What would you do if I give you the following information about a listed B2C company:

1. The brands of the company are jointly owned with promoter’s private entity.
2. The most premium brand owned by this company which brings a third of the revenue and bulk of the profitability, is under litigation, filed by company’s closest competitor and market leader, which claims that it registered it first.
3. The founding brother-duo are getting old (now in late 60’s) and its time for their next generation to take-over, we have no clue how competent they are and how well they gel with each other.

No matter how amazing the prospects of this company seem to be, would you be able to bet big on this opportunity? Take a while before you read further.

We are talking about ‘Relaxo Footwear’, whose stock went seven times in last three years. In  hindsight, it seems to be too obvious an opportunity  and frequently I hear people cribbing about how they ‘missed’ such an obvious story;  it had an amazing history of consistent and profitable sales growth led by healthy volume growth, they were shifting focus to premium brands like Flite and Sparx backed by robust advertisement campaigns to boost average realizations and thereby operating margins. We had Akshay Kumar, Salman Khan and Kartrina Kaif endorsing these brands and one could spot so many people around wearing those trendy red & black sandals and slippers. To top it all, there was a beautiful note by Prof. Sanjay Bakshi on how footwear in India is a huge opportunity which Relaxo led by Mr. Ramesh Dua (read ‘Intelligent Fanatic’) was determined to leverage. At that time, the market cap of this company was ~Rs 700 Cr., today it is  whopping Rs 5,000 Cr., a 7-bagger, before this recent market correction Relaxo had even crossed a billion dollar mark in terms of market cap.

What happened to issues raised above?

1). Promoter transferred ownership of all brands to listed company at Re1.

2). Relaxo reached an out-of-court settlement with Bata in exchange of one-time payment of Rs 60.8 Cr. (Aug’15), which seems extremely reasonable considering annual revenues of Rs 500+ Cr. and high margins of Sparx.

3). Second generation has started playing an active role in management, though it is still premature to talk about their competency and chemistry.

Think about the alternative outcomes if any of the risks stated above had played out:

1). Promoter start levying a hefty ‘Royalty’ for using brands owned by him (not at all uncommon, think Havells and Maruti) OR transfer these brands at a hefty price to the listed company (again not too difficult to imagine as these brands had indeed become big and their actual value must be in 100’s of Cr.)

2). Relaxo looses the right to use its premium brand name ‘Sparx’ to Bata, and the massive amount of money and decade long efforts that went into branding through marquee brand ambassadors like Akshay Kumar goes down the drain, profitability too takes a big hit as high margin flip-flops, sandals and shoes were sold under ‘Sparx’ brand.

For #1 we were totally relying on Management’s ethics, and

For #2 we were totally relying on Management’s competence.

The lessons from the above case study are as follows:

• In hindsight (ex-post) one may underestimate the risk (ex-ante) we faced by investing in this opportunity and may conclude it was a no-brainer, in reality it wasn’t.
• A perfect investment opportunity is a myth, one always has to take leap of faith somewhere, which makes management quality the most important parameter in investing.

Investing is an art and outcomes are always probabilistic. There are no easy ways to judge management quality. We have been regularly attending Relaxo’s AGM  where we got opportunity to interact with the promoters and also other shareholders, add to it the series of channel checks and  feedback from senior employees..all this gave us the conviction to bet big despite all those risks. We believe it is difficult to get that conviction being an arm-chair investor or blindly cloning others.

While judging management quality there are two key attributes to look for ETHICS & COMPETENCE. If either of it is missing, the probability of it turning out to be a successful investment is dim.We have some very smart business owners in India but they lack accountability to minority shareholders, at the same time there are very ethical promoters/management teams who haven’t kept with the times and lack competence to succeed.

Management Ethics

Though there are no easy ways to judge if a management is ethical or not, to us presence of any of the following is a red flag which warrants a deeper study:

 

1. Private companies of promoter group in similar Industry
2. Large unwarranted ‘Related Party Transactions’ specially for sale/purchase of goods & services – In some cases its okay like Swaraj Engines selling output to its parent M&M, in other cases there might be transfer pricing issues where it shows more profit in privately held companies.
3. Charging Royalty for brands, ownership of which lies with promoter or his privately owned companies (can be ignored in case of MNC’s if amount is reasonable)
4. Complex Corporate Structure; lots of subsidiaries and cross holdings, is generally used to ‘hide’ stuff.
5. Lack of Transparency & Poor Quality Disclosures – Only GDP/Macro Gyaan in Annual Reports, no Concalls/Investor Presentations, Management shying away during AGMs
6. Management Composition – High family involvement
7. Excessive salaries drawn by promoter family
8. Low Promoter Holding, Pledging of Shares (Interests may not be aligned with minority; incentive to siphon-off, deal in cash)
9. Frequent trading by promoter group in company’s share
10. Issuance of warrants to self at favorable terms (getting better with stricter norms by SEBI)
11. Political Connections

Management Competence:

How do we know if a Promoter/CEO is competent or not? Is it the qualification whether he/she went to Harvard, or is it the experience or the track record?

If it could be put simply in two words it would be a Promoter/CEO who is a good ‘Capital Allocator’

Company can raise capital by:

• Issuing Equity
• Issuing Debt
• Retaining Profits
• Selling Business Unit(s)

It can deploy capital by:

• Organic Growth: Investing in existing business
• Inorganic Growth: Acquiring competitors & diversifying into other industries
• Repaying debt
• Returning to shareholders by paying out dividends and/or buying-back own stock

In the long run, the single most important determinant of wealth creation by any company would be how it decides to raise and deploy capital i.e capital allocation.

There are some great cash cows out there which fail to get appropriate valuation because they are hoarding cash rather than putting it to good use or letting it go to shareholders. On the other hand, there are low-growth businesses (albeit ‘good’ businesses) trading at rich valuations, due to extra-ordinary payouts translating into high dividend yields.

There is a beautiful book on this subject ‘The Outsiders’ by William Thorndike where he profiles eight unconventional CEOs including Warren Buffet and shows how it was their outstanding capital allocation skill that created such enormous wealth for the shareholders. If you haven’t read this book yet, I urge you to order a copy now: Amazon Store

Disclosure: The stocks discussed in this post are only for case study purpose and are not recommendations. We and our clients are invested in Relaxo Footwear.