A year ago, my colleague Gaurav Mehta and I discovered that the Nifty churns by over 50 per cent every decade. This churn ratio is very high, compared to developed markets (where churn ratios are around 25 per cent) and to other major emerging markets (with churn ratios of around 35 per cent).
So why does the Indian market have such a high churn ratio? Consumed by this question, four months ago, we teamed up with the respected equity strategist, Anirudha Dutta, and launched an intensive research exercise. Our research has led us to realise that across all parts of the Indian market, great companies systematically slide towards mediocrity.
We found that the average probability of a sector leader remaining a sector leader five years later is only 15 per cent, implying that 85 per cent of BSE 500 companies slide towards mediocrity.
So why do successful firms slide with such regularity?
Promoters, in their own explanations for underperformance, tend to cite external factors (such as business cycle, Government interference, rising competitive intensity or the macro environment). However, such explanations are not always convincing because within the same sector (and hence subject to the same regulatory and competitive forces), whilst some firms are sliding, others are rising. Contrast, for example, the performance over the past five years of Infosys vs HCL Tech or Bajaj Auto vs TVS Motors. In our view, the slide is primarily due to poor strategic decision making.
Using a framework primarily based on the works of Jim Collins and William Thorndike, we can see that once companies achieve great success, they are often consumed by “hubris and arrogance” -- the bonuses, the awards, the press coverage, etc tend to have a bearing on most management teams’ self-perception. Overconfident management teams then make poor strategic decisions which usually involve unbridled expansion and the misallocation of capital. As a result, RoCE and RoE starts sliding and gradually, financial stress builds up.
As the share price loses its sheen, the company gets to use Collins’ phrase “Stuck in a rut”. Often cost discipline and/or product excellence erodes and prices are then raised. Profits, return multiples and valuation multiples start sliding. Company politics thrives. The leader becomes increasingly autocratic and announces ‘recovery plans’ that aren’t based on accumulated experience.
Then comes the sacking of the leader as the falling company now “grasps for solutions”. Often the new leader tries to fire silver bullets (a ‘transformative’ acquisition, a blockbuster product, a cultural revolution, etc). However, a new leader (ideally, someone from inside) who takes a long hard look at the facts and then acts calmly to put in place a measured recovery strategy with sensible use of cash and capital at its centre, could be the saviour.
Finally, we reach the climactic stage in the decline of a great company. Usually, the firm is sold or fades into insignificance or, and this happens rarely, shuts down. Occasionally, however, the firm pulls back from the brink and under its new leader, it begins the long slow climb to recovery.
Case study: Tata Steel
In the years spanning FY01-05, Tata Steel generated more cumulative Ebitda (Rs 135 billion) than it had generated in totality over the previous 15 years. Tata Steel’s RoCE rose from 10 per cent in FY00 to 61 per cent in FY05. With success came several awards. In 2004, Tata Steel, received a special ‘Leadership in Excellence’ plaque from the Tata Group to mark the company’s progress up the ‘Quality Value’ ladder. At this stage, Tata Steel was regularly being feted by World Steel Dynamics as one of the most-efficient and low-cost global steel companies.
In October 2008, Tata Steel won the Deming Prize, the manufacturing equivalent of the Nobel Prize. In November 2008, at a special ceremony in Tokyo, Muthuraman, who would eventually be bestowed the Padma Bhushan by the President of India, received the Deming Prize.
In August 2004, Tata Steel announced the acquisition of NatSteel, a South Asian steel maker with around 2 mt (million tonne) of steel capacity for ~SG $260 million. In December 2005, Tata Steel acquired Millennium Steel, Thailand, which has a 1.2 mt steel-making capacity and 1.7 mt long products rolling capacity.
And then came the mega acquisition -- in 2006, Tata Steel bid for Corus. The total acquisition cost for Tata Steel was $12 billion, which was funded through a combination of debt and equity. To put this acquisition into perspective, Tata Steel’s FY06 shareholders’ equity was just over $2 billion. To this date, this acquisition remains the largest by an Indian firm.
A year later Lehman went bust and the end of the liquidity-fuelled global growth cycle was especially harsh for European steel makers. Capacity utilisation in Europe fell and Tata Steel Europe reported an Ebitda loss in FY10 and in every single year post FY10. Senior management at Tata Steel Europe has seen multiple changes, with the MD being changed thrice within a span of two years.
Even as the firm’s consolidated return on equity declined from 32 per cent in FY08 to -17 per cent on FY10 and 7 per cent in FY12, senior executives from Tata Steel India who were deputed to Europe also returned to India within a short span as differences of opinion within the firm rose. The parent company also went for multiple rounds of equity dilution between 2007 and 2011.
Tata Steel undertook several measures to re-structure its European operations. Simultaneously, Tata Steel went ahead with expansion plans in India to increase capacity from 5 mt to 16 mt. Over FY08-12, capacity at Jamshedpur increased from 5 mt to 10 mt. Furthermore, the company is continuing with a 6 mt greenfield expansion at Kalinganagar (which has overshot its original budget by $2 billion). Net debt levels for the company have remained elevated at around `500 billion since FY08 (implying consolidated debt to equity of 1.6 times at the end of this financial year).
Tata Steel has posted a net loss of Rs 70 billion in FY13. According to the April 2013 cover story in Forbes, Tata Steel is looking for a new European head. The company also looks likely to get a new MD in the coming months. The current Group CFO, Koushik Chatterjee, is tipped to get the job. In effect, Tata Steel is about to enter the final stage of the corporate decline cycle.
Our findings have significant implications those who like investing in the most successful Indian companies. For starters, given how frequently great Indian companies fail, paying premium valuations for sector leaders (even as they are posting record results) is something every investor should think twice about doing. History says that such an investment strategy is highly unlikely to work.
Saurabh Mukherjea is CEO, Institutional Equities, at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.