Tuesday, February 18, 2014

Reading the Balance Sheet- Abusing Capital


We buy shares in specific companies because we use these companies as a proxy to participate in the business they do. For example, if I am betting on Colgate, I am betting on the toothpaste business predominantly. If I buy shares in Cummins, I am betting on their being able to produce and sell diesel engines far more efficiently than many others.

Thus, I expect each company to have its capital almost fully allocated to the main business I choose it for. “Capital Allocation” by every company is a key factor for me to take a call on the company. Just to give an example, let us take L &T. It is known for its competence in engineering related skills and strength. So I would expect the company to use the resources to focus on that business. In case it generates far more cash than what can be used by the business, I would expect the company to pay higher dividends. Or it could do a share buyback. But, what does the company actually do? Let us see:

Eng &Con Elec/Elec Mchinry IT Fin Dev Proj Others Elimin Total

(Rupees crores if not mentioned otherwise)

Top Line 58616 4846 2880 4999 4080 1406 52 -1683 75196

Seg P&L 6051 547 458 1107 848 412 8 -105 9326

65% 6% 5% 12% 9% 4% 0% -1%

Seg Ass 52170 3658 2146 3218 36593 33755 196 131736

40% 3% 2% 2% 28% 26% 0% 0%

Seg Liab 29782 1540 944 870 30141 6658 21 69956

The above data is from a section called ‘segment’ reporting from the latest annual report. Essentially, this section shows how much of assets are deployed in various businesses and what revenues it derives from each. There is one level after this, where there are expenses and assets that cannot be allocated to a specific business, which comes off from the total profits etc.

I look at the above and wonder- Why are they deploying so much money in to two segments named Finance and Developmental Projects? I recall that they used to have a modest finance business to support their sale of earth moving equipments. But it now seems to be a monster, with nearly 30% of the assets attributed to that company and that contributes to less than ten percent of the bottom line, before allocations. The case with Developmental Projects seems even worse. Maybe the company executives know better. Maybe when these projects can be exited from, the company will make piles of money. Who knows?

There are innumerable such examples. For example, I think ITC share prices are depressed because they have allocated capital to poor businesses like hotels, paper, and consumer products etc which earn far less than the highly profitable cigarette business. I think that if ITC did not have the other cyclical and poor return businesses, the share price could have been a couple of times higher than what it is today. I do not buy the argument of being protective of the future. Should the cigarette business have to be shut down, it does not matter to me as a shareholder. I know the risks. If I want to be present in hotels or consumer products, I may buy shares in Indian Hotels or HUL. In fact, if we take the amount that ITC has shovelled in to FMCG business over the years, including the massive losses and put it in to shares of HUL or Gillette or Godrej Consumer Products, the returns would have been spectacular.

When management or promoters decide to wrongly allocate capital, it is a negative sign. Let us take the latest move of the Government of India to force one company to acquire shares in the other. Why should the government do this? If I wanted to, I would buy a mutual fund or an investment company share. If I buy ONGC shares, it is for the prospective return from Oil exploration etc and not by making money in the share market.

Ultimately, if we put money in to shares of companies that wrongly allocate capital based on whims of owners and managers, the returns suffer. The owner is using our money to fuel his personal whims and fancies. Whether it be buying a private jet or a helicopter or investing in totally unrelated business with poor returns, the impact is the same- lowering of returns to the shareholder.

Misallocation of capital is perhaps one of the biggest corporate governance issues. As a minority shareholder, we never get a choice to have a say in this. For example, we had to read from the newspaper that Exide (a company that one invested in because it made automotive batteries) suddenly became the owner of an insurance company! The promoter did not even bother to take shareholder approval and the independent directors must have simply nodded their heads when the investment call was taken. Or when Piramals used the cash to buy shares in Vodafone, the principle was the same. Just because a decision turns out to be subsequently profitable, does not justify the wrong.

Same is the case where the Birla Group uses one company to hold shares in another. What they are doing is essentially create holding companies which they can control, using public money. And also spoil the returns for the other shareholders.

I get worried when I see companies sitting on large cash balances. It is like money burning holes in the pocket. One day, some investment banker will come and make the promoter buy out some business where there could be personal ego fulfilment, but no shareholder returns. IT companies like Infosys or TCS are worrying due to large cash balances that are kept in bank fixed deposits. Surely they do not have to worry about finding money if they have to buy something. The share is a fantastic currency. And after Satyam, there is always a niggling worry about the existence of the cash balances.

