Track capital allocation

In every investment choice that I make, I like to see capital allocation. Many big names do badly on this score.

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. 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 something which 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 optimise capital allocation so that it generates as much wealth as possible for its shareholders.

However, neither the ministry of corporate affairs 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’.

Sebi and 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!

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 that I make, I like to see ‘capital allocation’. Many big names do badly on this score. The ministry of corporate affairs 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.

The writer is a veteran financial advisor. He can be contacted at balakrishnanr@gmail.com