It reminds me of those famous words of Warren Buffett: “You only find out who is swimming naked when the tide goes out”. May be it is too late for many of us to realise, but it always pay to look back and learn from mistakes. One such interesting thing is about the illusion of assets.
Markets and investors like hyper-growth or fast-growing companies because of the hope of high returns and making a quick buck in equities. Thanks to the global economic crisis in 2008-09, investors now can vouch for how an illusion of assets has been created by companies and greedy promoters, and later on turn out to be a liability. The period between 2004 and 2008 has many such stories to tell. In a bid to grow, companies went overboard and acquired businesses despite lacking resources. They piled on debt, diversified into unrelated areas, expanded capacity when it was actually not required. They raised funds from all sort of avenues to create assets. In fact, the madness of the market allowed them to split businesses to have them listed separately. This helped promoters and companies to raise funds separately and create market capitalisation so high, that even banks felt the need to participate in the growth story and offer loans at their doorsteps.
Building Rome in a day
At this time promoters and companies realized that it takes only a day to build Rome. They actually did it. They pledged shares at higher market capitalization to raise huge sums of money to stay ahead in the madness of creating market capitalization. Money was raised till their necks, and later used to buy helicopters, yachts and other luxuries in the name of business. We as investors were happy because of the self-created illusion of assets. Analysts were telling us that the sum of all these assets, including helicopters and farm-houses was higher than the share prices in the market.
No! Rome was not built in a day
As more and more lunatic investors joined at the height a perfect storm developed. But the global economic crisis 2008-09 cracked the collective illusion of all analysts, investors and promoters. It is hard to know if promoters have learned their lesson, but, as an investor we have to learn a key lesson that assets which are not backed by sound business plans and cash flows are bound to become liabilities. Many of those so-called acquisitions are now bleeding. Moreover, money raised for these acquisitions and goodwill created in the accounts have turned into liabilities, which in many cases is larger than the net worth of these companies. Unwanted capacity expansion and unrelated diversifications are now eating into profits. In some of these cases the value of these assets is less than the cost at which they were acquired, which makes them liabilities. Would you agree how many power projects have become unviable and acquired coal mines have become liabilities rather than assets? We keep on hearing construction companies crying to sell projects to pay off assets turned liabilities. Today if you ask an analyst the value of those assets created in the boom time they will tell you it has negative value as they expect a negative contribution from these assets. Does this not mean that assets have turned into liabilities? In many cases equity invested in these assets has been (net worth) eroded and assets are now owned by banks. Promoters who were qualifying those acquisitions of assets and businesses as “best fit” and “a natural extension” to their businesses are now calling them non-core assets.
Asset trap
Those who follow Warren Buffett and value investing will agree that staying with businesses which undertake rational capital allocation, acquire companies that add value without adding risk to the balance sheet and those that diversify not for the sake of market capitalization but for sustainability and to create an economic moat should be preferred. A value investor will simply avoid a growth-hungry management that risks its core business and finances. Creation of assets in terms of huge capacity, acquiring big company does not ensure returns to shareholders. Today many companies have excess capacities and the new capacities are not utilised. On top of that servicing the debt has become a huge problem. Those forecasts of extraordinary profits have turned into extraordinary losses. One solution to this, as many value investors will agree, is to keep a tap on historical financials and pay more attention to its current earning capacity. One needs to ask if valuations tilted more towards future.
Creation of assets or owning them itself does not create wealth. It has to come with a sense of business and the ability of a company to own and retain them. If a business is entirely built on bankers' money at some time the bank will make more money than shareholders. Splitting businesses and listing them separately has certainly transferred money into promoters’ pockets but shareholders are left with the liability of owning them. We now see many companies reporting profits on a standalone basis but huge losses when results of subsidiaries and other businesses are consolidated. Companies take risks some time huge risk, but as an investor can we take that risk? What is the margin of safety that we have over its managers and promoters?
