A Law for Companies to build a Reserve

26 MARCH 2020

In a capitalist system, those with an idea, a product, or a service bring it to market and, if the market or the consumer likes it - they succeed. If they get it wrong (either because they no longer have a product or a service that consumers want or due to an external shock) then they fail.

The external shock could be a flood that damages their factory, a war that shuts down their country from the world - or a pandemic which disrupts daily life and hurts their revenues but leaves the companies with bills to pay.

Historically, capitalists looked after their own interest and profit - or failed - within a framework of rules. As such, they were more careful about the risks they took and the capital they held in reserve to take care of unknown events and uncertain times. Banks like HSBC had "hidden reserves" as recently as the 1990's. Family owned companies tended to have large capital bases as reserves to tide out the bad times - the European companies were good practitioners of this philosophy. However, as the world progressed from the traditional form of a risk-conscious capitalism to a more financial engineered capitalism, the rewards were passed on to the financial engineers and the risks to society.

Wall Street firms were initially managed by partners - their own capital was at risk. There were no external and distant shareholders. Insurance companies were "mutual", collectives or cooperatives where each insured person was a beneficiary of a good year or a bad year for the outcome of the collective risks the insurance company took.

And then came along the idea of "listing" the company and having external investors who did not run the business but invested in the shares in the business by estimating and valuing long term expected profits and cash flows. By the late 1980's this new breed of shareholders came armed to the table with money which the companies could use to grow their businesses - beyond the limits set by the finite resources of their own partners or cooperative shareholders. The managers who ran the business now had distant owners and could take more risks - with the money from the new, distant shareholders. A new breed of academia on financial engineering (many times supported and funded by grants from Wall Street firms) propounded the idea of the "efficient" use of capital and urged companies to seek funding from distant shareholders.

Soon, HSBC's hidden reserves were criticised for not "maximising" shareholder value. Insurance cooperatives were seen to be stodgy for not using their capital to grow their business into new markets or new business lines - even if these were not useful for their core original customer and investor base. By the 1990's HSBC no longer had hidden reserves. The UK, European and US insurance companies had become listed entities and no longer had "collegial" risk-return dynamics of a "mutual". Their CEOs could make wild bets and, if they succeeded, the hand-picked boards awed by the supposed genius of the CEOs gave the CEOs outsized rewards via salaries, bonuses, and ESOPs. If they failed, they left the ruins to the government to salvage through the rubble.

Private Equity (PE) firms jumped in the fray and bought out listed companies mostly in the manufacturing businesses. Their model was simple: borrow money to buy out the company mostly in tandem with management (Management Buy Outs or MBO) and then strip the assets of the target company to pay down the debt the PE firm had taken to buy the business. This typically left the business heavily exposed to the risk of the business cycle as it still had large debts to service. If the business cycle went in their favour, the leveraged buy-out deals of the PE firms (with a very small equity exposure and capital at risk) gave them an outsized return. If the business cycle went against them, the PE firms could wash their hands off the company and left the government to figure out what to do with the cost of shutting it down - including the labour costs and pension liabilities.

Today's modern listed company is driven by the need to:

  1. Show growth, for higher valuations
  2. Be profitable using metrics such as Return on Capital Employed, and
  3. Pay out regular dividends.

In exchange for this, the management is allowed to be rewarded with a salary, a bonus and an ESOP plan to share in the upside of the value they help create.

In founder-owned companies the equation is pretty much the same but may have a twist: the founder may have a large shareholding and prefer a larger dividend payout as they are not likely to reduce their shareholding and lose control. Hence, a high share price is academic but a large dividend is real cash in hand.

In the age of rubber-stamped Corporate Governance, which every company talks about, the companies need to think of the Triple Bottom Line or PPP (Planet, People, and Profit). Every annual report has a glossy write up of their corporate chieftain and lauds them on how they have become more socially responsible citizens. Yet, as the external shock of the CUPID-19 has shown, their claim rings hollow.

Clearly, no one could imagine that a virus cell whose diameter is 1/100th the diameter of the human hair could cause such havoc.

But every corporate, for all their fat salary and bonuses and brilliance to boot, should have had a Reserve Fund which took into account the possible impact of extreme and unlikely events. The management teams spend hours mapping out scenarios of growth and market share - how much time did they spend mapping out scenarios of disaster and how they plan to safeguard against the disaster?

Zero: Because the modern financial stock market rewards the companies that plan for growth and ignore disaster. Money sitting idle in a bank for that bad day is seen as a drag on capital efficiency.

