an eye for the main chance.
Posted by: jameshigham | February 11, 2010 at 08:49 AM
I've argued in the past that this problem explains why a firm large enough to self-insure its many factories might choose to buy insurance anyway--because its own managers have an incentive to take inefficiently low precautions, in the knowledge that if the low probability/high cost event does happen they won't bear much of the cost.
I like to describe the pattern as "moral hazard as a feature." Insurance transfers the risk to a firm better able to control it than the owner.
Posted by: David Friedman | February 14, 2010 at 07:15 PM
Every time there are risk in the companies, the most important thing is looking for the better option. The companies must to lower production costs.
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Maybe the Toyota problems are much wider and are problem of the industry itself, when the safety problems was only the trigger?
I hope that cars and trucks keep on being reliable and good, and also eco friendly.
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