Suman learns to trade and invest-I

Suman’s brows were furrowed. A slight tension gripped his jaws and his eyes reflected regret.

He was lying prone on his bed, staring at the ceiling. The critters of evening were singing their songs, but Suman’s thoughts were somewhere far away.

—-

“Joining us in studio today is Rajiv Goyal of PLD ventures… Rajiv when we met last time in our studio you were confident that NIFTY will be scaling 9000 mark. Now that it has, would you like to tweak your numbers higher?”
“Sonia, thanks for having me here. The way we see in PLD Ventures its the start of a secular bull run and definitely we will see NIFTY at 12000 anytime soon.The earnings are healthy, our economy is firing…”

The broadcast on TV seemed to have perked up the mood of the men having their lunch.

“I bought NHV last month, 50% up…”, Shekhar remarked stealing a small piece of paneer from Suman’s plate.
“… the way things are going, I dont mind paying capital gains and booking my profits” added Shekhar smugly.

“DishTV – long till 88. Short till 82. Doubled my 5 lakhs”- Arun, chimed in almost disinterested.
Easy money,folks! 

Ravi suddenly lost interest in TV and blurted out- “You doubled? Seriously?”

Arun looked up and gave a wink.

“Pass the dal first”

Suman had nothing to add really. A sinking feeling washed over him. Left out, alone, fending for himself. Did I make a mistake in not investing? Oh god, Arun doubled his 5 lakhs. Shekhar has made 50% in one month. If I would have invested  1 lakh in NHV- my return ticket from Bangkok would have been paid of. 50% monthly implies…

Envy,regret,anger. Everyone around him has become rich.A feeling of fear and envy swallowed him. His mind reeled back to a documentary he once saw- of a mongoose being cornered by a bunch of cobras. Helpless and Afraid. He felt something similar. Helpless and Afraid. Only there were no cobras here.

If someone asked his mother, she will never be able to remember if Suman had a mean streak. His wife at times got exasperated with the supine way he handled the office politics- taking on his chin and settling for the next time- everytime.

But at that moment, suddenly Suman felt the bite of a lost chance.He was envious and in pain. He could have invested 10 months back when Puneet advised him to. I should have listened to him. He is a wise guy. What did I do?

Puneet Khurana has always been a taciturn guy- measures his words and advices. But generous in spreading and voracious in gathering wisdom. An acute observer, of what the Bard said – “the tides in the affairs of men“. He eats behavioural psychology and breathes investing. If there ever was a stoic-thats him.

Puneet adviced Suman about two years back. Urging him to plough all in the financial markets. Suman was unsure and even he will never admit it that he was afraid.

Afraid of the “hairiness” and uncertainity of the macroeconomic situation. Fiscal deficit was high. Oil was higher. And investor confidence, if it could go any lower would have stood frozen in South Pole.Suman distinctly remembered the conversation he had in Puneet’s drawing room.

“Suman, look at it this way- can things get any worse?”

The Jack Daniels in Puneet’s hand made a beautiful color and Suman’s gaze was transfixed at that. His ears kept hearing the urgings and his mind, afraid of the uncertainty kept ignoring it.

The day melted into evening and his thoughts of anger and envy melted into pain. He lay on his bed trying to will away the pain. His thoughts drifted away to that chance encounter.

10 months back, Suman met Manish- a self confessed Ed Seykota fan, in the local pub. During the conversation they both discovered that Puneet was their common friend and the conversation really flowed from there. The conversation flowed from their family – both had a kid, of the same age to their drinking tastes- Manish liked Beer and Suman liked his whiskey.

The evening was amiable but when the conversation came to markets- Suman was not only afraid of investing in the markets but knew practically nothing of the markets themselves.How shorting works, what are futures, how to trade- nothing, nada! Manish’s message was clear- invest now. Suman felt it to be a misplaced confidence.

Suman lay on his bed simmering in a concoction of envy, anger and regret.If Puneet had a telescope inside Suman’s mind he would have shaken him into sense- because Puneet knew how deadly a combination this is. And if Manish would have known then he would have shown him how do savvy trader/investors make money.

Suman was close to losing it all. And he didnt know it.

He got up, took a long deep breathe and lifted his phone. A few jabs of keys and then a number. He is calling that number for the first time.

A ring.And then another. And then another.

“Hey Manish, this is Suman here.I need your help”

Can Suman get out of this cesspool of emotions? How will Manish help Suman? Can Suman master the financial market?

(…contd in Part II)

P.S: Its good to be back

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Why I am against any rate cuts at this moment?

There has been a lot of chatter, pleading, begging, hectoring, bullying and also inane hoping in favour of a rate cut by our RBI governor. Each fortnight every man on the street confidently predicts that there will be a rate cut. I am reminded of my father who predicted each years school exam question papers by pointing out each question as likely and very important.

However, I being the dogmatic and the contrarian stand firmly against any rate cut at this moment. However fortunately I do have some reasons in support of my stand, other than the usual one being “copper the crowd”.
Before I go forward, let me explore the various reasons the cut-mongers are forwarding. One of the most vocal and loud voices is from the government itself. It argues that a rate cut will inject liquidity into the economy, fuel credit expansion and bolster growth. Another section, equally astute argue that a rate cut will have the added implication of “rationalising” the cost of capital. In turn it will make many, now distressed borrowers into prime assets, reducing NPA of the PSU banks and improving hold your breath, credit expansion.

