India is popular for its large business groups and conglomerates with many subsidiaries/associates operating under one umbrella. These group companies are either in the same sector or in widely different ones.
Now, add to this the fact that certain industries generate better return on capital (ROCE) compared to others, due to inherent industry characteristics. For example, IT services is more profitable than steel manufacturing
Also, within a particular industry, some parts of the value chain are more profitable compared to others, due to ‘profit pools’. For instance, within the automotive industry, control cables manufacturing is more profitable than seat manufacturing.
Plus and minus
The advantage for business groups that have a portfolio of businesses under them is that they have the flexibility to move money from one business to another and they are, to some extent, protected from industry specific risk (although the latter is not applicable if all the companies in the group belong to the same industry)
The disadvantage for business groups is that there will always be a few good businesses that generate above average return on capital employed and a few that generate below average return on capital. I am not referring to the year-on-year fluctuation in ROCE but to the long- erm average.
Over time, each business reveals its characteristic ROCE level, which doesn’t change significantly unless there’s major shift in industry/company dynamics.
Often, these average ROCE levels are industry-specific and similar across the world.
The questions is: When you have a few businesses that consistently generate poor ROCE and a few others that generate good ROCE, what do you do as the chairman of the group?
If the chairman belongs to the Buffett school of thought, he would water the flowers (high ROCE businesses) and step over the weeds (low ROCE businesses). But this is easier said than done — here are some reasons why:
Low ROCE businesses are typically dependent on scale for efficiencies. This leads to the belief that if they focus on growth and become a large player, profits will eventually come; for instance, commoditised businesses with weak differentiators other than cost.
Depriving low ROCE businesses of further capital could result in them dying out of cash crunch — which means that the money already invested also goes to waste; for example, the state of most news channels in the country.
Hope of turning around ROCE by doing something innovative that others haven’t figured out. This could range from investing in vertical integration to changing the business model/technology used.
For example, every new airline believes it would be profitable although it sees most of the existing players struggling.
Hope for turn in business cycle, de-regulation or other changes in macro variables — sugar, oil marketing companies, general insurance, and so on.
Belief that money saved through cost saving strategies will not be passed on to the customer
Passion for the business and size overcomes profitability objectives.
High ROCE business may not require capital or does not have growth opportunities — so money deployed in any growth opportunity, even if it is in low ROCE business, is perceived to be better than paying out all of the surplus to shareholders in the form of dividends.
Growth opportunity
As a result of factors such as the ones listed above, many of which may well be justified, most business groups end up cutting the flowers and watering the weeds. In other words — they take cash flow generated by high ROCE businesses and redeploy it in the low ROCE businesses.
Examples include the ITC group that re-invests cash flow from cigarettes into hotels, Wadia group that re-invests dividends from Britannia into Go-Air, or for that matter even the UB group that has sold stake in the liquor business to possibly restore the airline.
The bottomline is: Business groups or companies in fundamentally low ROCE businesses may not be able to spend in the hope of boosting ROCE, although they may be able to clock growth.