The almost accidental discovery by my colleagues at Ambit almost two years ago that the Indian market churns significantly more than any other large stock market (the Nifty churns by 50% or more over a 10-year period versus 25-30% churn ratios in other large markets) led my colleagues to kick-off a research programme which has culminated, after six major notes, in a final thematic which describes the lifecycle of great companies.
In particular, we have found that ‘great’ companies evolve and as they do the shareholder returns associated with them change dramatically. Whilst investors tend to earn the greatest returns when a company is in its ‘youth’ (stage 1), the variability of returns is the lowest when the company is in its ‘prime’ (stage 2). This is almost inevitably followed by ‘descent’ (stage 3) and then, in 1 out of 3 cases, by a turnaround (stage 4). In the context of conventional investment analysis—wherein investors, rightly, place heavy emphasis on sustainable competitive advantages, corporate governance and capital allocation—we believe that the lifecycle phase which the company is going through is an equally important driver of investment returns.
Stage 1: Youth
The promoters typically start small and begin in their home state where they have a high level of comfort with the local business and political community. Eventually, the promoter hits on winning product(s) and ramps up production; this is followed up with the launch of new products and/or experiments with variants. Capital allocation is cautious, as the business takes its first steps towards growth. The company hits upon the first few innovative ideas. Once the company hits upon the winning product and ramps up production, the decision to expand is made, either into other products or into other geographies. As a result, whilst shareholder returns can be volatile in this stage, this is the most important stage in a company’s lifecycle in terms of shareholder returns.
Infosys (1994-2002), Berger Paints (1991-2000) and IPCA Laboratories (2003-2014) are backward-looking examples of ‘youth’. On a forward-looking basis, interesting examples this regard are Mayur Uniquoters, VA Tech Wabag and eClerx.
Stage 2: Prime
The company is on top of its game at this stage. It has acquired a stellar reputation and is the leader or at least in the ‘Top 3’ within its sector. As a result, the company has a strong following amongst institutional investors and equity analysts. The company chases inorganic growth through large acquisitions and announces large capex plans backed by fund-raising plans. Promoters yield to unrelated diversifications into new areas to keep the topline growth momentum intact. In this stage of a great company’s existence, investors have the greatest visibility (or certainty) regarding returns.
Bharti (1999-2009), HDFC Bank (2003-2014) and Sun Pharma (2003-2014) are backward-looking examples of great companies in their ‘prime’ whilst Page Industries, Motherson Sumi and CRISIL are interesting forward-looking companies in this regard.
Stage 3: Descent
Our research suggests that over 80% of Indian companies go into descent within five years of entering their prime. This slide to descent is usually triggered by imprudent capital allocation. Hubris and arrogance have set in as the company mistakenly believes itself to be unassailable. Unrelated diversifications made in the past eat into balance sheet and capital efficiency starts suffering. The management reduces access to analysts and investors; in particular, analysts who do not ‘support’ the company are denied access. This is the stage where investor returns are at the greatest risk.
Tata Steel (2003-2014), TTK Prestige (1994-2004) and Suzlon (2008-2014) are backward-looking examples of ‘descent’ whilst Asian Paints, Ambuja Cements, and potentially, Apollo Tyres, are interesting forward-looking examples in this regard.
Stage 4: Turnaround
We have found that one in three companies that slide into difficulty is able to turn itself around. Hence not all companies are fortunate enough to successfully turn around. The companies that do are those where their management teams course-correct with enough cash left in the tank. Tough decisions are taken, management teams are replaced, non-core businesses are terminated/sold-off and a turnaround plan with time-bound, measurable targets is put in place. Investor returns (and the variability associated with them) in this stage are similar to what they are in the ‘youth’ phase.
TTK Prestige (2004-2014), IndusInd Bank (2008-2011) and Titan (1999-2009) are the backward-looking examples of ‘turnaround’ whilst Ashok Leyland, TVS Motors and Bajaj Electricals are forward-looking companies in this regard.
(Saurabh Mukherjea is CEO, Institutional Equities, at Ambit Capital. The views expressed here are personal. His book “Gurus of Chaos: Modern India’s Money Masters†will be published on 21st October 2014.)
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