Another class argues that this will again bring in the risk taking animal spirits back into the economy. For good measures it will also improve infrastructure spending for the private players. Needless to say, many of the infrastructure contractors are having a tough time maintaining their cash flow on one hand and juggling the bureaucratic maze, fogginess in regulations etc on the other. All in all, the argument is broadly in line with the benefits of credit expansion.

What are the biggest problems staring ahead of us, right now? The biggest problem is a lack of economic growth. But this is also a very limiting answer. What kind of growth do we really need? Does the growth of 2003-2008 sound extremely desirable, especially in the wake of the cockroaches that are coming out of the various closets?

Let me offer an answer. We need growth, no doubt. Let that be a two digit growth- I will be the first person to call for policies which drive them. But definitely a mindless credit expansion is not the way to go forward. Let us tease out the various ideas here. Growth and its nature needs to be determined going forward for our policymakers. What do we really desire. I cannot say I have all of its facets down pat, but I definitely have some ideas:

1. We need a high technology driven growth. A growth which is fuelled by genuine innovation improving the efficiency of Indians and others. Our incremental capital output ratio since 2003 to 2011 has hovered around 4. This implies that Rupees 4 of capital was required to drive the output of 1 Rupee. Not a great number, but it looks stellar when compared to the ICOR of 2014. It is at a dismal 7. This ratio has to be reduced and this is only possible when real innovation comes through. A higher or lower cost of capital is not going to prove any difference here purely because the real engines of innovation- our MSMEs are anyway not considered credit worthy by our banks. What is needed is to encourage more venture capitalists, angel investors etc.

2. Any country can post stellar growth numbers if reported in a currency which is depreciating fast. Let us report our numbers in Zimbabwean dollars, we can have a mind boggling growth rate. This growth rate however is not because we Indians suddenly stopped reproducing and started producing more. This growth rate will look enormous simply because the “unit” which we have chosen to express ourselves itself is falling at a high rate. To rationalise the perspective, would we want an inflation-driven growth?

When I term a growth as inflation driven, it effectively implies that the total economic value added in the country is consistently and far less than the reported gross domestic product of the country. This is because GDP of a country is expected to reflect the total economic value added at the first place. If it is consistently beating the real fundamental then definitely it’s the inflation which is bufferring up the ship .

What about the usual adage that a little bit of inflation is always a positive thing for the economy?, you may ask. Sure enough, but we have so much in our country right now that we can happily export some of it and yet have more than we need.

3. The most sanest of ideas in favour of a rate cut is that of infrastructure boost. The current cost of capital is definitely a death bugle for many of our fine(and often fine paying) infrastructure companies. They were squeezed by a lethargic government and high cost of capital. Project overruns and fast deteriorating balance sheets are the welcome boards which greet any infrastructure CEO each morning.

However the bigger question is, is this a band aid on the problem or a real excision of the cancer? I argue that the real problem is not high cost of capital but the lack of capital. Each infrastructure project has a horizon of 20-25 years in the books of the companies. Bridges etc can be included as 40 years assets. However a bank financing these projects invariably has to match the asset and liability duration for prudential loan servicing. However by the norms of RBI long duration loans are not allowed to be issued by the banks. The logic goes that the banks are not financing or venture capital institutions but rather short term financing businesses.

In these contexts of numerous paradoxes and the proverbial chicken and egg situation- lowering the cost of capital wont be as helpful as opening up the entire bond market will be.

Asset-Liability mismatch is a clear problem and its only solution is financing has to move away from banks to properly functioning bond markets.

4. One of the biggest issue which compelled me to write this article is the problem of inflation. As individual investors the greatest problem we have is not lack of growth. It is inflation. Every dollar you earn from your paycheque or your investments is subjected to the swords of taxation. However taxation like all matters of devil need not be always visible, tangible and directly observable. You can have invisible, intangible and indirectly observable taxation as well. We know it by the name of inflation. To understand the implication of the same, consider the usual discounted cash flow mechanism to calculate the net present value of any investment avenue. At 8% real growth rate and another 8% long term historical inflation rate. This makes our index return a 16% compounded growth rate over the long term. This in essence brings a benchmark on all other investments we make. 16% in index will be our opportunity cost. This renders anything less than 24-25% less than desirable. An owner-manager with such business dynamics will find doing business tantamount to running on a treadmill. Lots of huffing and puffing but zero displacement. And needless to say a vast majority of our equity markets and ergo a common investors portfolio will consist of the businesses with their return on capital ranging from 18-25%.

Is it any surprise that in spite of capital markets having a history of more than 100 years in India we Indians still buy gold and not businesses? We have the answer even if we don’t know it. Between government and inflation nothing is left for us.

As in biology, survival first- growth next: similarly purchasing power survival first, hence the predilection of Indians towards purchase of hard assets: gold, silver, real estate etc.

