Barnett Helzberg was at New York’s Plaza Hotel, when he heard a woman holler, “Warren Buffett!” He spun around and yes, it really was. Helzberg did not waste the opportunity — he introduced himself and told Buffett he owned a company that satisfied the “acquisition criteria” laid out by him in the Berkshire Hathaway annual report (Buffett has been listing his acquisition criteria in the annual report for over three decades now). The billionaire investor told him to send across the information.
Having sent the details of his company Helzberg Diamonds, he soon found himself in Buffett’s office at Omaha. Buffett looked at him and said, “Well, this will be the fastest deal in history.” When a perplexed Helzberg asked about due diligence, Buffett replied, “I can smell these things. This one smells good.” Still, in doubt, Helzberg asked, “You would want a non-compete clause, right?” “No. You will never do anything to hurt this company.” Helzberg did an all-stock deal without any negotiation or haggling over price. Today, he still gets a monthly profit and loss statement of the company he sold nearly two decades years ago.
Helzberg Diamonds is just one of many businesses that Buffett has bought in double quick time. And Barnett Helzberg is only one of many promoters who would like to sell their businesses to Berkshire Hathaway. “They know he is not going to change it, he is not going to sell it, and he is not going to take it public. That is why he is the best person in the world to sell out to. That is also why Warren gets the opportunity to buy some very good family businesses,” says Helzberg.
The Helzberg story is a perfect demonstration of Buffett’s razor-sharp edge in assessing a business and his ability to gauge people and intent. It’s quite a combustible combination. And something every business leader needs to develop.
In 2009, when the world was emerging out of the global financial crisis, Buffett’s partner Charlie Munger said something fundamental about Berkshire Hathaway that resonated with the 35,000 people present at the annual meeting: “Our model is a seamless web of trust that’s deserved on both sides. That’s what we’re aiming for. The Hollywood model where everyone has a contract and no trust is deserved on either side is not what we want at all.” To which Buffett had added, “We don’t want relationships that are based on contracts.”
It is this seamless web of deserved trust that sets Berkshire Hathaway apart. No doubt, Buffett’s astute investing capabilities and rational behaviour even in a heaven-is-falling scenario is unparalleled, but what makes him stand really tall is the resolve to resist the temptation to do things simply because it suits him. “Buffett will never deal with someone he thinks is not right just to crack a deal or accomplish something. On Wall Street, you will not see anyone ever complaining that they got a raw deal from Berkshire,” says Mohnish Pabrai, founder, Pabrai Investment Funds.
The two-way trust Munger talks about is no altruistic idea that will not bear fruit in the real world — it has actually become a strong competitive advantage for Berkshire. If Buffett proved to be the private lender of last resort in the financial markets, he is also becoming the owner of first choice for private family businesses. Says Robert Miles, author of several books on Buffett, “What is unique to Buffett’s genius is that deals will come to him that will not go to anyone else because he has the money and the reputation.”
Indian promoters, too, vouch that creating trust and credibility lie at the heart of creating shareholder value. “For us it is easy to concentrate on trust and reputation because we are a brand-oriented consumer company. But even in other spheres, it creates immense value,” says Adi Godrej, chairman of the 116-year Godrej Group, one of India’s oldest business houses.
Another institution that inspires great trust in India is HDFC. “It is never a cakewalk. In the first 10 years, the retail saver never trusted us. Everyone came to us for loans, but they did not trust us to deposit their money. Now, they do. Trust is built over time,” says Deepak Parekh, chairman, HDFC. In the toughest times during 2008-09, when wholesale money became dear, HDFC managed to raise retail deposits worth ₹8,124 crore, accounting for 54% of the total funds raised in 2008-09. That’s obviously a demonstration of reputational advantage, given that the business environment was shaky at the time.
Then again, the Tata group has established a strong reputation and web of trust that has helped it crack international acquisitions, but when it comes to delivering value for shareholders, it’s a different story. In fact, very few promoters in India have proven trustworthy for shareholders, but it may not be fair to vilify Indian companies alone. Look anywhere in the world and you find a large number of listed companies fail to meet even the most basic investor test, which is to earn returns higher than their cost of capital.
