What does it take to be a successful investor? Saurabh Mukherjea tackles this question in his book, Gurus of Chaos: Modern India's Money Masters, published by BS Books and Bloomsbury. This is the concluding part of a two-part series excerpted from the chapter "Simple rules for successful investing" of the book that explains the unique philosophies that power investment strategies of experts.
Let's take the example of Infosys, the large IT services company. Surely, I hear you say, given the amount that has been written on this sector, by now the IT services business is easy to understand-the vendor finds corporate customers in the West and then uses talented but low-cost programmers in India to write applications for these corporations. The vendor then installs this application in the offices of the Western company and gets paid a recurring amount as development and maintenance fees for its services on an hourly basis and, on rare occasions, an upfront license fee.
The reality of the Infosys business is very different.
Solutions led approach: Given that the old business of providing Application Development and Maintenance (ADM) business through skilled resources at low cost has become commonplace, providing 'solutions' (as opposed to providing programming talent) becomes the key to remaining competitive.
Focus more on cost efficiencies: As mentioned above, Infosys' customers have become far more price sensitive than they were, say, five years ago. As a result, the firm has to stay focused on managing costs by sharing resources (across projects and across verticals), by using 'just-in-time'hiring, by consolidating offices and by using automation (i.e. replacing programmers with software which can be used to write software).
Building for Social, Mobile, Analytics and Cloud based services (SMAC): The precise size of the SMAC opportunity might be hard to gauge, given the pervasive influence of these innovations on our lives. But it is clear that more and more IT services solutions will have to focus on emerging technologies. Infosys too needs to invest in developing these capabilities - either organically or inorganically to create future drivers of growth.
These two case studies - TTK Prestige and Infosys - help illustrate that the ability of a firm to add value, in the context of the world around it, is at the core of its ability to generate high ROCEs (and hence central to its ability to reward its shareholders). Over the past decade, in a relatively stable industry-kitchenware-TTK Prestige has innovated systematically and, by and large, successfully, to create a thriving business with ROCEs close to 30 per cent.
In contrast, in a relatively dynamic industry - IT services - Infosys has struggled to adjust to the changes taking place in what its customers want, how they want it and how much they are willing to pay for it. As a result, Infosys' value levers (focus on solutions, focus on costs and build for SMAC) are largely the recipe for it to cope with a changing market whereas TTK Prestige's value levers (product innovation, distribution & supply chain management, top quality management) are the core drivers of its success over the past decade. The trick therefore is to understand how many different types of products a company manufactures, how it manufactures them and how it sells them. Associated with this is a flow of cash - from the time the company buys raw materials, to the time the goods leave its factory and until the point the company receives payment from its customer. Understanding this process-how a company generates cash and then re-invests it to generate even more cash - is at the heart of understanding a business model. Successful investors refuse to consider investing in companies where they cannot understand this process relatively easily.
Let's take the example of Infosys, the large IT services company. Surely, I hear you say, given the amount that has been written on this sector, by now the IT services business is easy to understand-the vendor finds corporate customers in the West and then uses talented but low-cost programmers in India to write applications for these corporations. The vendor then installs this application in the offices of the Western company and gets paid a recurring amount as development and maintenance fees for its services on an hourly basis and, on rare occasions, an upfront license fee.
The reality of the Infosys business is very different.
- Only a third of the company's revenues are from the sort of Application Development and Maintenance (ADM) mentioned in the previous paragraph. The other third of its revenues arise from Consulting and System Integration, while functions such as Testing (9 per cent of revenues), Remote Infrastructure Management (7 per cent), BPO (6 per cent) and Products (5 per cent) account for the rest.
- Only 70 per cent of Infosys' employees are in India; the rest are spread around the world with major development centres in US, Latin America, Australia, China, UK and western European countries. Furthermore, with increasing focus on local employment by Western economies, IT services companies need to increase the proportion of local staff in their customer locations overseas.
- A significant percentage of its revenues (43 per cent) are now from fixed price contracts where revenues have a weaker correlation with employee headcount (compared to 'time and material' contracts where there is a direct correlation between revenues and headcount). Indeed, there has been rising demand for 'outcome based pricing', where the vendor is rewarded based on savings generated for the clients. Furthermore, around 5 per cent of Infosys' revenues come from Non-Linear Products, Platform and Solutions businesses. All these developments indicate that Indian IT outsourcing is no longer just a body shopping business.
- Historically, agreements in the IT business allowed vendors to pass on the compensation paid to their staff for cost of living adjustments (COLA) to the customer. However, as the IT services industry matured, the balance of power shifted towards the customers. As a result, nowadays customers simply do not want to countenance COLA-related price hikes. This impacts the IT vendor's margins (since the vendor can no longer pass on the higher cost of wages to the customer) andthe only way to deal with such margin pressure is for firms like Infosys to become far more focused on costs.
- Emerging technologies that have powered a slew of interactive tools and products (Social Networks, Media, 'Big Data'Analytics and Cloud Computing) are disrupting the traditional IT services business model. The conventional license model is transitioning into a 'pay-as-you-use' model that implies smaller contract sizes for IT services firms. In light of these changes to the IT services business, the three critical 'value levers' for Infosys therefore have become:
Solutions led approach: Given that the old business of providing Application Development and Maintenance (ADM) business through skilled resources at low cost has become commonplace, providing 'solutions' (as opposed to providing programming talent) becomes the key to remaining competitive.
Focus more on cost efficiencies: As mentioned above, Infosys' customers have become far more price sensitive than they were, say, five years ago. As a result, the firm has to stay focused on managing costs by sharing resources (across projects and across verticals), by using 'just-in-time'hiring, by consolidating offices and by using automation (i.e. replacing programmers with software which can be used to write software).
Building for Social, Mobile, Analytics and Cloud based services (SMAC): The precise size of the SMAC opportunity might be hard to gauge, given the pervasive influence of these innovations on our lives. But it is clear that more and more IT services solutions will have to focus on emerging technologies. Infosys too needs to invest in developing these capabilities - either organically or inorganically to create future drivers of growth.
These two case studies - TTK Prestige and Infosys - help illustrate that the ability of a firm to add value, in the context of the world around it, is at the core of its ability to generate high ROCEs (and hence central to its ability to reward its shareholders). Over the past decade, in a relatively stable industry-kitchenware-TTK Prestige has innovated systematically and, by and large, successfully, to create a thriving business with ROCEs close to 30 per cent.
In contrast, in a relatively dynamic industry - IT services - Infosys has struggled to adjust to the changes taking place in what its customers want, how they want it and how much they are willing to pay for it. As a result, Infosys' value levers (focus on solutions, focus on costs and build for SMAC) are largely the recipe for it to cope with a changing market whereas TTK Prestige's value levers (product innovation, distribution & supply chain management, top quality management) are the core drivers of its success over the past decade. The trick therefore is to understand how many different types of products a company manufactures, how it manufactures them and how it sells them. Associated with this is a flow of cash - from the time the company buys raw materials, to the time the goods leave its factory and until the point the company receives payment from its customer. Understanding this process-how a company generates cash and then re-invests it to generate even more cash - is at the heart of understanding a business model. Successful investors refuse to consider investing in companies where they cannot understand this process relatively easily.
The author, who is Head of Institutional Equities at Ambit, has been nominated the Number 1 Strategist in India in 2014 by Asiamoney