Coming back to our original point if owner manager finds running a treadmill at 24-25% return on capital then surely the minority shareholders will find his capital not sweating enough for him. He may feel rich but he definitely wont be rich.

RBI thankfully has for the first time inflation targetting its core concern(which should be). I salute and thank Urjit Patel and Raghuram Rajan for bringing this pragmatism. There has been quite a bit of chatter and I hope a chatter rooted in genuinity, that Finance Ministry too supports inflation targeting and intends to make it a statutory responsibility. If that is so then it will be necessary to stick to the goals of 6% inflation by Jan 2015 (which seems to be slightly challenging) and 4% inflation by Jan 2016 (which seems to be genuinely difficult to achieve) which Dr Rajan earlier in December 2013 announced. In that light, the cuts should be indefinitely postponed; reforms of bond markets, capital markets, infrastructure norms accelerated and FDI norms relaxed.

Rate cut is no solution. At least I fail to see it as one of any of the problems we Indians are facing.

Distress Costs, Cash in the books and Value Investing

Cash on the books is always a great sight to see. Ample cash on the books though sometimes becomes an eyesore. Questions and concerns begin to rise regarding the use(or misuse) of the powder keg the management is sitting on. During a hammering, value investors cut from the Graham cloth swoop in screaming “bargain” and eyesight set clearly on that cash in the books.

But it is important for us to also understand that not all dollars are made equal, not all industries function similarly and not “all” inordinate amounts of cash is necessarily high. The traditional wisdom stands good still for the old economy companies. However it fails to explain the unusual circumstances for the knowledge companies.

The factor of intangible assets

Intangible assets play an important role in the economic well being of modern day knowledge companies. For a pharma company, the knowledge of the drugs, molecules, well trained manpower, research pipeline et al. are the veritable intangible assets in its balance sheet. A few years ago, Infosys created a big hullaballoo by discussing the prospect of including its human resource capability in its balance sheet (as fixed cost).

Quite surprisingly, the grey area of finance and economics mix with subjectivity of human perspective mix quite well when evaluating these intangible assets. How will you value the presence of Ajay Piramal as the new manager of one of your investee companies? How will you weigh the enormous goodwill a brand like American Express or MasterCard commands?

The scenario is quite like the old philosophical adage- if a tree falls in the forest and noone is there to hear it, did it really fall? When there is no one to value or place a premium on an intangible asset of the company, is it really of any value(in accounting terms)?

But it is of value. It is of supreme value to the company itself. It is the very blood of economics for these knowledge based companies. The fact is market too realises this. In 2000s, about 30% of Pfizers valuation was based on its R&D expenditures.

However if the company is sold to an outsider, it will be difficult to put a dollar value to it. Hence in absence of such a “clear” signal, the company has to take the onus on itself to protect its intangible assets at all costs. Necessarily, all the expenditures needed to maintain it is also of paramount importance.

To take this point a bit further, any contingency which develops in this department also has to be satisfactorily met at all times. Thus quite a many company, desire to take debt in their books to bolster their cash levels and choose to pay off the interest cost out of their cash flow.

This added burden of tax also provides a tax shield, as long as return on capital of the business is more than the cost of debt.

Distress Costs

But imagine if a company is in a net cash position and yet it is facing an intangible asset distress. For starters consider a near-complete wipeout of an IT company’s human resource by a man-made accident. For old economy companies a distress originating from debt is analogous to distress originating from intangible assets for knowledge based companies.

The possibility of such distress has to be matched with a distress cost for an owner-manager of a knowledge company. As a result, the distress cost arising from a distress(be it debt based or intangibles based) will be the financial impact of that default weighed appropriately by the probability of it occurring .

In light of such circumstances, a rational owner manager will seek to maintain enough liquidity at all times to comfortably sail through such distresses. This also explains why some companies have very high cash in their books without thinking about either distributing it, or investing it in other businesses. It is not up for distribution or investment because it IS already invested- it is invested in the core operations itself.

Thus the key takeaway from this discussion is:
1. Don’t judge the high cash in the books position by comparing it with other current assets. It is to often to fund the intangible assets/it distress of the company.
2. A cash bargain it is when, the holding cash in the books significantly outstrips the market capitalization and the distress cost of its intangible assets.

This in peripheral way also explains why a particular industry can horde significant amount of cash while the other industries don’t.
Consider the following table.

Cross Sectional Analysis

While all the industries save for the last, are knowledge based companies all of them have different average cash to net sales ratio. For a ratings business, the chances of meeting with a distress is pretty low(due to inherent economic advantages), whereas for the IT industry (a fragmented, highly competitive sector) the chances as well as the costs must be very high indeed.

However for an Indian railway wagons business, its intangible assets are pretty light. It has to have a huge and big pipeline of technology innovations to have something otherwise. As a result, an outsider can properly value its assets and thus the cash needed to tide over an intangible assets distress is pretty minimal.

The paradox of holding companies

Holding companies in the world of investing stand for a mirage. Many a novice have sharpened their horns by ramming against them. Looking from a strict Benjamin Graham style of play(where market capitalisation is compared against tangible assets) has resulted in many a tears and heartburns. They are numerously termed value traps, the final frontier where valuation fails and even a quicksand of the novice investor.

