Rethinking Shareholder Value

THEME/SHAREHOLDER VALUE

Ask any CEO what his prime goal is, and the chances are he will say "maximising shareholder wealth". Ask him whether the current share prices reflect his company's underlying value, and he will probably weep on your shoulders. Take a look at the five-year earnings growth of any two companies in the same industry and their relative market capitalisation growth, and you will know why: companies that are in the same league in earnings are not necessarily so in the market-cap league. Result: heartburn.

Example: Between 1997 and 2002, the earnings per share (EPS) of Tata Elxsi grew at a compounded annual rate (CAGR) of over 100 per cent. Infosys grew at 21 per cent. But market capitalisation of the former grew at 40 per cent and the latter at over 100 per cent.

Look at similar performances across different industries, and the difference is even more stark. Tata Power's EPS grew a mite faster than Infosys', but its market cap grew at a CAGR of just under 10 per cent over the five-year period.

Question: Why does the market value similar looking performances differently? That brings us to two corollary questions: Who determines valuations? And, what can a company do to deserve a better valuation? First, though, it is important to understand what constitutes the market. Investors in the stockmarket can be broadly classified into five groups: FIIs, domestic institutions (including UTI, LIC, GIC and mutual funds), HNIs (high-net-worth individuals), day traders and retail investors.

While all of them profess an inclination to buy or trade in "blue chip stocks" there are subtle differences in the ways they make their picks. All FIIs, for example, want "growth" stocks. Says John Band, CEO of ASK Raymond James: "A critical factor affecting foreign investors' decisions is the exchange rate fluctuation. A foreign investor needs to generate returns high enough to cover the loss due to the depreciation in rupee. That is a reason why several old economy stocks such as those in the utility segment fail to attract FII interest despite sustained good performance over the years. On the other hand, this also explains their overwhelming interest in growth sectors such as IT and pharma."

FIIs also look for large-cap stocks where volumes and liquidity are high. This makes it easier for them to enter and exit these stocks, when they need to in a hurry. Domestic mutual funds, on the other hand, often look for underlying value in a stock even if it doesn't currently have huge trading volumes. Says Bharat Shah, chief investment officer of Birla Sun Life AMC (Mutual Fund): "I do not bother much about (short-term) liquidity, i.e. daily turnover in the secondary market, because in my opinion if the business is good, the volume definitely picks up over time as more people discover value in the stock."

High-net-worth investors are equally willing to take bets on under-researched stocks in the hope of spotting multi-baggers. Rakesh Jhunjhunwala, who does only proprietary trading and no broking, says he looks at companies that can give him three things over and above basic non-negotiables like management credibility: quality of earnings, free cash flows, and higher returns on capital employed. That should give companies a good target to work for if they want the market to notice their performance.

As for the other two categories - retail investors and day traders - the former tend to be influenced by what their brokers tell them about stocks or what they read about companies in the media. Day traders are beings of the moment. They will buy or sell any stock that has volumes and momentum. It is the interplay of these different sets of investors that finally determines share valuations.

Says Raamdeo Agrawal, joint managing director of Motilal Oswal Securities, an institutional brokerage house in Mumbai: "It may not be an exact science but surely there is a method in the madness. In a market made up of dispersed rational and irrational investors, there is overall rationality and market efficiency - in the broader sense that stock prices converge to their true value in the medium to long term."

Motilal Oswal has been bringing out annual wealth creation studies over the last few years (see box: page ????00). Based on their experience in tracking the process, its chairman and managing director Motilal Oswal says there are three different aspects to the whole process.

One is the environment: the basic domestic and global environment in which the company exists. For instance, new generation steel companies such as Jindal Vijaynagar and Ispat reportedly have the finest steel production facilities in the world. But such is the state of the global steel cycle ever since they went into commercial production, that no one bothers taking a second look at steel companies.

Steeped in losses and with bad financial engineering, there is little chance that any of the steel companies will immediately benefit even if there is a revival in the steel markets. Such companies are essentially out of the market radar and therefore, whatever they do, it is unlikely that the market will take any notice of them.

Matters get complicated at the second step: quality and worth of management. Assuming a company is a simple black box, which buys some inputs from the markets and produces some output, the obvious value addition that happens in the box is where the management comes in. A good management, with a great vision and understanding of the dynamics of global markets in which it wants to operate, will (i) not enter a business in which the return on capital employed is uncertain or even seen to be faltering in a few years, or (ii) choose an investment in which the return on capital is not the highest.

The latter point is easier said than done, management gurus say. If left to a cold blooded calculation of only return on capital or return on net worth, no one would invest in a host of industries. For instance, it would be a wanton investor who chooses to invest in the tobacco industry or the steel industry currently. On the other hand, everyone would want to invest in the pharma sector or in the auto ancillary sector.

But the management's vision comes into play when the company chooses not the top grossing industries but the lower down choices: that is, it allows its understanding of its own limitations and knowledge of respective industries to make a conscious choice against the industries that could offer the best return on capital. Management vision comes in when it can say to itself and to its shareholders upfront that we know only so much about this industry but we have this great idea which we think can make us stand apart from the competition.

