‘Rome wasn’t built in a day’ is an equally true statement for a good company. Yet our inquisitive mind keeps searching for the best company today. There are quite a few parameters which define a good company. The secret, however, lies with the management and the promoters who are behind the wheel. We find ample examples of visionary leadership and charismatic CEOs who created a mark through their leadership style, guidance to the capital market and communication to trade analysts. But the question remains – “What makes a Good Leader who in turn creates a Good Company?”

 

William N. Thorndike, a brilliant Harvard Graduate is known for interviewing people like Warren Buffett, John Malone, and many others. In his highly acclaimed book ‘The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success,’ William interviewed some of the finest CEOs/Leaders of his century. The book gives a perspective on ‘what creates a good business and thereby a good company?’

 

One of the thoughts that resonated in the interviews was the idea of defining a great company. Most of the time we find, the reported earnings number is considered to be the best parameter for identifying a good company. We say good companies are those whose earnings are growing over a period of time. In simple terms, a company with a durable earnings growth is considered to be a great company to look and invest into.

 

However, the idea of a good company with high net income numbers or positive earnings growth gets significantly distorted by the differences in the corporate debt, capital expenditure, and past acquisition history. A deeper analysis into earnings number creates further insight to a healthy ROE (Return on Equity) and ROCE (Return On Capital Employed) that defines how efficient the management of the company is, in generating high profits from available resources (namely equity & debt). So a high ROE and/or a high ROCE can be a great indicator of a great business. But what does this simply mean?

 

In simple terms, it is the return on funds from shareholders as well as the return on funds from the reinvestment of profits. Great companies are those who create enormous profits, hence creating long-term shareholder value.

 

But how do companies create the fund for shareholders? How do they create profit to reinvest that pull the ROE?

Here comes CAS (Capital Allocation Strategy). A capital allocation strategy is about deciding on how to deploy company’s available resources to earn the best possible returns for the shareholders. So the secret of great companies lies in ‘Capital Allocation Strategy’ and not only on the sales and earnings forecast. Barry Schwartz in his book ‘The Paradox of Choice’ defines ‘what is a strategy?’ He simply explains that in business terms, “….strategy is all about making a few choices from the large available choices that create durable positive impacts on business numbers…”

 

So what defines a great Capital Allocation Strategy?

In the modern regulated environment, business generates capital through three routes –

  • Internal cash flow
  • Raising debt
  • Issuing equity

And what do you do when you have generated enough capital?

There are five things that a company can do with their capital.

  • Invest in their own business (CAPEX plan)
  • Buyout other businesses (Business acquisition)
  • Issue dividend to shareholders
  • Pay off debt
  • Repurchase shares

Each of these has a significant effect on the business over the short and long term. None of these substitute the other. But definitely, they work in great combinations at different market cycles.

 

How do these strategies work?

In rising market when stock prices are growing, issuing equity is a great option to generate positive cash flow; while in falling market, investing through share buy-back of your own company can be a great strategy. While others are fearful of your business, you are greedy enough in your own stuff – is a great way to high EPS (earnings per share). But in reality, many companies do just the reverse. Rather than investing in their own businesses, such business leaders start diluting equities or start selling their businesses. During bad times, all great leaders who have made great businesses, have either stayed put to their share repurchase program or have undertaken a business acquisition strategy. In others words, great business leaders are greedy while their peers are fearful in bad times. And that creates Good Business in the long term.

 

Good Business Bad Business

In early 2005, when IBM finalized the $1.75 billion sale of its PC unit to China’s Lenovo, a startling fact came to light. The IBM unit had been losing money at least since 2001, with the red ink totaling $965 million over the three years prior to the sale. Again, a company credited with creating the corporate market for personal computers failed to strategize well, when margins collapsed in their high-margin business.

 

In 2008 during Lehman Brothers crisis, when every other business leaders were planning to sell their businesses, Warren Buffett was busy writing cheques to make large acquisitions. One of his acquisitions was the famous deal with Goldman Sachs after eight days of Lehman-burst. The deal earned him more than 60% of return on his investment of $5 billion, in less than five years. Thus, while one business went bankrupt, some other business made 60% of return on its strategy. No business is bad unless ‘You’ run it badly.

 

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Romit Barat
Romit Barat

Romit is highly experienced in understanding Market Dynamics. He's a voracious reader and his flair for writing is deep rooted in his noteworthy insight on market behaviors that otherwise go unnoticed.

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