It is not that, they have not made money for investors but more often than not, the discount they were hoping to be closed never materializes. An extremely cheap stock of holding company just corrects 25% upwards instead of the expected 250% and penalises the investor with a decent opportunity cost. As a result this is an interesting puzzle in the equity markets- why doesn’t markets correct the severe undervaluation?

Numerous reasons have also been forwarded- holding company discount, conglomerate discount and so on which are often the different names for the same phenomena. However blaming conglomerate discount for 40-50% discount either implies that it not merely a discount but a wholesale writeoff. In facing such beasts , it is important to remember the customary honourable solution. Gently take a step back, ever so silently without disturbing the sleeping beast.

However instead of a strategic and brave retreat, just shuffle and observe it from a different perspective.

Look through Earnings

Throughout the 1980s Warren Buffett keeps etching, fleshing and time and again repeating the concept of look through earnings. In 1982 annual report he mentions( apparently, the then accounting rules don’t allow reporting of earnings where ownership is less than 20%)

“We prefer a concept of “Economic” earnings that includes all undistributed earnings regardless of ownership percentage. In our view the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used”

Finally in 1993 Warren goes to define it:
“Look through earnings consist of : (1) the operating earnings reported in the previous section, plus; (2) the retained operating earnings of major investees that, under GAAP accounting are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.”

In many ways, it reflects the difference between Berkshire Hathaway- a holding company and the other holding companies which never “come close to getting rightly valued.”

I believe Look Through Earnings is the correct lens to look through this problem. The entire ecosystem of Indian holding companies which I went through squarely looked costly to me rather than cheaply valued.

Economic Fortunes are enmeshed

The paradox gets resolved if we think in these terms: Whenever an investor buys a business from the market, he links his fortune inextricably with the economic fortune of the business adjusted suitably by his own buying price. Post that step, any and all fluctuations, gyrations and information thrown by the market ceases to matter materially to the owner-investor as far as the economic fortune is concerned. This implies that for the holding company the ultimate benefit comes from the economic earnings of the investee firm, implying free cash flow.

If in this lens, we try to analyse a few holding companies, they look inextricably costly. While a vast majority of the holding companies have their precious capital parked in businesses with questionable economics, the free cash flow (or rather the free cash sink) these businesses appear to throw, adjusted for the stake the holding company owns is materially reducing its book value.

In light of such facts, it is not a surprise that holding companies trade at a material discount to the book value. Consider for example a holding company which in its quoted investments owns the steel, power and other energy companies from the same stable. In essence it is investing in sister concerns. Though creates unwieldy holding patterns but not a crime definitely. However what makes it an economic sin is that the biggest holding- the sister steel company is the fact that, if it would have in its utmost graciousness returned the entire free cash generated by its operations- it would have wiped the book value of the holding company.

Capital Allocation

This problem can be described in only one way- capital allocation. Why allocate capital to a company which is a perennial cash guzzler rather than a cash thrower? But then the managers of these holding companies have precious little to do other than take a chunk of the stake away from the promoter’s names. Their decision making is zilch and capital allocation has nothing to do with it.

One holding company I came across, which also buys stocks of companies outside its parental stable is Bombay Burmah Trading Ltd. Not a pure holding company by itself, because it has its own operations of tea and coffee.However the proactive decisions (not necessarily the best) its management has taken has forced markets hand at valuing it at a premium to the book value. I consider the presence of an independent operation inside Bombay Burmah Trading Ltd to be an unintended advantage its owners , the Wadia group bestowed on it. Since a management which has some latitude in managing its operations will also be slightly more awake in picking and selecting the investee companies.

Before you go out and buy it, there are two factors worth knowing out here- one, it doesn’t imply that the aforementioned company doesn’t own its sister shares. At best its portfolio can be described a sister concern plus, implying sister concern stake and stake in other businesses(not necessarily the best ones), secondly the valuation of the same is too costly, perhaps only for my own taste.

There exists one holding company out there which breaks all these patterns and for breaking all of it, the market has rewarded it handsomely. That name is without doubt Berkshire Hathaway. But to be sure, that is not the only holding company out there which is charting a lone wolf story. There is Markel Inc and then there is Fairfax Holdings. All of them follow the best practice and praxis of capital allocation strictly.

A commentary on Competition Sutra #8

This is an analysis and commentary of the case study posed in the previous post.

For Vikram Monga, the scenario is completely skewed against him. He can’t win. And any victory will be merely pyrrhic( hollow). Plus, the choices shown here reflect only one iteration of moves. But real life is a string of moves – each joining with the next, caused by the previous. While a rational choice suggests to move to the Nash Equilibrium i.e. move towards price cuts and let the game play out. If Sam turns out to be truly wise he will also respond with his cuts. Not cutting will steal his customers, expanding physically to gain them back is suboptimal. Which implies there is only one action left for Sam to respond – price cut of his own.

As a result, a price cut will be matched by a price cut. But lets think from a different perspective. This game can be played once more, and again the same decisions will be taken – price cut matched by a price cut (perhaps this time Sam will cut the price first to force Vik’s hands).

