That’s what keeps businesses alive, that’s what makes the difference between good and bad managements and that is what makes investors better or worse off. To understand what drove the companies that outran the others over the past five years, we present The Outperformers.
Good is the enemy of great,” writes Jim Collins in his book Good to Great. Like the most of us who settle for ‘good’ in our lives, a majority of companies never become great because they stay satisfied with good. While his research yielded some remarkable insights on why some companies make the leap to greatness while others fall short trying, Collins goes on to say that greatness is not a function of circumstance but largely a matter of conscious choice. So, what drives outperformance in companies over the longterm? Why do some companies thrive while others struggle in the same economic environment?
Our annual edition The Outperformers tries to answer just that by taking a closer look at companies that have outperformed over a five-year period and what they have done right to create significant value for their investors (see: Coasting uphill). As a starting point, we zeroed in on companies with a market capitalisation of over a billion dollars and looked at their compounded stock return from FY13 to FY18. The Sensex generated an annual compounded return of 11.80% during the same period and companies that outperformed the benchmark index formed our universe. You can find the complete listing on page 124. From a sector perspective over the past five years, private banks and NBFCs have managed to deliver stellar return for their shareholders as they took away market share from PSU banks, which continue to grapple with NPAs and mounting losses. And their dream run is likely to continue according to Neelkanth Mishra, managing director, Credit Suisse India: “Private banks are the only space that will continue to see an 18-20% growth over the next five years as PSU banks continue to cede market share and private banks leverage technology to innovate and grow significantly higher than nominal GDP growth.” Not surprisingly, there isn’t a single PSU bank on our list.
Cash-spewing consumer companies are also prominently present. While some of them grappled with margin pressure, industry leader Hindustan Unilever used both technology and premiumisation to improve margins. According to the company, its Connected 4 Growth (C4G) programme has led to faster decision-making and increased speed to market, which is driving business performance. It also pushed localised innovation such as Pureit (water purifier) and Lever Ayush (ayurveda portfolio). Over the five-year period, the company’s net margin improved from 15.57% in FY13 to 21.10% in FY18. Limited capex and high operating cash flows meant it was one of the most efficient users of capital.
Sometimes being a market leader induces complacency. Only those who hold on to their leadership positions, lead or anticipate disruption (HDFC), adapt to change (TCS), or respond swiftly to competition (HUL) are the ones who stay big. “If you see the companies that outperform over long periods of time, they are not satisfied with the status quo and are in a perpetual challenger mode despite being market leaders,” says Nilesh Shah, managing director, Kotak AMC. He gives the example of HDFC, which continues to up the ante in customer satisfaction and never took its leadership position lightly. “It has always been in the boring business of home loans. However, its presence in only a singular vertical and being a market leader didn’t stop it for looking at ways to reduce the cost of funds by raising external commercial borrowings, foreign currency convertible bonds and masala bonds. It developed strong ties with developers by financing their projects, which in turn ensured getting additional customers from every new project,” he points out.
[Collins points out in his book that the ‘good to great’ companies understand what can make them the best in the world — what drives their economic engine and what they are passionate about. There is relentless focus on execution and efficient capital allocation (see: Putting money to work). Take the case of Page Industries, which has positioned Jockey using its first-mover advantage. Jockey has now grown to become an aspirational brand in India with a revenue of #25.52 billion and has also managed to extend its brand loyalty to other categories such as leisurewear. “When we launched in 1995, there was a void in the market for premium innerwear. Marketing in the category was virtually absent. As first movers, we succeeded in making consumers understand the importance of good quality innerwear. We made retailers realise the significance of giving prominence to innerwear in their shops and deploying Jockey brand display modules, allowing consumers to directly interact with our products,” says Sunder Genomal, managing director, Page Industries. The company’s revenue and profit growth over the past five years have increased by 23.84% and 25.26% respectively every year with operating margin remaining stable around 21%. Thanks to its asset-light distribution network and efficient capital allocation, its average ROE over the past five years has been around 52%. “We focus on our core competencies. We do not incur any capital expenditure that is not directly related to our core business and invest only in backward integration projects which give us a return in excess of 25%,” says Genomal. The stock market, of course, rewarded the company with a 47% compounded return over the past five years.
KN Sivasubramaniam, former CIO, Franklin India Equity, Franklin Templeton Investments and one of the best fund managers that the country has ever seen says outperformers stay relevant through economic cycles by anticipating and adapting to disruption better. “There are very few companies that remain relevant over a long period of time. Thus, the key is to identify what kind of competitive edge the company has and for how long the company is likely to retain it. Obviously, that period is going to change from time to time. But the outperformers ensure they stay relevant by making strategic changes to their business model,” he says. He gives the example of HDFC Bank, which has now built a digital channel as large as its retail network of 4,787 branches. In their retail business, the bank ensured there were at least four to five touch points, be it credit cards, wealth management, savings accounts or personal loans. This ensured the bank was not only able to retain its customers but also rapidly add new ones. When it came to corporates, the bank never focused on long-term lending but instead on working capital and cash management of the vendor supply chain of large corporates such as Tata Motors, which helped build strong relationships with them. Financing the supply chain vendors of Nestle, PepsiCo and Coca-Cola meant they had a good understanding of the growth of rural and tier II markets and the customers therein. So while most banks have been shying from rural markets, HDFC Bank found a profitable way to enter the market.