Narayana Murthy of Infosys has often said that he and his six friends who founded Infosys were always short of cash but they had a single beacon idea: to write great dependable software. That single idea is what counts.

So management vision, that thing which goes inside the black box, is not about choosing the vendor with the lowest cost of inputs or the business that gives the most value added output per rupee invested, but getting a fix on what the market would possibly require and whether the management knows enough about a clever idea to deliver the products at the cheapest price to the end user.

The third aspect of the jigsaw is the equity market itself, which in a seemingly inexplicable way puts a value to a company. It is at this point that the interplay between the environment, the management and the market becomes even more complex. The market picks up different aspects of company behaviour - at the same time and at different times - and that selection may often be at odds with an earlier stance. For instance, there is a Mumbai-based MNC pharma company which releases goods only after it has realised the value of bank drafts deposited.

Its distributors queue up every morning. It commands tremendous respect in the market for such behaviour, which is seen as a proxy for its market power. But at the same time there are companies which are treated as arrogant and out of line with market developments if they do not provide 180 days credit to their distributors.

Indeed, at other times a company that pushes an aggressive sales strategy based on easier credit terms is treated as a visionary. But it would still be useful for corporates to understand what the markets are looking for and finetune their communication strategy to address these critical concerns.

VALUE SYSTEMS: Markets value a corporate's value systems, the sum of all the things a company stands for, that it will not forsake in good times or bad. Good value systems create goodwill in the market, and this begets better customers, better vendors, better and more motivated employees and in general, longer and happier relationships. Value systems are not accumulated nor proved overnight. There is this story of some smart office manager in Wipro sending out a note to all detailing confirmed car parking for CEO Azim Premji.

The chief replied to the mail saying, if he were so important to the company, he would obviously be the first one to come in every morning. So where is the question of confirmed car parking? And, if he is not so important, he obviously doesn't deserve it. The person who recounted this story says this is simply indicative of one thing: the CEO doesn't think of himself as the chief, but as an ordinary guy whose value is only because he adds value to the overall process.

The value system reflects in how a company approaches the corporate governance issue, the rights of minority shareholders, its accounting systems and level of disclosures. Says Rakesh Jhunjhunwala, a high-net-worth investor: "It is amazing that in a supposedly corrupt nation like India, the three companies having the highest market capitalisation - Wipro, Hindustan Lever and Infosys - are companies with the highest perceived integrity. Sometimes, the ability of the markets to filter and value truly astonishes me."

DIFFERENTIATION: Yes, the markets love a new story of a product or a process done differently.

Differentiation is important because if implemented and communicated well, it gives the company market power. That means a wealth of difference to its cash flows and its overall bottomline. Market power is what makes Hindustan Lever so special. It has a negative cash cycle; it does not put in any of the shareholder's money into the production cycle; its distributors pay it in advance to produce the goods that it delivers on a later date.

Differentiation is also the reason why some companies can sell bath soaps at Rs 14 per cake whereas others have difficulty selling almost the same thing at Rs 8. Consumers, of course, don't know that almost all brands of soap are contract manufactured at a few facilities in Mumbai: so the Rs 14 soap and the Rs 8 soap come out of two different streams within one production cycle with roughly the same ingredients. Says Bharat Shah, CIO of the Birla Sun Life AMC: "A strong product or brand makes a business relatively stable."

COMPETENCE OF MANAGEMENT: Market sources quote the example of two companies, an MNC and a domestic company, which produce Hepatitis-B vaccines. The MNC sells it for Rs 125 a vial whereas the domestic company sells it as Rs 30 a shot. More people prefer to buy their shots from the MNC because they probably expect it to deliver consistently good quality.

Says Nilesh Shah, CIO of Franklin Templeton India, one of the largest private sector mutual funds in India: "In my opinion, the performance of a company's stock on the bourses is closely related to the performance of its products in the market. That is the reason why Sir John Templeton, the founder of Templeton group, placed the quality of business as number one among his 16 principles of investing." A pricing difference in the same product category can mean one of two things: the relative market perception of its value, or management's inability to convert a cost advantage (which enables it to sell at lower prices) into a significant strength - something the stockmarkets can assess for themselves.

COMMUNICATION WITH INVESTORS: Most companies communicate poorly with investors. They either push "good news" too hard when it happens, or disappear from view when they have only "bad news" to offer. A company's credibility is built not by the amount of good news it can put out in the media, but by the quality of its overall communication with investors.

Take the case of Infosys: Apart from the usual quarterly analysts' meetings and conference calls, it takes care to ensure that all information that has a material impact on the company's earnings potential is shared. Says a company spokesman: "We believe that our shareholders have the right to get all information which would allow them to take their investment decisions. We take sufficient care to communicate both the good and bad news to our investors on a timely basis. In April 2001, when the technology spending slowdown was in its initial stages, we guided the market for a 30 per cent growth in fiscal 2002."

The company also ensures that information is not merely available to big investors or privileged stakeholders but to all. "We respond to most investors' queries by e-mail or telephone. We treat all investors alike. We provide all information and address all the concerns of all the investors, irrespective of their size," the spokesperson adds.