When you set out to dig a grave for someone, dig two.

What looks optimal in short term, may turn disastrous in the long run. Having a long run perspective is perhaps the most important skill for a successful leader. If Vik realises that a price cut will initiate a chain reaction, then he can very well intrapolate that one day the margins left will be as thin as a wet tissue paper. He may walk into the sunset as a gung-ho leader who played a “no-holds-barred” game with his competitors and who knows the business media might celebrate it as well- and yet his successor will none the less be worse off.

A simple thing for Vikram to do is to choose to not to do something. That is- don’t disturb the apple cart, do nothing, choose nothing, let the status quo be maintained et al. However if he must he can try to completely change the nature of the game:

When you can’t win, change the rules

One of the big takeaway from this game is that there are certain rules at play. However real life is varied and different with its own dynamics. Vikram should try to change the rules of the engagement altogether

a. Invent itself as a platform: Can B&M increase the engagement of an average customer with its products and services? Can it make the average customer interact with the existing setup? And in the process can it give some value to her? Think how Target drives its business. It doesn’t see itself as a dispenser of products, it sees itself as a dispenser of retailing experience. That way it can turn the rules of the game on its head by imposing a psychological switching cost on the customers and monetizing it by raising the prices.
b. Niche, Niche, nice! : Can B&M and Jubilant Retail come to an unwritten, tacit understanding with the help of (plenty of) signalling to divide the offerrings completely among themselves? One of them completely focusses on the home and kitchen appliances, while the other stocks it minimally (else regulators will catch hold of them) and focusses completely on entertainment.
c. Loyalty Programs: Airlines do it, so can retail. Vikram should focus on increasing the psychological switching cost for his customers. Cutting price is also a kind of imposing a switching cost on the customer- but it is the feeblest and the weakest cost because anyone else can come in and undercut your price.

Competition Sutra #8: The games companies play

 

Vikram “Vik” Monga is thinking hard. And if he isn’t, he should be.

For Vik the piece of paper lying in front of his was telling everything he needed to know. And he was right. The situation is messed up- with no avoiding of the blood bath that lay ahead.

 

52 year old Vik was the CEO of Bentham & Martin – one of the largest retail chains in India and the largest in Eastern India. However for Vik, life wasn’t easy. He had Jubilant Retail snapping up at his heels.

Jubilant Retail was the new kid on the retailing block. Started merely 12 years back, aggressive expansion was in its DNA. It was almost as if the entire team of Jubilant were a bunch of toughened gun slinging westerners. There was Samarth “Sam” Prakash- their CEO, a young man with a taste for hard negotiation, close competition and fast expansion. 8 years back, Sam broke the back of a local suppliers cartel by acquiring a Bangladeshi supplier. At that time, the local suppliers scoffed at the move. But by the time they  scrambled to prevent the damage, their demise was cast in stone. Since then local suppliers stopped holding their prices high and Sam got cheap inventory.

Till now the Bentham & Martin had 450 stores in Eastern India. Jubilant Retail has 390 stores. 8 years back it was an expansion machine, but today it has settled down into an uneasy truce with Bentham & Martin. However, the low number of stores shouldn’t be judged as a giving up by Jubilant Retail. Bentham& Mills and Jubilant Retail were competing store for store in the most profitable circles of Eastern India. If anything, it didn’t compete in the sub 450 circles (Circles are divided as per the average billing rate of an individual customer unit- even a family shopping together will be counted as one customer. 450 implied here the average billing rate. It stretched to maximum 980 evident in metros to a minimum of 300 evident in tier 3 and 4 cities).

For Vik the problem was two fold. Western India was slowing down and to maintain the profitability he had to milk the Eastern cow. But milking the eastern cow was not easy. Any move to break the uneasy truce in East will lead to a bitter tooth and nail fight for market share.

It was a dicey situation indeed.

What in the hell is brewing here mate, muttered Vik to himself. If he opens new stores, Sam will mirror each move with his own store in every new circle. Result, driving real estate prices preventing further expansion, a decline in footfalls. This will kill the profits for both the firms and the net profitability per customer for both will fall to Rs 15/cust. However if Jubilant Retail decides to cut the prices- Bentham & Martin will be left holding the bag – Jubilant’s per customer profitability will outstrip Bentham’s.

 

For Vik Monga- the situation was worse than it looked. Any move to cut prices can create a converse situation where Jubilant responds by building new stores ( which will create the exact converse replica of the case where Bentham expands physically and Jubilant cuts prices, with the exact concomitant result) or matches the price cut by a price cut. In the later case, a price cut when matched by a price cut will give them both a near about the same net profitability per customer. Only, the  profitability difference between the two will shrink from 8% to 4%.

But for Vik – it was both a blessing and a curse that most probably Sam was also doing the same calculation. The blessing it was because in such a wafer thin margin business a dumb competition can kill the entire sector. Curse because dumb competition also meant easy lunch for the smart. And for Vik the balance was completely skewed. While he was given four choices – two of them were just decoys. And he understood it very well. If he played the game for a long time where each of them chose differing choices (i.e. not mirroring each other) then the resultant payoff for each player will  be sum of probability weighted profits ( in this case 50% of 30 + 50% of 20 = 25).

