What I DON’T want to back
Certain ownership constructs are inherently disadvantageous to minority shareholders. I my 3rd essay of this series, I cover all that is bad about them. And I cannot be nice about this.
Here’s the 3rd 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. This edition covers sub-optimal ownership constructs that are generally avoidable. I’ll start by dumping on entire categories of businesses. Once I have offended enough people, I’ll get to exceptions to all the nasty things I say below. Let’s start this airing of grievances.
These usually come in two flavors: bad people and bad context.
When it comes to judging people, it’s best to go purely by track record. Just as some promoters have history of doing the right things, others are history sheeters. Evidence comes in many forms: serial acquirers; chronically high debt; iffy accounting; shafting minority shareholders; treating company funds as personal piggybank; preference for dodgy clients; indefensible diversification; ‘cash’ transactions galore. Here, answer is easy: avoid. Since people don’t change, avoid forever. It’s best to even avoid meetings, so as to not fall for improbable redemption stories. Dodgy promoters can do convincing mother-promise on not screwing minority shareholders again. Remember the famous tale of Munger declining a meeting with Pearson (of bacchanalian Valeant fame) despite Ackman’s pleading. This risk is highest when underlying business is decent, as it’s tempting to ignore the promoter question. I wouldn’t take a chance on bad promoters.
Bad context is one where there’s innate misalignment between primary owners and minority shareholders. In bad ownership constructs, even good people can end up doing bad things, in the sense of acting against my interests. I can think of a few buckets: PSUs, MNC subsidiaries, conglomerates, private equity owned, no-owner.
I don’t think government is all bad and am far from anarchist. However, government as promoter isn’t good for minority shareholders, anywhere in the world. First, there’s no one individual I am backing. People overseeing a PSU keep changing, along with business priorities. There is no one to back. Second, irrespective of how decent people are, creating shareholder value isn’t high on any government’s priority list. PSUs will keep getting drafted into public service, irrespective of risk or cost to shareholders. I still don’t know what the true economic objective is for PSUs, despite having observed many for decades. Maybe they’re improving and some will eventually get privatized, but that’s a punt for thematic or event-driven investors. I’d stay well clear of this category.
True owner is at a different level:
Cummins India is an outstanding business run by fine people. So is Cummins Inc. Despite good people and a solid franchise, disproportionate part of every conference call over the past decade has been devoted to whether Cummins Inc is being fair to minority shareholders of Cummins India. Is new engine made in listed entity or private entity? What’s transfer price for exports? Will you shift production from Eastern Europe to India? Then, will it come to listed entity? Why is your expensive building being shared with Cummins Inc? What royalty do you pay? Root cause of analyst angst is that what’s best for Cummins Inc need not be best for minority shareholders of Cummins India. Cummins India is a division of Cummins Inc, not an independent company.
Conflict of interest is inherent to being a shareholder in any subsidiary or division, because the topmost promoter (i.e. owners of parent entity) wants to maximize value at his level, not mine. This not a problem unique to MNCs. You’ll find the same conflict with a captive finance subsidiary of an auto OEM, trying to push vehicle sales rather than lend prudently. Many MNCs (including Cummins) have behaved responsibly towards minority shareholders, but many haven’t. Even in the good ones, there’s no assurance good behavior will persist, as conflict always lurks beneath the surface. Sudden changes to royalty or transferring an outstanding manager to a global role (good for him, bad for me) keep happening. Spending a decade as shareholder, while doubting intent the whole time, isn’t my idea of fun. While many MNC subsidiaries are stellar businesses (e.g. engineering, pharma, FMCG, auto), there’s no good answer to “who am I backing here”.
Conglomerates are what happen when feudal promoters misinterpret Berkshire Hathaway for convenience and ego. It’s absurd to believe that one can achieve excellence across eighteen industries or that access to capital is still a competitive advantage. In most cases, mess has worsened over time, negating legacy as an excuse. Rant done, there are sober problems with conglomerates. This setting is also fraught with misaligned interests. Focus is lacking. When company #8 in the group is going through covid, it’s unlikely to get promoter’s undiluted attention (whereas it’s #1 for me, if I am not a shareholder in numbers 1 through 7). Many conglomerates shuffle senior managers from one company to another. As a shareholder in one company, I feel cheated. Managers are (generally) not owner-like. Some of the more egregious international acquisitions happened in conglomerates, as managers were happy to build empires and promoters were too scattered to think through risks. It’s hard for a promoter who owns eighteen businesses to deny a manager the joy of owning two or three. While a few stray examples of decent businesses get touted, norm is that of diffused mediocrity and misallocated capital. Unwieldy agglomerations getting valued way below ‘sum of the parts’ is one of the rare examples of an efficient market.
