We are grateful to those of you who reciprocate with interesting reads that you come across. Whilst we receive a few periodically, it was astonishing to see many of you recommending the same read within 24hrs of the blog being published. Such has become the following for Anand Sridharan’s blogs, which are a tutorial of sorts for new and old investors alike. And this one is all the more special given it touches upon a central aspect of Marcellus’ investment philosophy – capital allocation. Capital allocation, perhaps is the primary or even the only responsibility of the company’s management, even more so for companies which are hugely profitable and cash generative. Anand starts off with the curse of a wonderful business:
“Wonderful businesses come with a curse or three. These are: surplus cash, surplus time, surplus confidence. First, a dominant, lucrative business generates way more cash than can be redeployed to fund growth in the core. This is the most fundamental curse of a wonderful business, as idle cash is a devil’s workshop. Second, since such businesses have strong management, evolved processes and minimal firefighting, occupants of the top-floor at head-office have time to spare. While golf, running and yoga are noble ways to occupy spare time, meeting investment bankers isn’t. Third, buggy humans extrapolate from being good at one thing to being good at all things. Unfortunately, competence is domain specific. While protagonists are clearly good in one domain, it is misplaced confidence to believe that their abilities will extend to another country or category. A lot of good that is associated with a successful business is path dependent. Businesses get to #1 through a combination of skill and luck. They stay #1 because they are #1. It’s one thing to sustain leadership from a strong starting point. It’s a very different thing to succeed by acquiring some fringe company in Eastern Europe built by others in an alien context/culture. Unfortunately, that’s the sort of misadventure surplus cash, time and confidence results in.”
Anand captures the effect of such inherent value destructive tendencies of managements of even good businesses. It is not just the poor returns on the capital misallocated but often the bigger cost is the opportunity loss in the core business:
“No human can take on a second task without the first task suffering. This gets worse when second task is as daunting as fixing a failed acquisition. This distracts promoters and senior management from the core business. Trajectory of any business is disproportionately influenced by a few big decisions that can only be taken at the very top. These may pertain to handling a shock (e.g. covid/lockdown) or sign-offs on crucial projects or response to sudden competitive spike. As promoters are too distracted to apply their mind to such judgment calls, core business slips. I have seen cases where a business that comfortable outgrew industry by 5% a year when focused, started lagging the industry by 5% a year when distracted. This huge swing is often unnoticed as it is relative to a counterfactual (what would’ve happened had we not made that acquisition). Tale of slow-boiling frog plays out.
Here’s a secret: opportunity loss in core business is >10x worse than direct M&A damage.
Imagine a business worth 20,000cr. If it compounds 15% a year for a decade, it is worth 80,000 cr. If distractions reduce this to 10%, it is worth 50,000 cr (likely lower, as a laggard business will have lower margins, prospects and valuations). A 1000 cr acquisition caused >30,000 cr opportunity loss. By the time tail is amputated, it has wagged the dog sick.
Acquisitions do end up transformational. Just not in the direction promised by bankers. Typically, large acquisitions and other such needless self-goals ruin a decade of business compounding. In terms of investment returns, many billions of dollars of value has been lost, just in mid-sized companies that I directly track.”
He ends with some advice to businesspeople and investors on the temptation for empire building.
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