Bloody decoys. 

 

Vikram Monga looked up at the clock. It was 5.30 pm already. His  8 year old grandson had a school play today and he wont be missing it. He took off his jacket off from the chair, swooped his arms in. But his mind was still racing, he was thinking about the situation and mess both of the companies are staring into.

It’s a cesspool of blood, mud and filth. All the choices lead to either one of them.

If you are the advisor to Vikram Monga, what advise would you give him ?

How growth kills economy of scale: A case study

A newspaper article describing the losing sheen of tablets is on ET today. The premise is simple:

“The India tablet story is losing steam. After a 56% surge in 2013, tablet shipment fell nearly 28% sequentially in the first three months of 2014. 

As many as four million units were sold last year, compared with 2.66 million in 2012. But in the January-March quarter of 2014, only 0.78 million tablets were shipped, down more than 17% from a year earlier “

The growth of tablets industry has been phenomenal in the last few years. In 2012, a Hindu BusinessLine article showed a year on year growth of 673%. The growth this year has slowed down to 76%.
A 76% growth in any sector will draw deep cheers but so much has been the historical growth for this sector that a high two digit growth rate is a dampener.

But deep inside this development is a conundrum. The only difference between two manufacturers of electronic hardware is economics of production (or economy of scale). A smaller entity can’t make as much profit as a bigger manufacturer makes purely because the fixed cost per unit is lower.

In absence of any switching costs for the end consumer, price becomes the only difference. For laptops, mobile phones and tablets it is evident. There is just no switching cost for the end consumer. As a result, price or rather features per unit of price become the driving idea behind any transaction.

But with Google’s Android push in the last 5-6 years, almost entire onus of features have moved from hardware to software. There is just no difference between two devices! As a result, there is no differentiation and there is no switching cost for the consumer.

In absence of such demand side advantages, economics of scale becomes harder to protect. But harder still when there is growth involved.

As mentioned elsewhere in this blog, growth expands the pie and everyone becomes a competitor and no one the incumbent. This cocktail effectively makes the least efficient competitors quit the game. ET corroborates this:

“From a peak of 68 players competing in the market in the second quarter of 2013, the number has fallen to 30 now.”

A 50% reduction in the players implies a huge churn. This lack of stability is another indicator that there is no moat really.
However a small silver lining adopted is the new focus adopted by the companies. The manufacturers are going niche rather than going global. Increasingly making their tablets industry centric, they are re focussing on software. As a result they have a chance of creating durable moats, as professionals will (or should be made to ) spend considerable training time to master the different features of a software.
Reminds me of Bloomberg terminals.

Lorimer,MCX,Buffett and China

Of late, I have been caught up with certain things and posting frequency has dropped accordingly. However I started reading this book called “Letters from a Self Made Merchant to his Son” by one pig meat trader named George Horace Lorimer. Its comes widely recommended by Shane Parrish of Farnam Street blog and the partner of the most famous business of Farnam Street- Charlie Munger.

It is a a highly enjoyable book and I find it far better than all those books on aphorisms. It is almost a modern day “Letters from a Stoic” ( I highly recommend that one as well). And at times I felt that Lorimer is rebuking me for the countless mistakes I have done in my past just like his son Pierrepoint.

Sample this:

“You’ll find that education’s about the only thing lying around loose in this world, and that it’s about the only thing a fellow can have as much of as he’s willing to haul away. Everything else is screwed down tight and the screw-driver lost.”

Or the idea that the essence of capitalism is postponement of self-gratification.

It’s the man who keeps saving up and expenses down that buys an interest in the concern.

Or the most important mental model to success in the public markets:

If you find your crowd following him, keep away from it. There are times when it’s safest to be lonesome. Use a little common-sense, caution and conscience. You can stock a store with those three commodities, when you get enough of them. But you’ve got to begin getting them young. They ain’t catching after you toughen up a bit.

Please do buy and read it. It sits on my bookshelf between Letters from a Stoic by Seneca and the Autobiography of Benjamin Franklin.

They say that never push a good thing too far (and never get pushed by a bad thing in the tiniest). FTIL the erstwhile anchor entity of MCX, India’s largest commodity bourse and once of the world’s biggest had been taking the goodwill of authorities a tad too easily.
It adopted worlds oldest tactic for avoiding a decision.
Procrastination.
Delay.

While as early as September it lost the status of fit and proper entity it kept dragging its feet on the stake sale. [For those who are not very much familiar with it these links will get you upto speed-

1. Deepak Shenoy on Original Fallout of NSEL.

2. As early as July 30th market bloodhounds sniff problems in FT & MCX

A side note- whenever the CEO comes on record blaming bear cartels short the stock. Lehmann, Bears and Stern and even Satyam at one point of time blamed the infamous bear cartels.

3. And the whammy of CTT also strikes MCX killing the volumes off and attracting a Morgan Stanley downgrade

4. MCX hits an all time low of 212

5. FTIL gets “fit and proper” notice and Shah and Massey step down.

For valuations this will help, for my thesis this set of posts will help.

