Pricing power of businesses – holding power in the portfolio
by Naveen November 24, 2021
Source: Founding vs Inheriting
Recently, I was reading an article by Balaji.S (who I consider as one of the wonderful thinkers of modern technology today), speaking about the concept of founding vs inheriting. The article struck an immediate chord with me around how you can either find an institution (as a start-up) or inherit it (aka a family business, or a political post that is eventually passed down to someone else). However, most businesses that have scaled have done so by operating in between (founding and inheriting) exceedingly well.
What do I mean by the above?
Businesses grow an obsessive focus on the customer and creating value. There have been multiple businesses that manage to do this (which is where the founding element comes in). However, successful founders and CEOs transition from here, to become successful capital allocators, where they choose to inherit businesses (they get this freedom, due to the comfort of generating their cash flows). This inherent characteristic is the core that has distinguished good and great businesses.
Amazon, which has and will continue to be a case study to study as the example for capital allocation, has spent USD 38bn in acquisitions that have been done across 86 acquisitions (what we call inheriting). The company saw failures in ~72% of these acquisitions, but the ones that scaled generated a return on capital that more than offset the failures.
A less known example is Texas Instruments (market cap of USD 180 bn today) which has spent close to USD 80 bn in capital allocation over the last decade. The bulk of the capital allocation decision for the company was around R&D, Capex and Inventory (~34%), however, the company spent ~8% of the capital (~USD 6 bn) in acquisitions over the same period (again inherited companies). These inherited acquisitions have gone on to add returns to the shareholders in excess of 28% that has resulted in significant shareholder returns over the last decade.
It’s also important to realize that not all companies that scale have to do it through inheriting (or acquisitions).
If you look back at Costco, it IPO-ed in 1985. Costco wasn’t profitable at the time, but it was growing like crazy, memberships were doubling and tripling over a year or two, and you could see the business model, the framework was there. The company was talking about what it was doing and why and executing on it, but the profits weren’t there. However, the founders were insistent on growth through organic store additions across the US. In fact, breaking down the profitability, the Midwest stores as a whole, turned profitable only in 2018. You’d think this is a disaster and terrible capital allocation, but the company was just playing a much different longer game. I think what matters is that it never changed the framework and the goal post. It didn’t try to distract people and say, “We screwed up. Let’s focus on something else” It was always very consistent and logical, which is not to say it didn’t adapt and change courses.
Closer to home, we have seen some of the best capital allocation decisions being done by two companies I closely follow.
Infoedge, will be and remain a poster child of how a business can scale through prudent capital allocation. The promoters have had 3-4 large successes (through their investments in Zomato, Policybazaar) and their core businesses of Naukri continue to generate cash flow which has allowed them to make excellent inheritances (over time). The only difference here being, they act as long-term investors rather than long-term owners.
Secondly, Zerodha has built an incredible cash-generating machine, in an extremely commoditized space, who most industry veterans would have written off. Today, the economics of Zerodha stack up to the margins of the most efficient Asset Management Company in the country (HDFC AMC). However, the interesting thing about what he is building is not the brokerage he is building but the businesses he is inheriting (through his investments) which gives the business the ability to build a full-service financial firm in the country at scale.
While there are no business books or pundits who will speak about capital allocation, I believe this is one of the core distinguishing factors that identify businesses that can scale over the long term, where true growth can be realized over time.