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Its the vision that counts - Views on News from Equitymaster
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  • Sep 28, 2004

    Its the vision that counts

    In recent times, we have heard many a investor and fund manager say "This time its different...". It should be remembered that the stock markets have witnessed a dream run during the last one and half years (but for the month of May). The stock market gains were well supported by robust corporate earnings and the same is expected to be the case in the current fiscal. Not many corporates have disappointed so far.

    However, what is of relevance here is that since the economy is on an uptrend, the companies have improved their earnings. However, how many companies could actually stand the test of time in case of an economic slowdown or any adverse situation.

    We looked at 5 diversified corporates (Reliance, ITC, Grasim, L&T, Wipro) and 5 focused companies (Gujarat Ambuja, Infosys, Telco, Tisco, Reliance Energy). We considered 4 major factors for the analysis:

    • Operating profit margin

    • Return on net worth

    • Return on capital employed and

    • Asset turnover ratio

    After comparing the two groups based on the above criteria, over a period of 10 years, we arrived at the following conclusions:

    Operating profit margins: During the last ten years, it would be safe to say that the diversified majors have been able to face the adversities of business cycles, due to a diversified business portfolio. An integrated player like Reliance, the uptrend in petrochemicals during the FY97 to FY98 season helped it overcome the adverse conditions. At the same time, focused businesses such as that of Gujarat Ambuja Cements and Tata Motors witnessed a slump in operating margins due to rising inflation and raw material costs.

    Return on networth: Again, focused businesses have been playing in the hands of the economic trends, recording an upturn in returns on the shareholders' funds during favourable business environment, while the returns have been sub-par during other years. On the other hand, diversified companies having a presence in more than one business segments have been able to generate a reasonable amount of return on the shareholders' money. Having interests in more than one business is (although not always) a good proposition when the said businesses are inter-related, or atleast when it is not a diversification for the sake of diversification.

    Return on capital employed: Although returns during the last ten years on capital have been volatile, it should be noted that it is during this period that diversified majors such as Reliance Industries and ITC started expanding businesses. While Reliance Industries ventured into downstream petroleum sector (Jamnagar refinery), ITC funded its hotels and paperboard business. Although these new ventures started with initial hiccups, Reliance's investments have now started bearing fruit with the refining business contributing nearly 50% of the EBIT margins. On the other hand, application of capital into the main business has helped the Indian focused companies to leverage their strength and become a low cost manufacturer in many cases. One could easily cite Tisco's example in this regard. The company is the world's lowest cost HR (hot rolled) steel manufacturer in the world.

    Asset turnover ratio: Better asset sweating has enabled the diversified majors to post a steady improvement in the asset turnover ratio. To put things in perspective, Reliance Industries' Jamnagar refinery not only helped the company manufacture downstream petroleum products but also included an integrated petrochemicals (high margin products) plant, which enabled the company to generate above normal refinery margins. On the other hand, Tata Motors witnessed losses in the initial stages when it ventured into the passenger car segment.

    As can be seen from the above research, taking into account the past decade, it does seem that diversified companies have come up tops as compared to the focused players. However, we would like to caution investors that not all diversifications are successful and not all focused business ventures are prone to such volatile performances. For instance, Infosys has been a focused player in the software business and has rewarded its shareholders with super-normal gains. On the other hand, GAIL's venture into telecom business, GailTel, is still suffering losses.

    Therefore, think of diversification in the right sense and remember not all diversifications have been successful. As is clear from the comparison over the past decade, the diversified majors have shown stability, which is a solace for investors. But the thing to note here is that the companies that we have looked at in this article are probably the best in their business and are driven by the management's vision.

    But a lot of the diversified conglomerates have simply vanished in the past decade, like the Modis' and the Walchand Hirachand Group, to name a few. In essence, neither diversification nor complete focus by itself is a guarantee of future prosperity. What improves the chances of success is the management vision. If the management foresees the future business opportunity clearly and is able to adapt it to its corporate vision, then whether it chooses to remain focused or diversifies, it is more likely to succeed.



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