-This appeared in the Deccan Chronicle of 21/22nd August, 2016-

(http://epaper.deccanchronicle.com/articledetailpage.aspx?id=6149921 )

Many great companies go to bad only because of this- When the promoter uses listed company to meet personal goals.

 

“Are we really trying to do something worthwhile here?” “Or are we just building another monument to some diseased ego?”

The above is from an old business strategy classic named “Up the Organisation” by Robert Townsend. This was written somewhere in the 1970s. It is a wonderful book and you can dip in to it at random and get a lesson in some aspect of business analysis or management.

 

Often we see businesses that behave strangely when it comes to ‘Capital Allocation’. A business that earns a very high ROE, throws up so much cash that the management is tempted to do silly things just to feed personal egos. They take the spare cash and put it in to businesses that have poor returns and have no synergies with what they are doing. Shareholders are not asked about diversification but are informed subsequently. Here, the law is strangely on the side of the management, even if the company is listed. There is no compulsion to obtain prior shareholder approval even if a cigarette company wants to set up a hotel business, which will deploy several times the capital employed in the core business. As an investor, I buy in to a cigarette making company for the profits that it makes. I am willing to live with the risks of that business shutting down. Every investment decision has to be made from the point of view of using capital ‘efficiently’. Allocating capital to unrelated and poor Return business is mis-governance.

 

Investopedia, defines Capital Allocation as below

Capital allocation describes how businesses divide their financial resources and other sources of capital to different processes, people and projects. Overall, it is management’s goal to optimize capital allocation so that it generates as much wealth as possible for its shareholders.

 

The objective of ‘capital’ allocation is to generate as much wealth as possible for the shareholders. Thus, any diversification, should give at least as much as the existing business does. If it cannot, the management should return the money to the investor. The investor will take the call about where to put his money to work to.

 

Neither the MCA nor the SEBI require that a management should take prior approval from other shareholders for diversification or acquisition. Non-promoter shareholders have no say in this. In case of so-called ‘professional management’ NO shareholder has any say. In most cases, it is the CEO who takes the call and the rest meekly nod their heads or are presented with a ‘fait accompli’. How do you explain a company like L&T diversifying in to finance or shipbuilding? Why is a company named ITC making agarbatti or FMCG products or owning and running hotels?

 

SEBI and the MCA must wake up. If there is going to be a diversification or an acquisition or any other action that calls for deployment of capital in to new businesses, there should be a prior approval from the shareholders. And one thing that must be disclosed in detail is how efficiently would the capital be deployed and what is the logic behind diversification. There must be an independent view that is given to the shareholders. And non-promoter shareholders must have a say in what is being done with the money.

 

There are many companies, which diversify in to businesses that make a mess of their finances and then try and get out. At the time of diversifying, they call it ‘strategic fit’ and at the time when they want to get out, they say that they want to stick to their ‘core’ business! DLF is a case in point. Or we see L&T set up a finance company, a shipyard and so many other businesses.

 

Every company in multiple businesses publishes a ‘segment’ report. See the ‘capital employed’ in each business segment and the profits that come out of it. The probability is more than half that the non-core businesses generate a poor Return as compared to the core business. Clearly, it is an abuse of corporate governance.

 

In every investment choice I make, I like to see ‘capital allocation’. Many big names do badly on this score. The MCA should wake up to this gross mis-governance by companies and take steps to engage the non-promoter shareholders in such decisions. Otherwise, we will have ‘professional’ and ‘family’ managements destroy the other shareholders. And surely, no such data or information is ‘confidential’ or would materially change anything.

 

As the regulator does not oblige me, it is better that I vote with my feet. Why invest in to companies that engage in corporate action without a prior dialogue with other shareholders? If you follow this one rule, you will keep yourself out of poor managements. If the management has no use for the surplus generated, it should give it to the shareholder as dividend or buy back shares. Look at companies like HUL. They do not diversify in to ‘wind power’ or ‘NBFC’ business.

