Lessons from Rs 1 lakh crore-companies

New Indian Express

2 days ago

I used to have a singular focus on ROE but learnt only a decade or so ago, that high ROE alone does not create wealth. One needs a potent combination of ROE and growth. I used to believe, if you have high ROE, it means that you have a good business model with moats etc, time is on your side, and growth will come. Turns out, it's not true. Growth is as important at ROE.
Let's look at Bharti Telecom, which ranks #59 on the ROE rankings within this elite club. It ranks #4 in the market cap league tables. Its 10-year ROE is between 7-8%, which is a result of the price war with Jio. Its market value is $120 billion. Its book value is $11 billion, so the price-to-book ratio is 12.26. Contrast it with China Telecom, which is as dominant in China as Bharti is in India. China Telecom has a price-to-book ratio of only 1.03. In the near-term, markets may be wrong but such differentials between the Indian telecom sector and other markets like China have persisted for a while.
My take-aways from this: Government and regulatory risk is higher in China than in India, in spite of the big issues the Indian telecom sector has faced. China Telecom is majority government owned so it inspires less confidence. This is just the SBI-ICICI public sector-private sector valuation differentials I had mentioned earlier. The market share wars in Indian telecom are behind us and earnings growth should be substantial. And certainly, Bharti's management is far more dynamic than China Telecom. Like I said, it's not easy to be in this club.
Staying with return-on-equity, Indian ROE, weighted average for the listed companies as a whole is 13.5%. This is second only to the US, which is 16-17%. Brazil's is 12%. ROE for Indonesia's IDX Index is 7-8%, for China's Shanghai Composite Index it is 6.5%, for Japan's Nikkei it is 9%, for Germany's DAX index it is 10.5%, for FTSE companies in the UK it is 8%. This, combined with growth, seems to be India's magic formula for wealth creation. It feels good to see Indian companies dominating their industries in the market cap sweepstakes.
JSW Steel recently overtook the traditional steel industry market leader, America's Nucor, to gain the #1 spot at $30.3 billion in end-March this year. Indigo Airlines briefly became the largest market cap airline in the world, at $23.45 billion, beating Delta by a sliver, for a few days. Some may argue that these valuations in India may not sustain, but that's for another discussion. The fact is Indian companies are now in the top echelons of the global league tables, even if some may not retain their #1 status. Irrespective, Indian companies are a force to be reckoned with on the global stage. This feels good! Changing topics, let us look at long term wealth creation.
Warren Buffett argues that for strong companies, ROE etc may all be good, but it is the utilization of free cash flow and reinvestment of capital is what determines long term winners. Else, the businesses plateau. Guess which are the 4 most valuable financial companies in the world. The largest is JP Morgan at approximately $700 billion, Visa at approximately $675 billion, Mastercard at around $520 billion and China's ICBC at about $325 billion. Notice that two out of these four are nonbalance-sheet businesses. Visa and Mastercard are just enablers.
They take a small sliver of consumer spends. Just based on that small commission they have built a global duopoly. They have not used their surplus cash to buy a bank or do anything outside their core. They are like tech platforms with high up front set up costs, huge gross margins and network effects. Their success goes beyond the business model. It is discipline.
I was invited for a presentation at Tata Sons many years ago. The theme of the discussion was what might be the next Titan Industries in the Tata portfolio? The thesis was that TCS was an aberration and might be difficult to duplicate. But certainly, Tatas can create a few more Titans. Please note that currently TCS is valued at about $190 billion and Titan at approximately $38-39 billion. Clearly, they were thinking about the next twenty years.
That's what wealth creators do. Jeff Bezos is famous for saying that the financial results for any quarter were more-or-less baked in three years ago. So, he worries less about them and more about what's going to happen three years hence and so on. He says he thinks in minimum fiveto-seven-year time frames. Such get rich slowly schemes may be boring but they are the real deal.
Coming back to Tatas, they identified many businesses that had the potential to be the next Titan. One they narrowed down was Tata Consumer. They were going to put resources behind that. Look at the numbers for Tata Consumer in the last 10 years. Revenue growth CAGR of 15%-plus. Profit growth CAGR of 20%-plus. Market cap CACR of about 24%. And this is in a relatively benign consumer sector environment. That is the power of intent. So, how might the mighty stumble? It's well known that the average life span of a S&P 500 company is about 15 years. I have to narrate a rather interesting interview from late 1999 or early 2000. It was with the Chairman of the erstwhile Southwestern Bell in the US.
Remember, we were at the peak of the tech bubble. Southwestern Bell went on to become a consolidator in the telecom industry. Eventually, it merged into AT&T or Verizon or something, I cannot remember which. But in 1999-2000, crazy stuff was going on. Companies like Global Crossing were using the irrational exuberance of the financial markets to create unprofitable capacity.
Telecom companies were buying media companies or betting on technology. The dilemma before the boss of Southwestern Bell was as follows: Should he follow the crowd and do something audacious, which may eventually hurt the company. Or, should they refrain from following the current consensus, which may mean their stock price may correct and Southwestern Bell may become an acquisition target. It was a tough decision.
There was no clear-cut answer. But, Southwestern Bell navigated the turmoil well and its shareholders came out as winners. This required judgement. Many businesses don't display this when they are in a frenzy. They follow the herd or get frozen into inactivity. This separates the long term winners from losers.
The lesson for Neo, and I think they are well positioned to do this, is: they have to be able to play different types of cycles. They have to make money in a bull market and also figure out how to make money in a debt crisis. I was reading a report, which quoted from Indian tax data. They had drawn up a master list of all the tax paying companies in India and divided them into deciles. From that report, it turned out that the 2nd decile of the most profitable companies were seeing the highest profit growth. Their analysis showed that this was the result of two seemingly opposing forces at play.
The first was the secular shift from disorganized to organized, and the resultant industry consolidation that one was seeing in industry-after-industry. The 2nd decile companies were gaining market share over 3rd and 4th decile companies in their sectors and hence beating them at profit growth. On the other hand, they were more entrepreneurial than the 1st decile companies in their sectors, thereby making inroads into new niches and often growing faster.
This is the challenge for the Rs 1 lakh crore club. The 2n decile companies are dynamic, ambitious and nibbling away. They are the ones to watch out for. And this is even before we take technological shifts and new industries or business models into account. So, how can the 1st decile companies continue to retain their edge? I believe it's culture.
Take Toyota as an example. It's the largest car company in the world by volume. It makes about 10 million vehicles. If I recall right, they have 70-odd plants, of which only about 15 are in Japan. Toyota has a concept called the Andon Cord. Any worker on any production line can pull the Andon cord and stop the production line if they think there is an issue. Lesser companies may see risk of productivity loss; Toyota sees it as a mechanism for building an undisputed culture of quality. Toyota generates about 700,000 ideas for improvement every year. Most of these are small ideas.
But if you have a strong commitment to improvement, nothing is small. And 90% of these ideas get implemented. How does one compete with this kind of culture of continuous improvement? It seems that the path to the very top is quite mundane. Amazon has a concept of 'single thread leaders'. Employees are encouraged to pick up an idea and run with it, crossing product or functional boundaries. This kind of empowerment has led Amazon to tinker and add almost 2500 small new features every year, ranging from customer experience, to logistics to bandwidth and backend technology.