In the not too distant past, we recall that DLF, riding high on the back of an overpriced IPO and inflated market capitalisation, had diversified in to so many businesses, claiming ‘synergies’. Now they are trying to exit most of those, claiming that they want to be ‘focused’. Again, this is a case of misallocation of capital.

Misallocation of capital is worse when there is leverage or borrowing to fulfil that desire. Only time will tell whether the buying to Corus by Tata Steel or Novellus by Hindalco is good or bad for the shareholder who is left with underperforming shares and a large debt, apart from the ‘goodwill’ (the difference between the value of assets bought and the higher price paid to buy them) that has been eaten away. Ideally, one would have thought that before such a decision, other shareholders should also have a say. And it is more relevant, because in both these cases, the non promoter stakes are substantially higher than that of the promoter.

So next time you see an annual report, try and see this interesting section called ‘segment’ reporting. It is a good indicator of how much the promoter/ professional manager cares for the other shareholders. And just to add, don’t fall in to the trap of accepting CSR as an excuse for the manager or promoter doing dumb things with money.

8 comments:

Abhijit said...

Was investing in Kingfisher Airlines by Vijay Malya the same case like ITC, L&T or his personal business?

Because share price of United Spirits doesn't seem to have affected by KFA. It's only KFA's share price that has doomed.

AMAR said...

Great article

NRK said...

Thank you. If I am not exaggerating to say that you are Saraswati of Equity Investing.

Can you pls clarify below?

1. for its FMCG busieness, ITC WILL get a break even in a year or so and after that it should be profitable. Your comments please?

2. Almost all of the PSU's are not worth investing because of the reasons that you have mentioned in this post however what about Balmer Lawrie (which can be potential candidate for our portfolio because of its discount valuations, Dividend income etc.), Gujarat Gas company (which can be potential candidate for our portfolio because of its discount valuations etc.) ?

mehul doshi said...

RIL investing in Rel Gio Infocomm Ltd.!

Rahul Aggarwal said...

Very nice perspective, although articles like these make me wonder whether you should side with skeptics on Indian equity markets who advise to stay from them? Are there enough companies that you can trust your capital with? If yes, is it too uphill a task to find them?

Frustrations Amalgamated said...

1. Dear Abhijit
I think KFA investment was from a holding co where other shareholders had a stake. That is poor allocation of capital for that co.

2. Amar
Many thanks
3.Dear NRK
You make me blush... Even when ITC makes money on FMCG, it will never make returns like HUL or P&G. The amount already lost is also capital that has been burnt.
PSUs are trading opportunities- They could become investments should the owner get out.

4. Mehul,
RIL is beyond my digestion.

5. Dear Rahul
Why should we stay away from investing? It would be easier just to understand the risks and the downside. Then it is just a question of odds. I think equities are the best vehicle for creating wealth.

Frustrations Amalgamated said...

1. Dear Abhijit
I think KFA investment was from a holding co where other shareholders had a stake. That is poor allocation of capital for that co.

2. Amar
Many thanks
3.Dear NRK
You make me blush... Even when ITC makes money on FMCG, it will never make returns like HUL or P&G. The amount already lost is also capital that has been burnt.
PSUs are trading opportunities- They could become investments should the owner get out.

4. Mehul,
RIL is beyond my digestion.

5. Dear Rahul
Why should we stay away from investing? It would be easier just to understand the risks and the downside. Then it is just a question of odds. I think equities are the best vehicle for creating wealth.

Frustrations Amalgamated said...

1. Dear Abhijit
I think KFA investment was from a holding co where other shareholders had a stake. That is poor allocation of capital for that co.

2. Amar
Many thanks
3.Dear NRK
You make me blush... Even when ITC makes money on FMCG, it will never make returns like HUL or P&G. The amount already lost is also capital that has been burnt.
PSUs are trading opportunities- They could become investments should the owner get out.

4. Mehul,
RIL is beyond my digestion.

5. Dear Rahul
Why should we stay away from investing? It would be easier just to understand the risks and the downside. Then it is just a question of odds. I think equities are the best vehicle for creating wealth.