1. A tale of two kids- Part 1,  2, 3, 4 ]

So post two management changes , the new management has decided to take a very radical step. It has decided to keep the stake of 24% in an escrow account for MCX to sell it all by itself.

Now will the money go to MCX? No.
It will be just like the auctioning of a collateral by a lender. Over and above the amount liable i.e the sum of principal and interest, a lender returns the entire surplus to the original owner.
In this case FTIL doesn’t owe anything to MCX. Hence MCX will return the entire money to FTIL. Which is a good thing for MCX!

Why? Well simply because even the remotest association with a scrupulous man is costly. Hence that FTIL and MCX will go its own way is a very positive step.

For this to happen- MCX has to seek a shareholder nod for the change in its article of association. I am in favour of it and will vote my yes. However, is there a guarantee that this will not be used against anyone else?

I recommend to the directors to have a sunset clause associated with this proposal, where after a stated date without the shareholder’s nod the article association will revert to the present form.

On other ideas I am reading these days is 25iq.com where Tren Griffin echoes Buffett’s idea of mispriced optionality and his idea of portfolio of such bets-

“you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.”

This is at the core of probabilistic thinking. To weigh the final material gains and losses by their respective probabilities makes many decisions easier to make.

A higher application of such a mental model is a decision tree, where diverse alternatives are presented in an intuitive way. This kind of mental model is highly beneficial to assess special situation opportunities.

Which brings me to the special situation building up in the China seas. I am no Foreign Policy expert but the recent muscle flexing of China in the East and South China Sea is a cause of concern for India. It has huge conflicting claims with Japan, with South Korea (East China Sea – Diayou/Senkaku Islands and Goguryeo, Gojoseon problem).

Parallely it has problems with Vietnam and Phillipines in contradictory claims on Paracel Islands and Scarborough Shoal. If that was not enough, China went ahead and claimed one of Vietnam’s island (which is incidentally a very good fishing ground) as its own. In April this year, a Chinese fishing vessel uncermoniously crushed a Vietnamese counterpart. And it dragged a deep sea drilling platform into Vietnamese claimed waters.

In this light, what is India to do? Of note is in 2013 India unceremoniously dumped a joint sea exploration project with Vietnam, for fears of ruffling Chinese feathers. So what is India to do?

Or rather what is the cost of inaction?

Competition Sutra #6: The Coors went national

This is the sixth part ‘in Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”. We explored in previous posts what does growth do to incumbents. But we never did explore the effect of lack of growth on competitors who are trying to enter the market. This post aims to correct that.

It doesnt take much for Brendon Elliott Mills to stay amused. This is 1998 and his sharp mind, keen eyes and deep intellect has enough of the feed to keep him amused. For another lifetime. For the 67 year old Mills, amusements comes in three flavours- funny, damn funny and business hubris.

And why not, Mills have seen such an act of hubris from very close quarters. And he has been involved in it far more than he would like to admit. But Mills, today admits being struck with the fine predictions of untold riches due to a shiny new thing called internet. The Coors can of beer resting by his side, he glances through the business newspaper scanning the important news of the day. It took a lot for some people to spot others mistakes. For Mills, it comes easy.

Some one once asked him what interested him so much about failure and he couldn’t properly answer her. At 67 years, he understood himself better. He looked at the Coors can resting on the sofa side and his thoughts went 30 years back.

To his time in the company which didn’t have to pay a single penny to two greatest icons of his time to promote its products.

Because Paul E. Newman and Henry Kissinger drank Coors beer.

At the turn of the decade of 1970s, Coors had everything going in its favor. It produced a unique unpasteurized form of beer. Its devotees claimed it to have a certain “draft-like” taste of beer. Coors went one step further and touted the gifts of “Rocky Mountain” spring water with which it manufactured the beer. As a mid manager in Marketing division of Coors, Mills was aware of the strengths of the brand. However his sharp eye didn’t prevent him from seeing the differences between Coors and its bigger competitors like Anheuser- Busch.

Integration: The Coors way

For one, Coors was integrated vertically to a staggering degree. It produced its own strain of barley, mined its own coal and aluminum for the energy and cans respectively. It even owned the land from which the Rocky Mountain spring water came up from. It owned one big brewery in Colorado of the size of 7mn barrels in 1970. For the 37 year old Mills, it was a source of strength, for the 67 year old he has its doubts.

“Coors was a regional player till 1975. It produced and was consumed in 11 Midwestern states only. This lack of volume prevented the scale of economies kicking in for its various feeder businesses. That implied a higher cost and a higher management bandwidth to maintain it.”

These problems, Mills recounts, the management was aware of . But they drew the wrong lessons from it. He remembers “Old Jeremy”- Jeremy Wilkins, Head of Marketing and mentor of Mills , to have fought tooth and nail against the lesson which the management took from this.

At that time, Wilkins was seen as a dinosaur, a remnant of the past.

10 years later Wilkins was vindicated. But that didn’t matter- he died in 1980 and Coors started having trouble shortly thereafter.

