Not ideal, but backable
In previous essay, I covered avoidable ownership constructs for an investor. This (4th) essay discusses how to think about exceptions within those constructs.
Here’s the 4th essay of this series, trying to answer my most important question: Who am I backing here? What kind of controlling owner would be best for interests of a (long-term) minority shareholder such as myself? I previously discussed my ideal construct, one of a longstanding, focused, trustworthy promoter. I followed it up with sub-optimal ownership constructs that are generally avoidable. Current essay is my attempt to undo the damage from offending numerous folks the last time around. This is where I go “just kidding”. Just kidding.
I was intentionally harsh in my prior essay. It is only fair for a permanent owner investing in structurally flawed constructs to have a high bar for whom to back. Of the categories mentioned in last essay, I am loathe to make exceptions in the case of bad promoter or government as promoter. However, there are occasional exceptions in the case of conglomerate, MNC subsidiary, private equity owned or no-owner situations.
I cannot ignore a long history of owner-like behaviour just because it doesn’t fit preconceived constructs. Unit of analysis in investing is ‘company’. While categories and base rates can help, they aren’t a substitute for company-specific assessment factoring in idiosyncratic considerations. I’ll cover backable businesses, within sub-optimal constructs, in two parts.
Focus within conglomerate
Conglomerates have an owner, just not one exclusively focused on the business I am interested in. Certain conglomerate constructs automatically fix this problem, with clear demarcations on which individuals (or branches, from an extended family) are in charge of which businesses. Economic interests are also appropriately aligned. For a specific business, I can pinpoint the individual who functions as its focused, longstanding promoter. I can see decadal evidence of how that business has performed under this individual’s stewardship. This situation is no different from a standalone promoter-led business, except for a loose family affiliation in the background. A few well regarded South Indian conglomerates are illustrations of this model.
A second construct is where a promoter has multiple business interests, but my company of interest is, by a wide margin, the largest among them. While I’d ideally like 100% focus, it is never 100% even with a standalone business. There may be unlisted business interests, next generation floating new businesses, distractions within the listed company or philanthropic ventures that take a life of their own. If I get the sense that my business of interest is, say, 90% of promoter’s ‘portfolio’, I have reasonable assurance that big decisions will get adequate mindshare. 100% focus is figurative, not literal.
That said, I still believe conglomerates are a sub-optimal structure, requiring extra caution. When studying history, I explicitly check that focus has been getting better over time, not worse. Measures like divestitures to make portfolio less unwieldy, clear family settlements or disentangling cross-holdings are a positive. Periodically adding new forays or shuffling managers across group companies are negatives. After investing, I would be extra watchful for distractions or new interests creeping in. In summary, I can live with certain constructs within conglomerates, but with eyes wide open.
Philosophically, ‘owner’ is a mindset, not a shareholding percentage. While agency problem is real in owner-less businesses, there are noble exceptions. Longstanding senior managers have run businesses with more of an owner mindset than most promoters. In a no-owner construct, HDFC group has multiple businesses where ‘lifer’ managers have built best-in-class businesses. That they did it in financial services, a cesspool of agency problems, makes it extra creditable. Each company has done way better than peers that had actual promoters. In conglomerate construct, Titan and TCS come to mind as exceptional businesses built by owner-like managers over decades. In MNC-subsidiary construct, it’s hard to even think of HUL as an MNC, given decades of homegrown leaders. In other situations where private equity renters rotated in and out, there are examples of owner-like managers building industry-leading businesses over decades.
Exceptional, owner-like managers with decadal track records are clearly backable. The key is to ensure that they seem like ‘lifers’ in their mindset towards the company. A culture that produces an entire cadre of similar leaders ensures that this mindset survives succession. While there is some risk that managers can leave or be fired (unlike promoters), it is adequately low and manageable in cases like the ones I mentioned. This is a case-specific call, where I cannot generalize principles for spotting owner-like managers. This falls under a holistic I-know-it-when-I-see-it approach to decision making.
I have belaboured on this ownership issue over four essays. While an important question merits thorough discussion, there’s the risk of getting lost in detail. Why expend so much effort on ensuring a sound ownership construct? Because world is highly risky, making it inevitable that even good businesses run into trouble. Since we cannot anticipate trouble, we need a construct that can handle any trouble. There’s no better way to achieve this than through a business owner who has everything at stake and an obsessive focus on strengthening the franchise. True margin of safety arises from aligning my interests to those of such an owner. Unlike cash on balance sheet or disciplined entry price, this isn’t a ‘static’ margin of safety. It is dynamic in that the right owner can proactively respond to any shock, including those never-before encountered. Right ownership construct bestows a degree of anti-fragility to my investments. This has been invaluable, especially in ensuring decent outcomes even when I erred on some other part of my thesis.
(If you have stuck with this series so far, there’s light soon. My next essay will be the last. I’ll cover special case of ownership change and wrap it all up.)