While a promoter-less, board-governed structure is the norm in the West, India is a long way from there. Even in the West, this arrangement provides ample fodder for B-school case studies on agency problems. However, there are counter-balancing forces such as threat of lawsuits, activism, buy-out or hostile takeover should managers grossly mismanage a business. In India, most of these are untenable in any meaningful sense. With an untested model and without checks and balances, this is not a good construct for Indian minority shareholders. Posterchildren of this model have demonstrated egregious capital misallocation under zamindari CEOs, to create unwieldy hotchpotch businesses with deservedly high hold-co discounts. Overrated boards have been spectators if not cheerleaders. Similarly, a few businesses set up consortium-style (e.g. credit rating, stock exchange), with no clear owner, have seen managers stray to the point of criminality. Lack of a permanent owner is a huge problem.
Private equity owned:
Typo. That should read: private equity rented. Around the world, private equity firms claim high IRRs but return unusually low multiples on capital invested (1.5x on a fund is rare). While some of this is due to high fees, a lot is due to short holding periods. Effective holding period across a fund is hardly 2-3 years. In most cases, we have owned businesses for over a decade (and counting). It is therefore imperative for us to back people with an even longer time horizon. Private equity fails this test. Even if individuals are well intentioned, I cannot count on a short-termist system to do what is right for the long run. Like with conglomerates, owner is also defocused as my business of interest is only one of many in a portfolio. There’s also a skill issue, as financial investor and business promoter are very different roles. Much as I like my well-tailored friends in private equity, former consultants or bankers, with more confidence than real experience, aren’t my idea of a backable promoter.
Default settings are integral to sound judgment
I can picture you going “But what about TCS, Titan, HUL & Nestle, you foul fiend” (sorry, too much time with 7-year-old). I deliberately chose an extreme route, only highlighting negatives in each construct. Intent is to emphasize appropriate default settings for each construct, given inherent misalignment of interests between controlling and minority shareholders. Intent is not to tar every business under these categories with same brush.
Given how overwhelming markets are, sound judgment is impossible without default settings. We have to categorize whatever we encounter, understand patterns of behavior within each category and have a predefined framework for approaching each category. Investment decisions cannot start from a blank slate, just as morning routine cannot start afresh with “So, which toothpaste is optimal risk-reward”. I cannot get excited about one PSU without framing it more generally against category risks. I cannot get carried away by some PE-backed white-knight story, without remembering what happened the last time they bestowed a new logo & CEO to a shitty bank. In old English, this is called stereotyping. In new jargon, AI/ML. This is not a bad thing. This is essential for limited brains to process an unlimited world. These are the mental shortcuts and heuristics that let buggy humans emerge as our planet’s dominant species.
Default settings efficiently incorporate historical odds into a decision-making process. They’re neither 100% right nor the final answer for each instance. But they’re certainly more right than wrong and do more good than harm. They ensure that we don’t miss category risks and ask appropriate questions. Since sub-optimal ownership constructs are fraught with conflicts of interest, it is important to approach them with the right default setting. Bad behavior isn’t inevitable, but good behavior cannot be taken for granted. I’d rather distrust and then verify.
Therefore, my default setting for aforementioned six constructs is ‘avoid’. I am not advising others to adopt the same (separately, ignoring all advice, especially on the internet, is a good default setting). It’s perfectly fine to end up with a less extreme default setting than mine. However, I believe that the risks that I outlined are a material input into whatever default setting works for you. Even if you aren’t at ‘avoid’, hopefully you’re at ‘eyes wide open’.
Exceptions are possible, but should be part of an established process
Having offended as many people as possible, let me undo some of the damage. It is possible to find acceptable businesses within sub-optimal constructs. If lack of an appropriate owner is the problem, others can step into an owner’s shoes in certain situations. Empirically, this happens infrequently and needs to be carefully tested against preponderance of evidence. I’ll cover the criteria and approach for making exceptions in my next essay. Partly since this essay is already too long, but mainly because I don’t want to dilute my main message.
Certain constructs are inherently risky for minority shareholders. They are best approached with a default setting of skepticism. Since this is a big deal for my professional wellbeing, I chose to be blunt about how I think through such situations. I’d rather be offensive than wrong.