Investment Strategy 2.0

January 19 2020

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Recently, market commentator Saurabh Mukherjea pointed out the  formalisation in various sectors of the Indian economy leading to the  emergence of one or two giants in each industry, thereby creating a  market structure where a larger share of the profits sits with fewer  firms. The price action India witnessed last year with the BSE Sensex  soaring even as BSE Small-Cap index failed to keep up would provide  further credence to the theory.

The above-mentioned ability of  large firms to capture larger profit shares and investment dollars would  imply that there is value in considering a business that can create  "accretive" growth platforms that, in turn, can create future giants.  Essentially, now is perhaps the time when investors, including local  conglomerates and foreign funds, must look at sectors that still have  structural demand but are constrained by poor capital allocation and,  more importantly, lack of access to capital. The trifecta of deal  sourcing, deal-making, and truly creating operating efficiencies can be a  game-changer.

Primarily, the major focus for funds in India has  been on carve-outs or traditional buyouts of companies in India. In a  carve-out, the fund primarily acquires an asset that perhaps a large  conglomerate is divesting. Alternatively, the traditional buyout  business has seen investors take a stake in an existing business. Going  forward, creating "platform companies" that can be growth accretive  platforms is a strategy worth pursuing. The focus of the "platform  companies" will have to be not just growth, but growth that can drive  the levers of value creation through volume expansion and margin  improvement at the same time.

Quite simply, one can think of the  value of businesses as the present value of the free cash flows a firm  generates. The free cashflow is essentially the difference between the  "return on capital" and "cost of capital". The phenomenon Saurabh  Mukherjea talks about is the fact that smaller businesses in India have  struggled to generate a significantly higher return on capital over and  above their cost of capital. And this is where investors need to step in  to create growth-oriented platforms that can generate profits through  creating efficiencies.

While creating such platforms, the focus  must remain on using growth and related scale advantages to expand  margins and indeed, create pricing power, lower cost of borrowing and  improve operating leverage. Fundamentally, improve free cashflows  significantly.

The ability to create platforms that can be  profitable and generate value will stem from the capacity to truly  expand margins and lower the cost of capital through acquisitions and  growth that do help in achieving the two objectives. The phenomenon of  large efficient companies capturing more significant market share is  amongst other factors driven by the virtuous cycle of a lower cost of  capital allowing them to do "projects" that offer a lower return and yet  the project still helps them reduce their cost of capital further --  thereby creating a cycle of growth, margin expansion and profitability.

To  illustrate the above point, suppose there are two companies A and B.  Company A has a cost of capital of 10 per cent while that for Company B  is 14 per cent. A project that offers a return of 12 per cent is not  only profitable for company A but may even assist in synergies that may  help further lower the cost of capital for company A. What the "inners"  as such have been able to do is to continually work towards growth that  has assisted them in creating more substantial free cashflows, thereby  allowing them a lion's share of sector profits.

Value accretive  investment platforms are a phenomenon quite visible in the West. While  their merits and demerits can be debated, the fact remains that when  done well, they have created significant value. The IACs and AB InBevs  of the world have demonstrated that growth-oriented accretive platforms  can generate value for all, including for both the end consumer and  shareholders.

Creating such platforms will also allow investors  to have a higher level of control on the debt structure of the business.  Issues around debt have hurt investors and businesses alike in India.  When one adds to the mix that Indian debt-markets are still evolving,  one realises that a good investment thesis in India will require much  more thought, control and execution around the capital structure.  Identifying high-demand sectors is a good start, but unless in the  long-run one can ensure that the return on capital is higher than the  cost of capital, high growth may not always guarantee high investment  returns.

In the quest for the next phase of growth and returns,  growth accretive platforms deserve focus. However, success will need  time and operational diligence. The winners of tomorrow may be decided  in no small extent by the capacity to be hands-on and create the next  phase of free-cash-flow generators.

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