A pioneer in the area of openness an corporate transparency, Infosys has a huge advantage over similar companies. Observes Jhunjhunwala: "Over the years I have observed that the pioneers and innovators are rewarded disproportionately (by the markets)."

GETTING NOTICED: Even with a good communication strategy, it may not be easy to get noticed by the market. Consider the stats: Of the 6,000-plus stocks listed on the Bombay Stock Exchange, barely one per cent - about 60 of them - are actually extensively researched.

Meaning, only these stocks have several analysts tracking them and reporting about developments on a daily or weekly basis. Not surprisingly, these are the focus of market interest and trading volumes. Outside this charmed circle, there is another group of around 80-100 stocks that are infrequently researched, or researched only on specific requests by high-net-worth investors or mutual funds.

Invariably, these two groups of stocks attract investors and traders alike - and that's where shareholder value is delivered on the basis of corporate performance.

Which brings us to the question: What must companies do to get noticed? Interviews conducted by Indian Management over the last few weeks with big investors give us clues on what the markets are looking for (See voices, page 36). Here's a checklist of when the market is likely (or unlikely) to take note of a company's performance:

NOT EPS, BUT ROE: Over the last 10 years, the market has learnt to differentiate between real performance and mere numbers. Most investors look at three sets of numbers closely: the return on equity (or return on net worth), free cash flows, and the return on capital employed.

Says Shah of Birla Sun Life: "A high ROE does not necessarily reflect quality management. At times favourable demand conditions and high margins make companies profitable. But when high ROE is sustained over a period of time it gives us sufficient reason to believe that the management has been certainly doing the right things to create shareholder wealth. Further, if the ROE is rising, it is even better." Motilal Oswal says that companies that reported ROEs of 35 per cent, created over 50 per cent of market wealth during the 1996-2001 period.

CAPITAL INTENSITY: Investors reward capital hungry businesses less munificently. Take an example: Reliance and Hindustan Lever had sales of Rs 25,320 crore and Rs 10,972 crore in the latest accounting year. But the latter has a far higher market-cap of Rs 43,254 crore as compared to the former's Rs 27,266 crore as on May 23, 2002. This was despite two years of slow growth.

The reason: Reliance raised huge amounts of capital throughout the eighties and early nineties (in associate companies), while Levers mostly used its own free cash flows for investment. Says Dileep Madgavkar, CIO of Prudential ICICI Mutual Fund: "The market normally undervalues companies which tend to tap the market frequently. Investors prefer cash-flow-rich firms which finance their growth with internal accruals."

GROWTH: Companies that are perceived to be growing are valued higher by the market. Says Chandresh Nigam, CIO of Zurich India Mutual Fund: "Some companies are valued on the basis of the expected growth in its business which, in turn, is likely to be reflected in the financials over a period of time. Many others are valued simply on the basis of the current payoffs measured in terms of the dividend yield. These are normally commodity firms with little or no surprises expected in the company's performance."

CYCLE AND LIFE-CYCLE: Share valuations can change depending on whether a company is facing a cyclical downturn or upturn, and also if the industry itself is in an early stage of growth. Says Gurunath Mudlapur, head, equity research, Khandwala Securities: "Two major determinants of stock valuations are cyclical movements and the life-cycle stage. For example, Tisco is one of the most efficient players in the steel sector in the world. It is not able to get a high price-earnings multiple these days because the common perception is that steel prices the world over are likely to remain depressed in the near future."

On the other hand, says Mudlapur, "A company normally enjoys higher valuations at the growth stage when the business often reaps surprise gains by following innovative strategies. This is the stage when earnings are less predictable and thus such a stock is a high-risk, high-return proposition." This is the stage we are witnessing in IT and pharma companies and that explains their rich valuations.

LIQUIDITY AND FREE FLOAT: Opinion is divided on whether the availability of more shares for trading (the free float, or aggregate non-promoter holding) and liquidity improve share valuations.

Says Chandresh Nigam: "Market capitalisation and available free float matter for institutional investors and so does trading volumes in the secondary market. But it is clear now that the companies which tried to create artificial volumes in the market failed to sustain it over a period of time. So the liquidity should come from genuine interest in the stock to be sustainable." Shah of Franklin Templeton feels that this is not a big issue. "Issues like a relatively low free float or thin trading volumes in the market are secondary factors," he says.

INTEREST RATES: There are some factors that are totally external to a company - but they play a key role in determining share prices. Interest rates are one of them. When interest rates are high, the market tends to assume a high discounting rate for future cash flows of companies. Result: share prices fall even though the company may be performing well in terms of financial parameters.

In today's scenario, where interest rates in India have been continuously falling for two years now, the stockmarkets too have been ruling weak. Perhaps, company managements will get their wish after all as the markets realise that at current interest rates, companies with decent, predictable cash flows need to be re-rated.l

(Additional reporting by R Jagannathan & K Giriprakash)

 (This article appeared in the June 2002 issue of Indian Management magazine)