September 30, 2015


When a company like Larsen and Toubro shouts about economic conditions being a matter of concern and is put forth as the reason for a poor financial performance, it is time to pause. A company’s poor performance can be on two counts- Poor economic environment or poor company circumstances.

Why I worry is because the company has an order book that is getting executed. So, to put up a poor show, it would imply that either the customers have called off their orders or are unable to pick up their bills.

If orders are getting executed as planned, but not getting picked up, it should mean a working capital tightness but should not impact the EBITDA margins. If EBITDA margins are poor the reasons are not the same. It could be pricing pressure (which means that poor profitability was written in the day the order was booked) or rise in input prices. To my knowledge, there has not been any appreciable rise in input prices over last two or three years. In fact, if we take commodity prices, they have been trending down.

In his 1987 letter to investors, Warren Buffet made the following observation: “the heads of many companies are not skilled in capital allocation, and … it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.”

Read the sentence and see how many companies seem to so easily fit the description above.

L&T is a conglomerate with multiple businesses. Unfortunately, in bull markets there are ‘strategic’ diversifications that become white elephants sooner or later and then the company uses jargon like ‘retain core focus’ or ‘shed non-core’ businesses. The businesses that are set up in bull markets, become a millstone round the neck and in bear markets, even the realisation of that business cannot be great. A strategy that seems fluid in a bull market, unchallenged by analysts too, becomes a bane during hard times.

I am using L&T as an example. I do not know the company enough to say whether it is a good company or not, from an investment perspective. All I know is that the ROCE and ROE is nowhere near what good companies earn.

Companies with long working capital and long lead times for execution, generally deliver below average returns, over a long term. Unrelated diversifications are also a big sin. It is what is classically referred to as poor ‘Capital Allocation”. How do we identify poor capital allocation? When a company seeks to enter in to a new business, the first test one should apply is whether the new business will deliver a superior return as opposed to the existing business? If not, then the diversification should not happen. Alternately, it should help to protect or preserve margins in an existing business.

Thus, if we the diversifications of companies like ITC or L&T in to businesses that are of poor quality and profitability, that the management quality becomes a matter of concern. If a company management cannot find enough profitable uses for the capital, it should either buy back shares or return the money to the shareholder as dividends. Shareholder money should not be used to justify expansion or waste in to unrelated areas which dilute shareholder returns. As a shareholder, I invest in a tobacco company because it is a highly profitable business. If I wanted FMCG, I would buy that company. I do not want a tobacco company to get in to selling soaps and agarbattis without MY permission. These are decisions which the shareholder has not agreed to. A company like ITC has multiple poor capital allocations- FMCG, Hotels, Paper,etc etc . None of them stand to any logic other than a fear that the tobacco business will vanish. If so, let it. As a shareholder, I have good choices from these industries, should I want it.

If ITC had put the same money they put in to FMCG business, in to buying shares of HUL, Marico, Godrej Consumer etc, the value of that would have been several times the value of ITC as a company, today! If the tobacco business dies down, let it. Shareholders buy different businesses with different goals. Do not take the decision for them, without their permission, before the fact.

The word called ‘diversification’ hides a lot of sins by the executives and the Board of Directors is answerable for this. But, who will question a ‘great’ company like L&T or ITC? Financial institutions? Mutual Funds?


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