Alok Kshirsagar, senior partner at McKinsey & Company says that another characteristic of outperformers is their ability to convert what their peers see as risks into opportunities. “What great companies consistently do is develop proprietary insights from all their stakeholders, be it their customers or suppliers, and then use these insights to anticipate market change better. They can, thus, do things others cannot and what might be risky for others becomes an opportunity for them.” For instance, as PSU banks, which disbursed 70% of the credit, grappled with NPAs and capital adequacy issues, it threw up a huge opportunity, especially for NBFCs, to cater to the growing credit demand from retail and SME segments. Bajaj Finance, whose stock has generated an annual compounded return of 71% over the past five years, has successfully leveraged technology to emerge as a market leader in consumer finance. With a relentless focus on generating high ROE, the company not only uses technology to speed up the approval process, but also uses analytics to keep its default rates low.
While companies in both manufacturing and service sectors are leveraging technology to become more efficient and understand consumer needs better, Indian IT companies have been grappling with transition. In the case of Infosys, leadership wrangles and growing scale made the company more bureaucratic, limiting its ability to respond to change. “Scale is definitely an advantage but if it is the only advantage that you have, then you are going to struggle. Choosing to cut costs over increasing revenue momentum is never a sustainable strategy,” says Romal Shetty, president, consulting, Deloitte India.
Even as Infosys refused to enter a price war when the demand for IT services started to slacken, TCS and Cognizant were more than willing to compete on price, gain market share and grow faster than the industry. In fact, Cognizant came from behind to overtake Infosys in terms of revenue while TCS held on steadfast to its leadership position. McKinsey’s Kshirsagar disputes the notion that scale can be a limiting factor for companies to deliver superior return in the long term: “There is no correlation between scale and agility or the ability to adapt to change. Some of the largest companies in India have put together teams to bring out new products or solutions, go after new markets or address a shift in regulation. You can have agility at scale and large companies have used scale to their advantage to adapt, become nimble and create a larger impact.” Take the case of TCS, which created smaller business units to go after newer markets and develop platform-based solutions, the company managed to bridge the margin difference it had with Infosys in FY10 (500 basis points according to a report by Spark Capital) through higher revenue growth. TCS then utilised its scale to continue reducing overall costs for its clients even as it grew incremental revenue from them. What also helped the company was stable leadership. In fact, the company has had only three CEOs — all from within — in the past 25 years, with the third only taking office two years ago. Kotak’s Shah believes that in times of transition, unless a company is able to reinvent itself, it would be hard to replicate its past return (see: Contrasting fortunes).“To expect Infosys to create the same value it had created in the past will be too much to expect. At the same time, in the next 25 years, expecting Infosys to become a $100-billion entity will be too less — they will do far more. Given the industry opportunity, the size of value creation will be larger than the past but small in percentage terms.”
Along with stable leadership, outperforming companies exercise the discipline of not venturing into unrelated businesses or making unrelated acquisitions. In fact, knowing which risks to take and which to avoid goes a long way in creating value. Take the case of Ashok Leyland — it had to pay the price of mindless expansion and unrelated joint ventures. Rewind to 2013, Ashok Leyland was imploding from all sides: demand had fallen by 25% for two successive years and entry of new players meant excessive discounting. If that wasn’t enough, the company was saddled with excess capacity and it was reeling under a huge debt burden thanks to a five-year investment binge from 2008-2013. Revenue and profitability had taken a significant hit. Over the next two years, Ashok Leyland strengthened their core truck business by pruning its overall cost, launching new models to fill the gaps in its portfolio, expanding its network and investing in technology. Shifting capital to its core business helped the company in achieving economies of scale. The company also cleaned up its balance sheet by either writing off the losses or exiting unprofitable ventures. As a result, the company’s revenue and profitability have seen a significant improvement over the past five years. Revenue has grown faster than the industry growth of 16% every year, with profit clocking an annual growth of 29% as margins improved and debt burden came down. Now the company is working on decreasing its dependence on the cyclical heavy commercial vehicles (HCV) business by increasing the revenue share of light commercial vehicles (LCV), which are counter-cyclical to HCV; and exports and defence. “It is not the question of ‘if’ electric vehicles will take off. It is a question of ‘when’ and we are ensuring that we are future ready. We are looking to reduce the contribution of medium commercial vehicles (MCVs) from 60% of the overall revenue to about 45% by growing the defence, exports and LCV businesses faster than the core business. There is no escaping the cyclicality of the business. So we have to transform the company when it is stronger,” says Vinod Dasari, managing director, Ashok Leyland.
While capital allocation decisions are part of every business, in certain cases, they can either make or break companies. “Capital allocation becomes even more important when you are in the commodities space because there are global factors at play and you have to be able to read the cycles right and plan your expansion at the right time. Otherwise, you will be saddled with excess capacity and lots of debt,” says Mishra. Apart from smart capital allocation, commodity companies that tend to outperform also operate efficiently. Take the case of Dalmia Bharat, the country’s fourth largest cement player with an overall capacity of 25 million tonne per annum. Over the past five years, its stock has generated an average yearly return of 81% as the company reported better than industry revenue growth of 26% per annum thanks to a series of organic and inorganic initiatives. What’s more — according to CLSA, the company has the best unit EBITDA due to its brand focus and turnaround of its acquired assets. “We wanted to be one of the most efficiently-run cement companies in the country as well as to improve profitability. We, thus, focused on launching a premium brand. In order to create better value, we worked on both levers,” says Mahendra Singhi, group CEO, Dalmia Bharat.
Though there is no escaping economic cycles, these outliers have shown that by anticipating disruption and through relentless focus on execution and efficient capital allocation, it is possible to generate superior return for shareholders. While sectoral tailwind definitely adds momentum to the outperformance, companies that create a sustainable competitive advantage are the ones that stay ahead.