A fat bank balance sitting idly as reserve money to be deployed to protect Planet People Profit is a drag on ROCE. It hurts valuations. Investors with a quarterly mindset don't want to know what contingency plans a company has in case of a 9/11, a Lehman bankruptcy or a COVID 19. When that event occurs these investors will exit and sell their shares at a loss if need be. The investors have no interest in PPP: they want to see a "capital efficient" company with a high ROCE. Whether a company closes down, jobs are lost, or the CEO gets fired is of little interest to most investors or punters. But society and governments should be concerned.

As soon as the coronavirus hit India and self-quarantine rules kicked in - even before the lockdown was announced - corporate chiefs and lobbyists were already on the TV channels asking for a series of breaks from the government: from tax refunds, to hand outs, to tax breaks on buying back their shares to support their eroded wealth (they marketed it as "giving a retail investor confidence"!).

What corporate India needs is a whack on its backside for building a fragile foundation that cannot withstand an earthquake. A structural engineer and architect designs buildings, bridges and dams for contingencies; in contrast, the profit-loving financial engineers and chieftains build for short term gloss not long term sustainability.

Table 1: Mantra of Corporate Governance - Planning for me, not for the future

Year end, March Companies Net Profit Dividends Paid DPO Ratio Salary
    INR bn INR bn % INR bn
2009 180 1,418 1,222 86.2% 1,434
2010 180 1,944 1,311 67.4% 1,530
2011 180 2,273 1,347 59.3% 1,807
2012 180 2,339 1,538 65.8% 2,382
2013 180 2,399 1,608 67.0% 2,805
2014 180 2,668 1,687 63.2% 3,228
2015 180 2,434 1,927 79.1% 3,577
2016 180 2,744 2,179 79.4% 4,095
2017 180 3,265 1,956 59.9% 4,348
2018 180 3,763 1,715 45.6% 5,388
2019 180 4,006 1,954 48.8% 5,738
Total ./ Avg   29,252 18,443 63.0% 36,332
Source; Equitymaster

As the data of 180 companies between the period FY2009 and FY2019 shows, the companies earned a total profit of Rs 29,252 billion between March 2009 and March 2019. Over that 11 year period they paid out dividends of Rs 18,443 billion. This resulted in a Dividend Pay Out ratio, on average over the 11 year period, of 63%.

But what if, the Boards of the Companies had insisted that they begin to build a buffer for those unusual - but increasingly frequent - outlier events like the Asian Crisis (1997), the tech bubble implosion (2000), 9/11 (2001), SARS (2003), Great Financial Crisis (2008), and COVID-19 (2020). What if the Boards had said, start to build a reserve so that you have enough cash in the balance sheet of your company to pay your expenses for 1 year - even if your revenues are zero for that entire year! A good corporate governance model worries about the impact a failing company can have on the People it employs and the Community within which it operates: true to its core, it would have begun to build a buffer.

If the companies had kept 20% of their annual profits aside for this buffer (see Table 2), Corporate India would be in a sweet spot - as would the People linked to the company. The government would not have a cranky child tugging at the sari of the Finance Minister begging for lollipops and ice cream: it could focus its energy and efforts on alleviating the needs of rural and urban India as the poorer sections of society struggle with the financial impact of the lockdown.

Table 2: Protecting People and Community with a Reserve Pool Fund

Year end, March Companies Net Profit Reserve Pool Dividends Paid DPO Ratio Salary
    INR bn INR bn, 20% INR bn % INR bn
2009 180 1,418 284 938 66.2% 1,434
2010 180 1,944 389 922 47.4% 1,530
2011 180 2,273 455 892 39.3% 1,807
2012 180 2,339 468 1,070 45.8% 2,382
2013 180 2,399 480 1,129 47.0% 2,805
2014 180 2,668 534 1,153 43.2% 3,228
2015 180 2,434 487 1,440 59.1% 3,577
2016 180 2,744 549 1,630 59.4% 4,095
2017 180 3,265 653 1,303 39.9% 4,348
2018 180 3,763 753 962 25.6% 5,388
2019 180 4,006 801 1,153 28.8% 5,738
Total ./ Avg   29,252 5,850 12,592 43.0% 36,332
Source: Equitymaster

Under this risk-control of shoveling 20% of their profits aside for a rainy day shut-the-hatches approach, the 180 companies would have built a cash reserve of Rs 5,850 billion. This would have covered their salaries and wages of Rs 5,738 billion for one year. Even if you add other expenses that exist in any business and account for defaults, there would still be a buffer of over 6 months as companies continue to protect People and Community.

A business built for the long term, like a building designed to withstand earthquakes and hurricanes, has shock absorbers. Corporate India's shock absorber has been the government. Any excess profit in good times has been theirs to keep and the bill for a disaster and dislocation is paid by the government - by society.

