Over 80% of ‘great’ Indian companies slide to mediocrity in a short span of time led by poor strategic decision-making fuelled by ’hubris and arrogance‘. Such faulty strategic decisions usually result in poor capital allocation which destroys RoCE and creates financial stress. Thus, the importance of evaluating and tracking strategic decisions to achieve long-term outperformance cannot be over-emphasised although it is an area that is often overlooked.
The systematic slide to mediocrity
We find that the average probability of a sector leader remaining a sector leader five years later is only 15%, implying that 85% of BSE 500 companies slide towards mediocrity. In fact, the average probability of a ‘great’ company becoming a sector laggard five years later is 25%. Even the Nifty ‘churns’ by around 50% or so every decade (as compared to around 25% for developed markets and around 30-40% in other major emerging markets). The tendency for large, successful companies to slide down the market-cap spectrum is not confined to the Nifty.
We use our ‘greatness’ model to assess the probability that sector leaders (defined as firms with a ‘greatness’ score in excess of 75th percentile of the sector) from five years ago are now amongst the sector laggards (defined as firms with a ‘greatness’ score of less than 25th percentile of the sector), i.e. what is the probability of self-destruction? We contrast this against the probability of sustaining leadership i.e. what is the probability that sector leaders are still sector leaders five years hence. We check this historically starting from 2003—for example, we assess the chances that a sector leader in 2003 was still amongst the sector leaders in 2008 and contrast this against the chances of it becoming a sector laggard by 2008 and so on.
The five-stage framework
In this note, we use a modified version of Collins’ framework and Thorndike’s approach to analyse capital allocation to understand why great Indian companies slide. The core stages in our framework are as follows:
- Stage 1 - Hubris and arrogance: The company is on top of its game. Operating margins, RoCE, growth, valuation multiples, etc., are at all-time highs. Captivated by the success in its core business, the management starts believing its own press. Success and adulation intoxicates the top brass. Arrogance sets in. The company loses sight of the factors which made it successful in the first place.
- Stage 2 – Unbridled expansion: In search of more growth and more adulation, the management begins an expansion drive which is often inorganic. The firm ’overreaches‘ into new geographies and product lines where it has no real experience or expertise. Sub-par capital allocation begins.
- Stage 3 – 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.
- Stage 4 – Grasping for solutions: The company thrashes around and looks for a solution even as profits and financial strength continue to slide. Senior management jobs are on the line. Often a new leader comes in and sometimes he tries to fire silver bullets (eg. 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.
- Stage 5a – Capitulation: The firm is sold or fades into insignificance or, and this happens rarely, shuts down.
- Or Stage 5b – Recovery: The firm turns the corner and begins the long, slow climb to recovery.
(Saurabh Mukherjea is CEO, Institutional Equities, Ambit Capital. Gaurav Mehta is an analyst with Ambit capital.)
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