FMEA to Risk!! Learning from Operational Excellence

I enjoy investing!! I enjoy as it allows you to apply frameworks from a diverse set of fields.

One of my favorite source of these models is Operational Excellence (OE) and the reason why I like these is that they force you to list and quantify all assumptions in a systematic manner. Also they are fairly simple to execute.

A new process! A new launch!! As soon as on OE practitioner hears this they would do this. They will try to identify break points. They will quantify impact of these breaks. And finally and the end of doing this in a systematic manner they would be able to see what are the biggest risks you need to worry about.

The blogpost discusses one of the common tools for this called FMEA.( Failure Model Effects Analysis)

Any FMEA analysis has following inputs.

1.     Failures across Processes

2.     Modes/Reasons of Failure

3.     Effect of Failure

a.    Impact of Failure (10 being catastrophic and 1 being negligible)- This will require you think business in terms of systems with one part of business impacting other with lag

b.    Probability of occurrence (10 being highest and 1 being lowest). You can use Baynesian thinking here to put probability basis a baseline and then change if things change.

c.     Detection Number: Your ability to detect this failure (10 being worst ability and 1 being best)

4.     Net Score

Now simply multiply for each risk the probability and impact to get to a net score. Higher Score means Higher Risk.

Example: Let’s look at Aashiana Housing. Any stock you own is a business which has multiple processes running. Using FMEA we want to identify failure modes associated with each of these processes. Here I have listed few business failure modes for Aashiana Housing

And now you can see the big failure modes you need to track. Example I had ignored the risk of softening of demand. I had assumed that the probability of slowdown is low and company should be able to handle it. But if I had understood the impact and my limited ability to detect this I would have been more prudent in understating this failure mode.

However, this analysis is not a static analysis. In OE world you keep reviewing the process and refreshing the risks. Similarly, you need to keep revisiting the probabilities, impacts and ability to detect on regular basis and if required adjust them to new information.

PS- The probability, impact are my assessment of these. The detection ability is my ability to detect in advance this failure reason with limited information.

The "WHY" Mental Model

I was thinking  of  writing on this topic after after I saw this lecture on TED by Simon Sinek and then read his book. 

The trigger came after reading this paragraph in Kiran's superb blog 

1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner  understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. .

So here goes my rant :) 

The Traditional way of evaluating a business has this flow:-

• What's of the business/Evaluation of outcomes- To quote Simon Sinek all business know what they are doing. They know are selling cars, homes, pipes, IT services etc etc. These "what's" are evaluated using metrics like Revenue, Profits, Growth Rates etc
• How's of the business/ Levers of business - We then try to evaluate the levers of business like the domains in which business competes, which products sell where, what are their weaknesses, Moats etc etc. These " how's" are evaluated using metrics like Return on capital, Return on Assets, cash flow etc.
• By this time our investment decisions is almost made and we typically look for confirming evidence. Very rarely will we go to the next step of 
• Why's of the business/ Purpose of business- This is the domain where things become grey and fuzzy. This is where we need to think of words like Trust, Loyalty, Vision etc. There are no metrics to evaluate these. Think of a stock in your portfolio and ask can you measure the trust or loyalty generated by it. Its a tricky one to answer. And therefore most of the times this is ignored.

To summarize, we start with what are the outcomes of business, then try to identify how they are achieved and then pretty much stop.

The new way of thinking prescribed by Simon Sinek is to invert this process:

• Start with the "WHY"- Try to identify the purpose of existence of a company. Great enduring businesses know this crystal clear and all their actions are defined basis that. Few examples
• Apple- The founders gene was to rebel and almost all their products reflect that
• Coke- All along the single message they have tried to convey is Coke stands for happiness. Look at any campaign, product , communication and its always has this philosophy
• Google- Do no evil. Again every single google product tries to do this. Every communication to their hiring page reflects this

From a business perspective this defines the way it creates space in its customers mind.                   We ( can say for most of us) trust Google, We ( can't say for most in India) love every apple               product.

Their "WHY's" have resonated with their customers to create an unflinching loyalty.     

I realized while reading few Buffet letter that how rarely does he comment on metrics related               to How and What of business. Most of the times he comments on "Why" and things associated           with it like Trust, Loyalty, Belief etc

• The "How" is next- This is where we start to look at how business is trying to achieve the why. Spends on moats, technology, asset turns, RoE etc etc
• The "What" is last- This is where we evaluate if the How's are working. 

For me this has been a great mental model to use. Now I try to find the "WHY" of business using

• Mission/Vision Statements
• AR Commentary on these statements, if any
• Promoter interviews
• Scuttlebutt to see how these are translated at ground level for companies

Earlier I would ignore these portions. Now, I read them and try to see if its just  jargon or does the business actually try to follow it. If its jargon then for me that becomes almost like a no-go criterion.  

In some cases these statements will be so obfuscated that you just can't figure out the WHY. To me that is also a no-go.

As of now with my limited experience I see the clarity of "WHY" beautifully displayed in few businesses which i own.

Look forward to more suggestions on finding the "WHY" :)

cheers,

Saurabh

PS- The stocks mentioned above are held by me. This is not a recommendation to buy or sell any stock.