In his latest annual letter to shareholders, Buffett recommended a book by LJ Rittenhouse, Investing Between the Lines. The book talks about capital stewardship —the term means acting like a trusted steward of capital, a guardian of shareholders’ wealth. “Buffett is one of the greatest proponents of proper capital stewardship,” says Sanjay Bakshi, who runs investing boutique, ValueQuest. At the core of capital stewardship is the understanding that shareholders hold equity in the company because they want to earn higher returns — as long as the company can earn a return higher than its cost of capital, it is worthwhile to stay invested in the business.
Management actions, therefore, have to be geared to meet this objective. So, how do you deal with cash, how much leverage should you use, how much should you pay out as dividends, how much should you reinvest in the existing business, should you diversify or make acquisitions — all these decisions need to be governed by this single criterion.
Barring Dhirubhai Ambani, and a handful of others who have demonstrated that they care for shareholders, the track record of promoters in capital allocation hasn’t been up to the mark. With his acute sense of business, Dhirubhai understood that he had few options to raise capital and he needed to treat public shareholders with respect; otherwise, his own growth ambitions would be scuttled. It worked well for him and his shareholders. Unfortunately, even the Ambani group has not been able to keep up to the standards set by the group patriarch. “Capital is treated with disdain in India,” says Mohandas Pai, former chief financial officer of Infosys Technologies.
There is a reason why capital is often misallocated in India. Historically, capital has been expensive in the country — with the government running high fiscal deficits, interest rates have been high. Equity markets, too, were shackled by the government until two decades ago — the Controller of Capital Issues allowed companies to offer shares only at par. Accessing foreign capital was difficult for many and impossible for most, which meant promoters were capital starved and there was a tendency to hoard capital. “Much of that has changed over time, but the mindset has not,” says Pradip Shah, founder, IndAsia Fund, who serves on the board of several Indian companies.
Things changed dramatically after 2003. Global growth was strong and, suddenly, capital started coming too easily, deluding companies into unsustainable growth. Promoters and managers threw prudence out of the window and started chasing assets they should have abstained from. As Buffett says, it is when the tide turns that you know who is swimming naked. The tide turned abruptly in 2008 and investors were left staring at naked companies.
“Today a number of companies are struggling because they over-leveraged. When you get a situation where your Ebitda to total debt is out of whack, it can’t be blamed on some junior analyst in your financial department or the term lending institution,” says Vallabh Bhanshali, co-founder, Enam. HDFC’s Parekh elaborates, “Indian companies tend to over-leverage because promoters don’t want to dilute their holdings. Promoters tend to think their shares are undervalued.” Pai says sarcastically, “Industrialists these days believe their status depends on the debt they take, not their market-cap.”
So, many of the failures of the past decade were not because of cheap money — they were the result of ambition, ego and greed.
Equity is free
Apart from the scarcity syndrome that stops them from parting with cash, there is another vital reason why companies are not doing enough to unleash shareholder value. While the cost of debt is clear to every finance manager and CEO because it is a cash expense paid out every year, the cost of equity is not. “It’s an intangible, it’s like spirituality. It is difficult to make people understand there is an expected rate of return from the company and that, if not met, could hurt the company in the future,” says Prashant Jain, chief investment officer, HDFC Mutual Fund. “Companies often think of dividend as the cost of equity because that is what they give back to shareholders,” he adds.
However abstract the concept of cost of equity may sound, in the end it is a simple argument. If a company produces piles of cash, it has three options: reinvest the cash into the business if the business provides attractive returns; if not, look for options that will deliver as much or more return; or simply hand the cash back to shareholders as dividend. If the company decides to sit on cash that does not earn as much return as the business generates, it drags down the return on equity. And that’s bad for shareholders.
Then it is a question of coming to terms with the business reality, and taking a call on whether it is time to start giving away cash. Granted, there are situations where you may want to hold cash for strategic reasons. Take Infosys Technologies. For the longest time, the company was criticised by investors for sitting on a pile of cash that dragged down its return on equity. But the management said the cash reserve was important because the company operated in a volatile global environment and needed to keep adequate cash for paying its employees because it had a large head count.
“There was method in the madness,” says Pai. Later, as growth slackened and shares started languishing, the company upped its pay-out ratio. In 2011, the company increased its pay-out to close to 50% although in 2013, the pay-out stood at 25%. Higher pay-outs also altered its return on equity although with growth itself coming into question, the stock has not kept up its performance. Infosys has often reasoned that the cash pile is also to ensure it could exploit any acquisition opportunities but it hasn’t moved in that direction.