Frankly, building a reserve to absorb shocks should make business sense: a company that can stay the course and survive a downturn should emerge stronger when the economy turns around relative to its competitors who may be under-funded to withstand a downturn. A Board and a CEO focused on a 10-year view would voluntarily build such a shock absorber on their own! (As a disclosure, the companies that I have started have all built their shock absorbers: that is a directive to the CEOs!) But, alas, neither the Boards nor the CEOs generally see themselves as stewards of a long term business that should not harm the Planet or People. Many have been trained like the Pavlovian dog to salivate at short term performance and bask in the rewards misguided punters shower on such short termism.

Now, as the companies come out in hordes to ask what the government could do for them, it is time to ask them: "What will you do for the Planet and for People?"

This "too big to fail" smugness that they have used to protect themselves against a calamity should be disbanded and done away with. The government needs to pass a law to force companies to allocate 20% of their annual profits into a Reserve Pool Fund to build their own shock absorbers and buffers against bad times.

It is sickening to see this Machiavellian Act repeated at the time of every crisis: Indian businesses should start being capitalists, and stop being crony capitalists.

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Quantum Long Term Equity Fund, Quantum Equity Fund of Funds, Quantum ESG India Fund Quantum Gold Fund
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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is Founder of Quantum Advisors Pvt. Ltd which is the Sponsor of Quantum Asset Management Company Pvt. Ltd - the fund manager of the Quantum Mutual Funds. Ajit is also the Founder of Quantum Information Services which owns Equitymaster and PersonalFN. The views mentioned above are of the author only and should not be acted upon unless the reader has sought detailed financial advice from a qualified individual. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim the contents of the article to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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6 Responses to "A Law for Companies to build a Reserve"

Arvind Mathur

Mar 29, 2020

Dear Ajit,

Very well thought out and well-reasoned recommendation. I completely agree with you that companies should maintain a reserve equal to 12 months essential expenses including , particulary salaries.

The ROE will decline but thats fine and realistic. If someone wants a higher ROE, then he should be more innovative, creative and dynamic in running his business. Not by sacrificing the reserve you so rightly speak of.

P.S. We have met before.

Kind regards and be safe.

Arvind Mathur


Bhavin Patel

Mar 27, 2020

This is called the Honest & straight Truth.
Very nice article. Hope this kind of sanity prevail in world economy.
Otherwise with the advent of easy money we are looking ahead with devastation of lower purchasing power due to QEs by central banks all over the world.


vasant srivastava

Mar 26, 2020

Very relevant, and it is elementary that everyone should save for the rainy day, be it corporates or individuals. Also, given that everyone talks about the VUCA world with more uncertainty, this becomes even more important. However, these pressures come from investors all over the world, with most large US Corporations having spent a lot in share buy backs ofin in recent years instead of saving for such times due to the pressure on ROCE and share prices, and now have to be bailed out. The same investors and analysts also put pressure on Indian companies with the result for every one to see. Are we seeing some corporates move in the right direction of keeping such reverves, and how can this become more prevelant across corporates. Would like to read and hear their stories



Mar 26, 2020

Really like this article! Totally agree on companies that should focus on building reserves and government also mandating it instead of just bailing out floundering companies with public money! Superbly written with facts to make the case. Thanks a lot Ajit!

Like (1)

Ramesh B

Mar 26, 2020

excellent! hope companies/govt to mandatoryly implement it.
yesterday, your views good on the lockdown etc. but u were
very negative. see today govt has provided package of l.5l cr.
for the people at the bottom of pyramid.is not excellent?
whereas we, above thatexpect package for ourselves every day.
we will get our share in due course. rbi's liquidity/forex measures
quite commendable. be positive for something pl.
and DO write. will wait for the next......with best wishes.

Like (1)

n.k. patet

Mar 26, 2020

well, yes. the article is right. companies have turned into corporates. they throw crumbs at their retail share holders (who own only limited shares) while garnering fat dividend payouts for their owners, directors etc.

for too long we have been having growth only one way - up and up. even spectre of war is an opportunity for growth. old fashioned mentality to save for a rainy day is gone. and govt has also done its bit towards ever increasing consumerism. no incentive to save ( i mean you can't keep cash more than a limit at home), cut down on bank withdrawals at slightest whispering of wind, bail out packages ad infitum to corporates who then flee the country ( did not the govt know they had a foreign citizenship ?).

I hope wwhen the covid-19 finishes with us, we can have a new order of things and we fall back and realise the thoughtfulness of our ancestors.

Like (1)
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