More reports on: Financial services

The art of creating value and wealth

08 August 2015
Sanjay Kulkarni, finacial services practitioner and authorSanjay Kulkarni is the former managing director and India country head of Stern Steward and Co, a boutique global consulting firm focused on value management. He has also mentored group businesses and investments at the chairman's office, Reliance industries Ltd. He is currently a partner at Seven Capital Ventures and director at Tranzmute Capital and Management. In this interview with Swetha Amit, he talks about the idea behind his book, the herd mentality of people and how organizations should inculcate internal motivation.

The Value Elephant is an interesting title. What was the idea behind this book?
If you ask a few people, what value creation means, their responses will remind you of the classic fable of the six blind men and the elephant. Each have their own idea, each seemingly right, of what the elephant is, but very few are likely to have the complete picture. Value Creation is akin to the elephant in this fable; this book attempts to give you not only a proper view of the elephant, but also a nuanced understanding of the creature.

The book is about value creation through investing (outside-the-business perspective) and through management (inside-the-business perspective.)

Your book talks about the herd mentality when it comes to buying or selling in the market, which is not desirable. What do you think prevents people from adopting their own stance instead of always following the popular trend?
There could be number of reasons largely driven by inherent human biases.

Consensus is quite comforting. People gain confidence from the majority, irrespective of the majority being right or wrong. More often than not, the majority is driven by 'instant gratification' – why get rich slowly, when a quicker way is available? And this is how grows the caravan.

People are affected by 'relative performance' (recollect the ad Bhala uski kameez meri se safed kaise?). When you see the next person gaining, you cannot resist the temptation of following. People often believe in and do things merely because many other people believe in and do the same things. This is known as 'bandwagon effect' and it is an inherent human bias.

In contrast, adopting your own stance is a rather lonely and difficult affair as it tests your patience and your faith in your own judgement. Quite understandably, not many venture on this path. For instance, I have not seen many people preferring the stairway over the escalator / elevator – have you?

You have talked about how speculators tend to delude themselves in a bubble. Today there is this entire buzz of the ecommerce bubble doing the rounds. So how do you see the future of this bubble going forward?
Bubbles are usually seen in hindsight. I am not sure if there is consensus about a bubble in e-commerce. If there is, then it will get pricked.

E- Commerce business valuations are largely in the private domain .Very few  or  none are in the public domain. Yes, they seem stretched but they are dependent on the future view of a limited set of investors. The actual performance might differ from the optimistic expectations and this could affect future investments and valuations.

However, this is unlikely to affect the rest of the world beyond the small club of private investors, few lenders, etc. In all likelihood, people who are in the game will take turns to keep the music going. They don't want the music to stop, if it stops, the party will be over. This is a difficult prospect as most of these businesses will be unable to sustain growth with operational cash flow.

You have mentioned about the 'recency bias' concept in your book with regards to investment.  Now with the Maggi fiasco, people seemed to have stopped buying Nestle shares. However the company seems to have to have a good equity and is seen as an excellent opportunity for growth.  So how do you think people should overcome this 'recency bias' and invest wisely?
Human beings suffer from these cognitive biases. Unfortunately, there is no magic pill to inoculate ourselves, including you and me, against these biases. You can reduce their effects only by evaluating your thinking patterns. Simply being aware of these biases will make you less likely to fall victim to them.

Coming to Nestle, I think it is better to look at the business than its stock price. How will the overall business performance of Nestle be affected by the ban? How will its growth and operating performance be affected? What risks does it face and does the company have the ability to manage/mitigate these risks? Well, simply put, focus on growth, risk and operating performance. Through this if you assess that the business is worthy more than its stock price, then you should invest.

However, simply jumping to a conclusion (to either buy or sell Nestle) based on its price movements is fraught with risk. The Maggi episode is a good example, that brands do not necessarily define a lasting or good moat. They can fall and fall dramatically and they can be fragile and get wiped out with some unforeseen, unfortunate incident.

Publisher: Penguin / Price:Rs 799
Pages: 314 / Genre:Business

Indians in general are known to be aversive to risk when it comes to investing. Why do you think they have this rather cautious approach when it is known that risk and reward go hand in hand?
Risk and reward go hand in hand is a commonly accepted notion, but it can be questionable.

This notion has led to a common belief that 'risk avoidance' is incompatible with investment success; that high returns are attainable only by incurring high risk; that long-term investment success is attainable only by seeking out and bearing risk, rather than avoiding it. This is not entirely true.

This commonly accepted 'risk–return' notion may well hold true in some cases, for example, debt instruments or fixed-income securities.

As you know, 'risk' is defined in the dictionary as 'the possibility of loss or injury'. Debt instruments 'promise' an investor 'specific cash flows' at 'specific times'. Risk, in debt instruments, arises from the possibility that the borrower will be unable to make the 'promised' payments. Here higher returns are expected if the risk of default is higher – clearly, risk and reward go hand in hand.