“Old Jeremy correctly saw what the problems were and what its solution was. When you see the problem as lack of scale you will infer that the solution was building scale. And the management bought into it. Jeremy understood that things were not as easy. If you tried to build in a scale, that would imply expanding into untapped markets and territories. That strategy puts the company fortunes in terrible jeopardy. Expansion and growth is never free. And expanding into unknown territory with other competitors firmly entrenched can prove to be very costly. And indeed it was. Old Jeremy saw it.” remembers Mills.

It was not that Coors management are to be solely blamed for its harakiri. In 1975, Federal Trade Commission mandated Coors to go national. It was just the excuse that management needed. They expanded with gusto and shipped with passion. Till 1975, a single can of Coors earned almost twice an AB can did. At 11%+ net profit margin on a $520mn sales, Adolf Coors and Co. eked out more than AB did out of every single dollar of sales- $85mn profit on a sales of $1.65bn.

The Cost of Growth

” Coors when it expanded into new markets, had to buy its way in. We had to forge new relationships and new wholesellers. Often the stores with whom we signed the contracts were fringe players themselves. The larger ones were all taken and locked out by the heavyweights. That’s one. Coors flagship product was High Life brand of beers- which were unpasteurized. This implied tight cold chains, fanatical inventory management and the entire works. And that’s two. In business its hard enough to survive with three strikes. In beer business, two is all what it takes. Somewhere in late 1980s, we realized we have lost the plot.”

By 1985, Coors sold in 44 states across US, completely negating its local advantages of scale. On top of it, Coors ran a remarkably integrated ship. Its hub and spoke model of beer distribution centered around Colorado also increased the transportation costs. The story of Coors cuts across two big developments- beer is seldom seen as an aspiration product and expansion in a commodity business is fraught with immense risks. But what about the endorsements by Newman and Kissinger?

Priceless Mystique

The mystique of Coors didn’t translate quite well into profits.

In 1977, Coors collected $41.50 per barrel whereas AB without all the mystique collected $46.The trend continued till 1985 as well.

That mystique is no mystique when it is sold for free.

With the absence of such differentiation, Coors beer reduces to just another beer and thus a fiercely fought commodity war ensued. On top of it, while AB expanded its production capacity aggressively it was able to pick up the economics of scale quicker. In 1977, Coors production costs per barrel was $29 compared with $36.60 of AB. In 1985, it was $49.50 for Coors compared to $51.80 for AB.

 

But what changed between 1970 to 1985 that made Coors turn into an also ran? Mills takes a long gulp of the beer and recalls:

“Coors before 1975, was a regional powerhouse. We had 8% of our market share in our pocket by merely focussing on three Pacific Coast regions. Two out of these three, Coors was the dominant force. And in the other we ranked equally with AB. Post expansion, we still had 8% market share but we trailed AB in every state.

For Coors, expansion meant dispersion and dispersion meant costs. When Coors went national, it sacrificed its local home advantages and chose to compete on a level playing field with AB. For the national beer market, AB was the incumbent and Coors was the player outside looking in. AB was saved by the lack of growth in the beer market. It grew by only 3% annually in that period. And for Coors this lack of growth implied that scale advantages couldn’t be achieved fast.

The result? Coors operating income margins fell from once mighty 20% to a mere 9%. AB expanded to 15%. The difference is more stark in the details.

While AB spent 3 times as much as Coors for advertising, but $4 less per barrel.

Coors had this equation inverted, when it stayed limited to a region. Advertising costs are fixed on a regional basis. So AB coming in and trying to wrest away markets purely on an advertising spree will not be on a terrific advantage (just because of its deeper pockets).

Mills remembers somewhat wistfully- “If you take a look at the numbers of AB and Coors from 1970 to 1990 and hide the years you can perfectly imagine it as a zero sum game. Coor lost and AB won. Almost to the exact decimal point.”

Its inevitable that Mills doesn’t feel some chafing at the great fall. He saw the giants make mistakes and saw its demise from a very close angle. He quotes von Clausewitz these days to make sense of it all.

 

“Perhaps, Coors should have read ‘Vom Krieg’ , Clausewitz said- concentrate your best forces on your central line. Coors should not have expanded into unchartered territories. And when pressurised by FTC, should have done it only sparingly, trying to meet the bare minimum requirements. Perhaps we could have charged heavily for each can so that real demand stays low. Its counterintuitive, who kills a demand after all, but perhaps necessary”- offers Mills if somewhat presciently.

There is no guarantee that the “think local” strategy would have worked. But there is a fair chance that it would have made lives of AB executives a little bit more tougher. Beer drinkers are remarkably fickle. Footloose customers often signify lack of differentiation. So what remains is in essence branding and promotion to take care of it all.

As the markets make new highs, one is tempted to ask what he thinks about the new dot coms.

“Make no mistake”, Mills says – “Internet has made everyone an outsider looking in. There are no incumbents here. It is just the opposite of the beer industry. We are seeing a spectacular growth and everyone is competing. Growing a scale advantage or any other advantage is easier said than done here.”

“At the end, every site is a toaster. Zero differentiation.”

 

The post is a fictionalised version of the brilliant chapter in Competition Demystified. The characters are imaginary.

 

Edit: Discovered there were bucketful of grammatical errors. Fixed them all.

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