Holding cash can indeed be an advantage. “When you are in the acquisition market, if you have cash, you command a premium. People know you can write out a cheque in a minute, so you are valued and you have options. But when you don’t have cash, sometimes you have to compromise, you have to pay a higher price,” says Bhanshali. “Today, companies like Toyota and Apple and are sitting on large piles of cash. The managements are not foolish — it is about how they see the future,” he adds. The problem is, the majority of companies in India are still family-owned and, often, families do not look at themselves as shareholders — they consider themselves the owners and the company, privately held. “Their actions are often tailored to deliver value to the family, not to public shareholders,” says Shah.
“When personal needs are taken care of, the marginal utility for cash is zero. That’s one reason promoters prefer to keep the cash in the company and control it entirely than pay dividends where they will only get their share,” says Jain. That means the biggest risk with companies sitting on cash is not the opportunity cost of cash for the shareholder, but the temptation for the management to make stupid moves — remember there is ambition, ego and greed to contend with.
The Ambition that lifts
Buffett once said, “There are thirteen and a half people at the Berkshire headquarters in Omaha and I am the half.” That sort of modesty is rare and quite unlike many Indian business families. “It’s very difficult to find Indian companies that don’t want to become conglomerates,” says Bhanshali. Most business families in India are ambitious about expanding their empire. Often, that means using group companies as ATMs to fund new ventures or even loss-making ventures, which ends up destroying value. “Capital allocation and respect for equity can be a lot better in India. There are many companies that are continuing without thinking what return they get from marginal investment, that is, the return on incremental capital employed,” says Bhanshali.
That is not to say that diversification is bad. Capital stewardship does not necessarily mean you need to stick to just one business, especially since it’s not as if companies that didn’t diversify have done uniformly well. Indeed, Buffett himself bought Berkshire in 1965 when it was a sick textiles company going cheap. But he soon realised textiles was not a great business and used the money to buy into other, more lucrative businesses. This is where Buffett’s philosophy of sticking to your circle of competence comes into play. He understood his strength was in making smart investment decisions and stuck to that, leaving operations to his CEOs.
In a growth economy like India, there are umpteen opportunities to grow, but not everyone with piles of cash has succeeded — in fact, that is seldom the case. That is because if you wish to succeed — and success in business, according to Buffett, is not about building scale and size but the ability to produce superior return on investment — you need to have an edge.
Large Indian business groups went down the diversification path, only to fail miserably. “Very often, managements tend to become overconfident of their enterprise and managerial capability. If they take their success more seriously, they make more mistakes,” says Bhanshali. Seconds HDFC Mutual’s Jain, “Companies have to realise that just because you are successful in one business does not mean you will be successful in all. You were successful earlier because you had something going for you — you were either the first mover, or you were at the right place at the right time, or had some edge.”
Instead of critically assessing their odds of success, companies simply took the cash and rushed into new areas. That was a show of immodesty, quite unlike what Buffett and Munger practise. “While the top three business groups in India have created more winners than losers through diversification, as times have changed, they are also being more careful. Now, you see more focus,” says Bhanshali.
But looking back, Reliance would not have become the giant it is today if Dhirubhai hadn’t taken the call to diversify from textiles to petrochemicals and then into crude oil. And if Azim Premji hadn’t ventured out of oil and rice trading into software services, Wipro would not have become the tech giant it is now. You can always attribute such success to randomness but as finance guru Michael Mauboussin would say, skill plays a greater role in business success than in stock markets.
The Ego that hurts
While the role of luck can’t be underplayed in any activity, in both investing and in business, you have to increase your odds of success all the time. Going with Mauboussin, it’s about focusing on good process, and not getting taken in by bad process-good outcome. That’s where Buffett continues to do a fine job even at the age of 82, $1 billion of float being generated monthly. That’s also the thing every business captain needs to perfect. Business itself is about investing, making acquisitions is even more like it. If you do it at the right price, it will largely work out okay. Even the best company bought at a bad price can’t make a good investment.
