How can retail investors identify if management is misallocating capital?
Investors put money in any company with an expectation that management will utilise this money efficiently and generate profits. Wealth creation for its shareholders is, after all, the primary aim of a company. However, there are times when companies invest their capital sub-optimally and thus, fail to meet the expectations of shareholders.
Therefore, investors have to be careful where they invest their hard-earned money to avoid the companies that allocate capital poorly. This can be done by an in-depth study of available annual reports of the company and studying its history of financial management. The annual reports contain data to assess and analyse the outcomes of various investment decisions taken by the company. These may include decisions like capacity expansion (capital expenditure), acquisitions of new businesses, investment in subsidiaries and joint ventures, investment of surplus money in financial instruments, etc.
Given below are some of the examples of how management often misallocates capital and how you, as an investor, can identify these instances of poor capital allocation.
Poor returns in mainline of business -
A large diversified company may have several lines of business; however, the primary business is the one that generates most of the company’s profits. A good example of this is ITC, which operates through four segments namely, FMCG, hotels, paperboards, paper & packaging, and Agri-business. However, it is the cigarette business (part of FMCG) that generates around 85 per cent of the company's operating profit. Hence, the performance of the main line of business is critical for such a diversified company. Many times, companies are not able to run their core business efficiently and as a result, investors notice that the money invested is not able to create returns for the shareholders. Investors need to be careful in their analysis and investment decisions related to companies where the main business is producing poor returns.
Loss-making subsidiaries -
It is often seen that subsidiaries consume a lot of money in terms of equity investments, loans & advances. These subsidiaries may be complementary to the main business or run independently. If subsidiaries are loss-making entities, it is not easily identified by investors who look at consolidated financials because the profits of the main business of the company mask the poor performance of the subsidiaries.
Therefore, it is important for investors to analyse the outcome of investments in each of the subsidiaries and study the annual report in detail. Companies usually disclose critical information about the subsidiaries in the detailed notes & paragraphs to the financial statements, which are not captured in the summary financials provided by various online sources.
Poorly planned acquisitions -
When mergers and acquisitions cost billions, mistakes can not only cripple an acquiring company financially by committing its capital reserves but a high-profile failure can cause severe wealth erosion for the shareholders of the company. A good example is Bharti Airtel’s acquisition of Zain, a Kuwait-based telecom company's assets in almost 15 countries of Africa. This acquisition took place in 2010; however, even five years post-acquisition, the company suffers from low EBITDA for various reasons. Bharti Airtel lacked in their due diligence and later discovered that Zain had not invested enough in the assets of Africa and hence, the acquisition was considered a failure.
Acquisitions that are completely unrelated to the main business and done with an aim to diversify its business activities may end up consuming a lot of cash & resources but do not produce commensurate profits in return. Hence, an investor should assess companies that undertake acquisitions on a regular basis with a lot of care before making any investment decisions.
Losing investors’ money in derivative transactions
Derivative transactions carry a lot of risks and can result in severe losses if not used cautiously. This holds true for both individuals as well as companies. There have been several instances where companies have lost money heavily in derivates by speculating or by entering into derivative transactions to hedge risks like foreign exchange fluctuations.
A good example of such a company is Indo Count Industries, an Indian textile player having a significant share in the home textile segment of the USA with marquee clients such as Walmart, Target, etc. The company was going through a rough phase during 2008-2010 due to the global financial slowdown and was facing deep losses due to various financial decisions. One of the decisions which hurt the company was to enter into a forward derivative contract that led to losses of Rs 150 crore. When the rupee was at Rs 41 per dollar, the company took a forward contract that the rupee would appreciate to Rs 35 per dollar but instead, it went to Rs 55 per dollar. According to the company, this event pushed them into corporate debt restructuring and set them back by at least three years.