Sunday, December 29, 2013

The high cost of market consolidation

One of the things that has fascinated me no end is how a high market share inevitably leads to a superior pricing power in the long run. I've used this as a fundamental thesis to identify and invest into companies that are leaders in a consolidated industry.

The reason why any marginal movement in marketshare (without any change to pricing yields or cost structures) is tremendously accretive to shareholders since it involves little or no incremental expenditure and hence all of the benefits accrue to the bottomline and hence to the shareholders.

This led me to discover one of the great truths in investing:

One of the biggest sources of shareholder value creation is a material movement of market shares (without any change in pricing yields/cost structures). Ironically, this runs counter to the popular intuition that it is new products/launches, it is actually new products/variants or improving sales/distribution/entry into new geographies that makes for the greatest impact.

The reasons are fairly intuitive - lower marginal costs, lower risk (of failure  - since it is extending a proposition that is hopefully already well proven in the market).

Conversely, I have been quite amazed at the cost of becoming the lead consolidator in a fairly fragmented industry (think Amazon, even after all these years and with a cost structure that gives it an advantage over the brick and mortar retailers).

Being from India, I am amazed at the amount of  money e-commerce retailers have to raise (and consequently burn through) to make a dent on what is ostensibly a large, growing market.

Even with a significant structure/cost advantage, lead consolidators in a fragmented market (where their product/service is not too differentiated from the rest) have an extremely hard time in expanding their bottomline and generate cash profitably.

This is a lesson that I drew on from Warren Buffet who compared small box retail as akin to running a marathon, competing with new sprinters at every turn. I fully understand the choices in front of, say a Jeff Bezos of Amazon, he can choose to raise prices now or penetrate further by improving market share. However, every time he gains some ground, he has to fight against a newer set of competitors.

Cases in point, have been the Future group in India, which has destroyed a lot of shareholder value, with bottomline and hence, sustainable value creation proving to be an elusive mirage and has seldom earned above its cost of capital.

Too many times, the definition of a star or a dog or a question mark is'nt about the market share growth or the size, but about profitable growth. That's profit with a big P - the purists would argue that it is long term profits that need to be taken into consideration. For that, my answer is simple - long term cannot be more than 5 years; I have seldom seen traditional businesses that have continuously had losses in their core offering, who have scaled up profitably beyond.

To me, this question of allocating capital profitably represents a core strategic one - not an afterthought to a strategic one, like a lot of consultants believe. You do not decide about launching an iPhone in China, unless you understand its financial implications and if it will deliver above its cost of capital.

To me that represents the unison of strategy and capital allocation - a field that I am most passionate about. More to come in the later posts.

Wednesday, December 18, 2013

Capital allocation - watering the weeds or weeding out the weeds !

One of the things that has endlessly fascinated me over the years is the intertwining of finance & strategy. Everywhere, and most importantly at B-School, you are asked the question, "Do you wan to get into consulting or finance ?". I wonderered if those should be two sides of the same coin. Down the line, my stints at private equity and investment banking led me to ask the eternal question ? What drives shareholder returns ? To avoid any bias, by shareholder return, I mean the growth in intrinsic value - and for that measure, the only tracking I know of is the book value of the share. This, I believe is the only measure that can be used as a common standard - across private, public companies and across companies with smooth and sporadic cash cycles.

After a serious of experiences, I am now starting to connect the dots. I now understood that capital allocation is actually an important part of strategy. The greatest companies that we know of, Google, Microsoft or for that matter in India, an Infosys or TCS or Wipro were not born out of repeated dilution  of shareholders and raising mountains of money frequently but instead were founded in compounding a small amount of money at very high rates of return.

To put that in perspective, it is the difference between a Toyota Corolla (which is the world's largest selling car) and say a  GM's chevrolet Malibu. The latter has a lot more bling but also needs frequent visits to the workshop and is far less reliable. Ask anyone who has owned a car for 10 years and he would tell you that the best car is one that sips fuel, has very little need for TLC (Tender Love & Care) and runs with bullet proof reliability.

However, in the investing community there is always this craze for the next new bling - the next new meteorite which could become a planet. Investors rush head over heels and pour loads of money, into businesses that barely have the capability to deliver returns above the cost of capital (which ranges from 7 % to 15% depending on which country one lives on the type of industry).

As is shown in the figure above, a company that has the ability to earn consistently high returns on capital employed is eventually like a car that stretches each gallon/litre of fuel and ultimately pulls ahead in the long run.

However, the hare in the story, the company that has low rates of return on its invested capital, ultimately fizzles out simply because if it earns less than its capital, it means it has  created no significant entry barriers and hence needs more and more cash to keep up its competitive advantage. Sort of like a castle that needs a water supply from outside to maintain the depth of its moat.

Businesses of the above variety are numerous and the ironic fact is that they often have large runways ahead - retail, radio cabs, aviation, EPC contractors (there could be significant exceptions), asset heavy businesses like hospitals etc.

"The best business is one that earns high rates of return on large dollops of capital. There are very few businesses like that."

In the global context, the few businesses that I can think of are google, coca cola, Microsoft - businesses that have a monopoly like or part of a duopoly in what is a very large, expansive, growing.

In the indian context, wide moat stocks are infosys, wipro, TCS, Hawkins, Prestige, Page industries and so on and so forth. It's worthwhile to note that most of these wide moat stocks have RoE's in excess of 25--30% - that means every incremental $ invested earns 25% - or almost 2.5 times of what you get from a bank.

Contrast that with a lot of private equity/institutional investing that chases momentum stocks - investments whose thesis is based on an expansion in multiples - based on the fact that EV of 3 x sales is lower than the market multiple of 4 x Sales and hence the stock must be undervalued.

So, there it is, lesson well learnt - from now on, I shall analyze individual investments/publicly available announcements and offer my commentary to make it far more interesting.