That is a reality haunting companies such as Tata Steel, Hindalco and Bharti Airtel today. While the companies they acquired are not necessarily bad assets, they were bought at top dollar. “These companies bet their entire fortune on very large debt-financed acquisitions that impaired their balance-sheets,” says Bakshi. As this story goes to press, Tata Steel has announced an impairment charge of $1.6 billion. Shares of Tata Steel are down 30% since the Corus acquisition, against a 55% rise in the Sensex. Bharti shares have been stagnant while the index rose 16% since March 2010 when it acquired Zain. Hindalco, again, is down 21% when the index had gained 46% after its Novelis announcement.
Not very long ago, all these were great companies; Tata Steel and Hindalco were counted among the world’s lowest-cost producers of steel and aluminium, respectively, and Bharti Airtel was one of the most profitable mobile operators in India. “It’s improper capital stewardship when a management ‘bets the company’ on one thing. It doesn’t matter if the bet will pay off or not because it’s bad process,” says Bakshi. Tata Motors is a classic example of a bad process-good outcome — yes, the Jaguar acquisition has turned out well with demand taking off in China, but it brought Tata Motors to the brink of bankruptcy. “The lesson to learn from Buffett is to be transparent and admit your mistakes. Buffett admits his mistakes openly. Success hasn’t gone to his head,” says Pai.
But Bhanshali see things differently. “I don’t think one can dismiss all acquisitions in one swoop. Sometimes acquisitions, especially global acquisitions, are necessary because they help globalise your thinking, your workforce, your markets, your entire organisation culture, and this is an aspect that won’t be caught in numbers. These are investments one has to make for low returns.” That’s probably a valid point, but debatable especially when neither the management nor the shareholders have any clarity about the next opportunities that will make up for the low returns.
Such gigantic financial commitments with ambiguous objectives also go against the grain of Buffett’s first principle of maximising per share intrinsic value. “The problem is that there are few managements who have the real desire to excel. Mostly, they would like to increase their sphere of influence by expanding, making acquisitions and so on,” says HDFC Mutual’s Jain.
Thankfully, there are companies that have done acquisitions that have created value for shareholders. “Every time we look at an acquisition, we see how much it will add in terms of per share value. We expect to increase the EPS in the first year itself,” says Godrej. Godrej Consumer has done about half a dozen acquisitions in the past few years based on his 3X3 approach which focuses on three core business areas of personal care, household care and hair care across three continents — Asia, Africa and Latin America.
Three years ago, Godrej Consumer made its largest acquisition for $250 million. Now, that company is looking at acquiring another large player using its own balance sheet, so Godrej got a valuation done for the company. “The investment bankers have valued the company at $1 billion. But we will raise the money only if we need it,” says Godrej. It’s back to the same point — how do you use capital efficiently? “The cost of capital is often forgotten. At Godrej, we have strong incentives based on EVA improvement that encourages people to use capital more efficiently,” he says. (Economic Value Added captures the return on capital employed over the firm’s cost of capital.)
Apart from sticking to your focus area and competence, another unique criterion Godrej points out for acquisitions is a human resources audit. “We believe a local management team with experience is the best to run a business. At best we only send one to four people from the existing team. So, if we think the quality of management is an issue, we do not go ahead,” he explains.
That’s also how Buffett operates — Munger calls their management style as “decentralisation almost to the point of abdication”. Every other year, Buffett asks his managers to send him a letter about who will take over if something happens to them. He also tells them to send a monthly balance sheet, profit and loss statement and any major capital expenditure they would like to make, for approval. While his operating managers have an astounding sounding board at their disposal, Buffett never calls on them for any nitty gritties. Says Brad Kinstler, CEO, See’s Candies, “I speak with Warren four or five times a year and it is generally if I have something to talk to him rather than the other way round.”
It’s not the same in India. “The CEO and the professional executives don’t get the same kind of freedom empowerment or recognition as they should get in most family-run businesses,” says Shah. “It’s not that Buffett pay his employees markedly more than other employers but he has a holistic system in place and he is able to motivate them through non-financial means, which is really the culture.”
