Blogs from Our Experts | March 08, 2017
It is a common proverb which we had learnt in our childhood days “Rome was not built in a single day”. In today’s capital market, neither good businesses nor good companies are built over single day. Yet our inquisitive minds keep searching for the best company. While there are quite a few parameters which definitely define a good company but the core truth lies with the management and the promoters who are behind the wheel. There have been a lot of studies which define a good management through its visionary leadership or charismatic CEO who had created a mark with its leadership style, guidance to the capital markets or with communication to the trade analyst. But the question still remains under veil - what makes a good leader who in turn creates that “GOOD COMPANY”?
I was recently reading a book called “The Outsider”, written by a world renowned author William Thorndike, a brilliant Harvard Graduate known for interviewing people like Mr. Warren Buffet, Mr. John Malone and others and received a huge appreciation on the said book. THE OUTSIDER is considered to be one of the finest and remarkable compilations that studies some of the eminent CEOs/leaders in this century and gives a clear perspective on “what creates a good business and thereby a good company?” Most of the time when we see or read around, we find the reported earnings numbers to be best parameter to identifying a good company. We often say that Good companies are those who have income earnings and whose earnings are growing over a period of time. In simple terms, company with a durable earnings growth is considered to be a great company to look up to and therefore, invest into. But simply reporting high net income numbers or positive earnings growth is a bit of blunt instrument and can be significantly distorted by differences in the corporate debt, taxes, capital expenditure, and past acquisition history. A more deep analysis into earnings numbers creates further insight into healthy ROE and ROCE that defines how efficient great management is to generate high profits from available resources (namely equity & debt). So a high ROE is a great indication for a great business. But what is this ROE? In simple terms, it is the return on funds from shareholder as well as the return on funds from the re-investment of profits. But how do we create fund for the share holder or how do we create profit that can be re-invested which in turn will push up my ROE? So we come to the end of the tunnel for our search for great companies. The great companies are those who create enormous profits and thereby create long terms share holder value. And that is exactly done through an efficient capital allocation strategy. So, a capital allocation strategy is about deciding on how to deploy firm’s available resource for earning the best possible returns for the shareholder. So, the secret lies in “CAPITAL ALLOCATION STRATEGY” and not only in the Sales and earnings forecast numbers. Barry Scwartz in his book “Paradox of Choice” defines “what is a strategy?” He simply explains that in business terms, “Strategy is all about making a few choices from large available choices that create durable positive impact on business numbers” So, a combination of two concepts “Capital Allocation” and “Strategy” is what defines a great Capital Allocation Strategy. In modern regulated environment, business generates capital through 3 routes – internal cash flow, raising debt and issuing equity. But what do you do when you have generated enough capital? There are five things that you can do with your capital. They are; invest in your own business (CAPEX plan), buy out other business (Business acquisition), Issue dividend, pay-off debt and re-purchase shares. Each of these has a significant effect on the business both in short term and in long term. None of these are substitute to each other but definitely they are great combination at various market cycles. In rising market when stock price grows, issuing equity is a great option to generate positive cash flow while in falling market investing in your own organization (through share buy-back) is a great strategy to invest in your own business. Being greedy in your own business while others are fearful and vice versa is a great way to High EPS and thereby, creating long term share holder value. But in reality, it just happens opposite.
Rather than investing in own business, business leaders start diluting equity or start selling their business. During that bad time, all great leaders who have built great businesses either stick to share re-purchase programme or undertake a large business acquisition. Or in others words, the great business leaders were greedy while their peers were deeply fearful in bad times. That actually created a Good business in the long term. In 2008 during Lehman Brothers crisis, when every other business leaders were planning to sell their business, Mr, Warren Buffet was busy writing cheques to make large acquisitions and one of them was a deal with Goldman Sachs that earned him more than 60% return on his investment of 5B$. That day Lehman went burst. So, while one business went bankrupt, other business made 60% return on their business. It clearly shows that “No Business is a bad business. It is badly run business…”