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Businesses profitable for all but shareholders! - Views on News from Equitymaster
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  • Jul 9, 2012

    Businesses profitable for all but shareholders!

    A business, distinct from being a charitable organization, is run with the motive of generating profits. The profits generated by the business are supposed to compensate for the resources employed. Rentals for leased premises, depreciation for fixed assets, salaries for employees, interest payments for bank loans are certainly some of the prominent operating outgoings. This is irrespective of the utilization of productive capacity. However, last but not the least, the profits or internal accruals are supposed to compensate shareholders as well. This is in addition to strengthening the reserves or contributing to capital expansion.

    But if we look around, there are several businesses that tend to be only profitable for stakeholders other than the owners (share holders).

    Take the case of aviation for instance. Companies like Kingfisher Airlines have displayed in adequate measure that the business yields nothing for its shareholders and bankers. But the customers were certainly a happy lot, as long as the flights were regularly airborne, as per schedule. Business like aviation and retailing are so competitive that they need to go out of their way to delight and attract customers. In the bargain, the interests of all other stakeholders get sacrificed.

    Banking again is a business that has come to associate itself more with steep employee compensations than with economic motives. From the fat bonuses to Wall Street bankers to the multi-revised pension payouts for our own PSU bankers, most banks have hardly had enough headroom for retaining profits. In the bargain, while customers and shareholders end up getting a raw deal, employees end up being the most enviable stakeholders of banks.

    Capital intensive companies often end up fooling investors with their high growth models. We come across several of them and their managements, where neither growth rate nor profitability is an issue. The only issue here is that so much capital needs to be ploughed back to the business that every time the company ends up borrowing more. The banks or lenders of these highly and perpetually leveraged companies therefore make more money from their growth than the shareholders ever do. A look at the return ratios of commodity business like textile, metals and packaging will convince you of this. The fact that the money returned by the business is hardly enough to cover the cost of capital, makes the business attractive to the banks alone. The shareholders keep perpetually waiting for the once-in-a-blue-moon value unlocking opportunity.

    Investors therefore need to be extremely careful about the businesses they invest into. Getting confused between a good business and a good investment can be one of the worst investing follies. Diagnosing a business' health based on the Porter model will help you decide whether and how long will its strengths last, if any. Studying the macro economic and regulatory environment will also caution you about some unforeseen risks to profitability. Studying past fundamentals and execution track record could be an aid to judge management credibility. But nothing beats the investors' classification of profitable businesses into stakeholder friendly and shareholder friendly ones. By skipping the process of differentiating the two, one could find oneself in a 'chronically leaking boat'. And in Buffett's words "...energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".

      Tanushree Banerjee (Research Analyst), is the editor of ValuePro, The India Letter, and Stock Select, Equitymaster's oldest recommendation service. She is also the editor of Equitymaster's most popular newsletter read by over 200,000 subscribers, The 5 Minute WrapUp. Tanushree started her career at Equitymaster covering the banking and financial sector stocks along with scrutinizing the RBI policies. And over the last decade, developed our research processes that have helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham and Joel Greenblatt.



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