In a different context, that boils down to circle of competence. Buffett and Munger understood early on that they were best — and happiest — at evaluating businesses and making investment decisions. So they created an organisation structure that envisaged a role for themselves and others in a manner that maximised everyone’s potential. It’s a model where capital allocation is highly centralised while operations are completely decentralised. Managers thrive in this environment, as do Buffett and Munger. It’s not surprising, then, Buffett is unparalleled in his leadership. In 48 years, he has never lost a sitting CEO to a competitor. Says Miles, “Many other companies like GE grow and they grow their competitors because there is a pecking order and if three of them don’t get chosen, they compete.”
Like Buffett, CEOs of Berkshire companies are not subservient to Wall Street. They have no quarterly pressures; they need to focus only on the business. Says Kinstler, “If you know what you are doing is the fair price for selling candies or insurance, you need to remain focused on what’s right and not cave into situations just because competitors might be pricing much below you.” That’s again a leaf from Buffett’s Bible. “There is no second guessing or paperwork you have to go through to get things approved at Berkshire. You are given the trust as well as the responsibility. This is unique to Berkshire and will remain part of our culture,” says Kinstler. On the other hand, “Many Indian business families are still feudal in their mindset,” says Pai.
The greed that kills
At the Berkshire annual meeting, when a shareholder thanked Buffett for having the doors opened up early because of the drizzle outside, Buffett quipped, “If we had a company that sold coats we would have left you out there.” It was said in a lighter vein but Buffett’s mind is always looking for opportunities. He transformed from being a shrewd investor who would spot cheap stocks to one who would buy quality businesses that would earn superior returns for a long time. He understood that the most important advantage that a business can get is compounding — the concept is as relevant for businessmen as it is for investors. When you think of compounding, almost immediately you start thinking long term as opposed to short term. When you think long term, you stop making the mistakes that short term focus often forces people to commit.
Some Indian businessmen have latched on to the idea. A case in point is Hero Honda. Brijmohan Lall Munjal understood the India market and stuck to his competence, ensuring cash was not misallocated. Hero Honda became one of greatest compounding stories in India, although now the stock market is struggling with lack of clarity on management thinking after the 2010 breakup with Japan’s Honda. HDFC is another classic example, delivering compounded annual returns in excess of 20% consistently.
The man at the helm obviously sees value in Buffett’s philosophy. “The biggest takeaway from Buffett is how you can create value for shareholders with such great consistency,” says Parekh. HDFC has done nothing dramatic — it has just bettered its processes and stuck to its knitting. But that has yielded magical results. Other companies, such as the Shriram group, Asian Paints and Bosch, too have unleashed the power of compounding for shareholders by sticking to their competencies.
Compounding works best only when you are patient, but often “companies end up hurting themselves because of lack of patience,” says Pradip Shah. At his lunch with Buffett, Pabrai had asked about Rick Guerin, the third partner who started off with Buffett and Munger, but then went off the radar. Buffett’s reply, recalls Pabrai, wasn’t direct but it was packed with wisdom. “Charlie and I always knew that we would become incredibly wealthy,” Buffett said.
“We were not in a hurry to get wealthy. Rick was just as smart as us, but he was in a hurry.” What happened was that when the stock market nosedived in 1973-74, losing nearly 70% in value, Guerin was highly levered and got margin calls, and so was forced to sell shares — Buffett bought Rick’s Berkshire stock at under $40 apiece at that time. “If you’re an even slightly above-average investor who spends less than they earn, over a lifetime you cannot help but get rich if you are patient,” Buffett said. “My question was, what happened to Rick? The lesson was, don’t use leverage. And be patient,” says Pabrai.
Often, the mistake promoters make is to focus on multiplying because it seems alluring in the immediate run. In today’s context, take the example of a bank licence — there is a long queue to grab bank licences today and you can pay about ₹500 crore and the market wisdom or market nonsense, depending on how you look at it, would ensure the company will get a valuation of $1 billion. “There is a big multiplier, but that is not compounding,” points out Bhanshali. That multiplier can make you rich immediately, but longevity is not guaranteed.
Only when you have created a business that will continue to grow because of an economic advantage — it could be a superior product, systems or processes or anything that gives you relative advantage over others — have you created a compounding business. “The fundamental lesson to every businessman from Buffett and Munger is that, if you want to create a lasting business, don’t think you are successful until you have brought in compounding. If you are not compounding you must question whether you should remain in that business because sooner or later it will devour capital rather than generate more capital,” says Bhanshali.