Equity, in contrast, makes no promise of specific cash. You make equity investments based, on the 'expected' cash flows of a company. The risk in equity, therefore, lies in 'actual' cash flows turning out to be different from 'expected' cash flows. This way, equity risk is fundamentally different from that in debt.

By investing in equity, you do take risk, but you can avoid loss. Avoiding risk and avoiding loss can be different. Investing in businesses is taking risk. But, if you invest at a price which minimises the possibility of loss, you can protect your capital. By investing at the right price, you take the equity risk, yet you can avoid long-term loss.

Indians do take risk. The large number of Indian companies, and entrepreneurial ventures show that Indians are just as good/bad as others. If you/I go back in time to Mahabharata, then we might even conclude that Indians not only take risk, but also indulge in gambling and rank speculation.

You have mentioned about how internal motivation is a key factor to value management in the long run. How do you think companies can harness this to the maximum?
There is no simple or seemingly single answer. Internal motivation is experiential, focusing on the self. It cannot be systemised. This is where organisations struggle. Many know the merits of internal motivation but they look for something that can be woven into existing systems. This is quite tricky.

Internal motivation is context specific. It cannot be integrated into management systems, but can be woven into the softer system and that is culture. Internal motivation is about the culture that defines an organisation. It can achieve wonders because it taps relatively 'higher' energies. Performance systems rarely touch these higher energies.

Many management processes such as budgeting, goal-setting, financial reward systems, etc, actually undermine conditions that encourage internal motivation. They tend to operate under the 'command and control' model, which believes that managers are agents of business owners and act as though they were in a performance contract with them.

Notwithstanding this, you know intuitively that internal motivation works. Internal motivation has long been an integral part of Indian philosophy and spiritual systems. Unfortunately, however, Indian philosophy, consciousness and way of life have not had a meaningful influence on mainstream management ideas and practices.

The good news is that some of the existing management models are undergoing change. There has been considerable research and development in recent years. 'Self-determination theory' (SDT), which identifies the core principles underlying sustainable motivation, has explored many domains, including business, education, sports, medicine, entertainment and leadership. The intuitive appeal and strong evidential support for SDT has influenced many. 

In an organisational context, internal motivation thrives when systems foster three elements: a sense of autonomy, an opportunity to build mastery and a sense of purpose. It is not just about economic incentives, but lot more. Organisations that recognise this will be able to adopt and encourage internal motivation.

Lastly what are your future plans? Any more books in the pipeline?  
Right now, my attempt is to enable value creation and to help individuals and business to adopt some of these lessons in real life.

The initial feedback says that this is a unique book.  It needs to reach out to the wider audiences and people need to benefit from it. That is my focus at the moment.

However, I do continue to write and if things work out well, there might be another book.

Excerpt from The Value Elephant
Value investment can be intriguing to many. A friend who manages a venture capital business once said, 'I like this idea of buying assets at prices which are at a discount to value. But, in the process, would you not miss out on growth companies?' Well, the short answer is 'no'.

A question like this does not arise in isolation-you will find similar doubts among many investors. Investors can be roughly classified into two types - 'value' and 'growth' investors.

A 'growth' investor focuses on companies, which have rapidly growing earnings, but are trading at 'reasonable' price earnings multiples. His premise is that markets are not fully capturing his target companies' growth prospects. A 'value' investor is on the lookout for quality companies, which are available at relatively lower price-earnings multiples. A value investor puts his money in a company when there is underestimation of its underlying value in the market.

Both types of investors are essentially saying that the market's current expectations are incorrect, and are investing on the premise that these expectations are likely to undergo revision. Both are evaluating a mismatch between price and value. Therefore, a differentiation between these investors appears superficial. One might even argue that all investment is value investment, else it is speculation. Evaluating performance expectations is quite critical to the identification of price-value mismatch. This might well be a prerequisite for sound investment decisions.

How would you evaluate performance expectations? When it comes to business performance, you cannot go wrong with economic profit (EP, or EVA-economic value added). It is possibly the best periodic measure to define performance expectations. Simply put, it is the operating profit of a company after deducting all costs, including costs of capital employed. Companies that are improving their economic profit performance are necessarily creating value; that is, they are necessarily improving net present value (NPV).

Expectations of future economic profit matter
Godrej Consumer Products (GCPL) and Hindustan Unilever (HUL) are fast-moving consumer goods (FMCG) companies. Let us go back in time to fiscal year 2001-02, and this is the backdrop - in 2001, the economic profit performance of GCPL was a positive Rs32 crore. GCPL had delivered an improvement of about Rs10 crore over its previous year's economic profit.

HUL delivered an economic profit of about Rs900 crore. This performance was an improvement of about Rs280 crore over the previous year. HUL was among the companies in the market reporting the highest economic profit. However, over the next few years, GCPL's share price more than doubled, while HUL's moved sideward or declined.

How would you explain this? Apparently, both companies were delivering positive economic profit. Both were improving economic profit performance as well. In fact, HUL was delivering substantially higher economic profit performance than GCPL. However, it underperformed GCPL in delivering returns to share owners.

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