 

R Balakrishnan

 

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11 thoughts on “CAPITAL ALLOCATION

  1. Sir, why should shareholders be asked about how to allocate capital. That is the CEO’s job assisted by the BOD.

    Asking shareholders about how to deploy capital is very much like Kejriwal’s SMS Way of managing affairs. Look at the mess created in New Delhi.

    If we do not approve of the way capital is being allocated, we are free to move it elsewhere, no?

    Liked by 1 person

    1. Nilesh, Probably I have not been able to communicate my thoughts well. In the UK I have seen independent reports that are given to shareholders, when it comes to accepting or refusing offers for take over or merger and they are truly helpful. Shareholders are asked about the business goals. And non promoter shareholders can be smart. I am not referring to the 100 share fellow who cannot think. But they are the ones who get assisted if there is a good wicket keeper. When the CEO wants to screw up, it would be good if someone were to pull him up or restrain him. It surely is wishful thinking, given the fact that the rich write the rules. And yes, if I do not like what someone does, I just do not be with him.

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      1. Sir,

        I agree with your line of thought. But as an outside shareholder one can seek capital protection by other means than shareholder activism. . . Even if we do not like what someone does, we may still continue to be invested with him if :

        1) The underlying asset is grossly undervalued;
        2) The underlying business is so good that it can continue to have profitable growth despite some capital misallocation &
        3) In hope of better business sense prevailing in the future.

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  2. Totally agree. Problem is shareholders have no clue. They are presented with a fait accompli. Robbed blind. So maybe have an ‘independent’ committee appointed by SEBI which can give its independent view to shareholders on any diversification/M&A etc. Make it more difficult. And at least bring it to notice. Maybe some pension fund will take on litigation. My view is that the legal system should not be one sided- Today, everything is in favour of the promoters- And they pay off politicians from shareholder moneys

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  3. Misallocation of capital due to either lack of character or lack of competence or both is always a possibility. As outside shareholders we may have to live with it.

    We can try to protect ourselves against consequences of misallocation of capital by buying low (in comparison to replacement cost) or by buying into highly profitable businesses.

    Leaving it to SEBI appointed independent committee may not be a good idea. There’s not much comfort in being robbed by the blind than being robbed blind.

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  4. Well said and i totall agree and i am giving below live example.

    Pl take a example of SBI associates merging with SBI. There is no proper revaluation of reserves, investments and NPAs. Based on in priciple nod of Govt, Some arbitary date was choosen for Swap ratio. that too SBI associates produced loss in even retail banking. How it is possible unless they are lending to very very very poor peoples or very very smart peoples. There is no protection for small investors or minority shareholders. They want group of 100 minority shareholders to file grievance for this merger. Why the person having 100 shares of SBBJ not even eligible to register his/her grievance. What an armtwist by SBI?

    Bala sir, i request ypu to take this merger issue forward in moneylife.

    RRR said Real estate liquidation of banks can be used as capital infusion. SBI babies and SBI is having huge Real estate with no proper valuation. this would be a moment to create welath for shareholders and take out the right NPA ( pumkin hidden in rice grains).

    what a mockery by SBI management? i did not expect this from Govt.

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  5. LOL

    It is the CEO’s role to allocate capital. It is an open secret that people as well businesses flush with cash more often than not do stupid things with it. Because they CAN. other beggars CAN’T!

    A promoter starts a business to make himself richer not to serve the society. If as a shareholder you don’t like what the CEO is doing – you are free to exit the stock!

    (you can add a blog post – when to sell a stock ? — When ITC goes into Hotel business blah blah )

    Do you think an average moron who reads all the financial blogs knows which is a better allocation of capital ? More often than not he/she bought the stock for dividend or got some SMS on their smartphones.

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  6. funny that this article appears in Deccan Chronicle .. perfect example of capital allocation to meet personal goals of promoters leading to bankruptcy , loan defaults , criminal proceedings etc…

    ravi

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