Last year the chief executive officer (CEO) of a well-established international bank, which has operated in India for decades intriguingly observed that its large retail lending portfolio was not a contributor to profitability. The bank was still in investment mode, the CEO quoted, noting, at the same time, nostalgically, that the banks commitment to India had been proven over the past 75 years.
What was the time horizon to make the business profitable? I wondered. Does the long-term view of markets really extend to 75 years? one puzzles. Did the shareholders of this bank, no doubt trusty solid pensioners in a developed country, feel okay about this open-ended approach to investments?
Similarly, the aerated water market has seen very visible investments in brand building over the last 10 years, including endorsements by high-profile sportsmen. A well-known publication gushed recently, on its cover, that the fizz was apparently back, for one of the Cola brands. Yet, in eight encomiastic pages dedicated to this story, I did not find any reference to the most important number which summarizes performance, profit. The closest reference was a statement that the company was making profit on a turnover of more than Rs4,000 crore.
Is this, one wonders, the level of revenue required to just turn profitable and, if so, what might be the accumulated losses of the past 10 years? From ketchup to fast foods and from banking to breakfast cereals, unlisted subsidiaries of international companies have invested in brand building, retail space acquisition, channel development and expensive hiring with no visibility into financial performance. (It is almost impossible to get profit figures for companies in this set). In contrast, a competing listed Indian company faces the challenge of continuous scrutiny of its financials.
Herein lies the rub, one of the less visible consequences of being listed. While listing on a stock exchange can secure capital relatively cheaply and create a certain cache associated with being traded, it has one much-debated downside, being subject to the short-term demands of the investing community.
In India, listed companies can face an unusual challenge when, their main competitors are unlisted entities with deep pockets. Since 1991 it has become commonplace to see Indian-quoted entities often competing with the unlisted subsidiaries of large, multinational companies, which are often listed in their parent markets, but not in India. As a result of this asymmetric transparency, the Indian listed entity is often subject to a level of scrutiny which is absent in its unlisted but nevertheless large and wealthy counterparts.
If, as is usually the case, the unlisted competitor to the Indian listed entity is a small part of the global whole, the losses of an unlisted entity would have an almost invisible impact than in the case of the listed competitor. Given the inevitable pressure from analysts and investors to eliminate all lossmaking businesses, it can sometimes be difficult for the listed firm to play the waiting game that its unlisted international competitor could. This condition is compounded by the fact that free spending on visible elements such as advertising can create an impression of successful performance which can often be far from the truth.
A consequence of this distinctive situation is that the ability of some Indian companies to absorb the short-term costs of long-term investments is impaired, while their unlisted competitor—often a subsidiary of an overseas company—faces no such constraint. While this situation is not unique to India, the same is unlikely to happen in reverse. Even when large Indian listed companies own unlisted subsidiaries, in say, the US or Europe and where those subsidiaries can compete with listed entities there, the sheer skewness of the exchange rate means that even a relatively small company by global standards is likely to be material to the consolidated accounts of its Indian parent. Thus the performance, or lack thereof, of any international subsidiary of an Indian company is quite visible in the consolidated accounts of its listed Indian parent leading to the higher level of focus in India on, say, the overseas operations of our large companies. For instance, the performance of the subsidiaries of the big three auto firms in India represents no more than a blip on the consolidated accounts of the parents. The reverse cannot be said to be true.
This particular asymmetry enables the unlisted subsidiary of an international company to incur substantial expenditure without the natural constraints imposed by needing to show a profit, or facing the criticism for non-performance. Although there is nothing wrong about this situation, it has important implications for boards as well as investors.
If one were a director of a company making, say, breakfast cereal, one would perhaps take a very different view of the performance of the company if there was also visibility about the relative performance of its competitor. To truly assess the success of products and services, boards need to see the return on investment made by other competitors before taking strategic investment divisions. Investment decisions that otherwise get turned down may be approved if a board had information to indicate that their own management, though potentially loss making, is really the best among peers. Such investment calls, which are desirable for optimal allocation of resources across the economy, can only be taken if there is greater visibility on financials of all comparable entities, including those that are not listed .
In addition to being an important factor in investment decisions at the board level, investors can find it difficult to value a company without reference to peers. When investors value companies, they often add premiums, justified on the basis that in the event of the consolidation in that industry, the best-managed company, even if at present lossmaking, would benefit the most. The valuation of even an unprofitable player could be significantly enhanced if it were seen to be performing better than its peers. Such an evaluation cannot be performed if investors do not have enough information to judge an organization’s performance.
Shareholders need to keep in mind the presence of competitors who exist outside the pale of market scrutiny. If their company is likely to be forced to make public large losses while its its major competitors do not need to disclose their accounts, there can be an undue lowering of valuations. It has for long been debated whether Thums Up for instance, should have been sold for $60 million (Rs284.4 crore), when even after 15 years and significant investment by its peer brands, its leadership in the market remains unchallenged. It appears that excellence relative to peers, even when present, may be masked by substantial losses and thus may not be factored into the valuation.
This kind of asymmetry can be avoided by seeing the financials of peer companies. It may be argued that such information is available with the registrar of companies, but the information available is rarely of the depth that is available for a listed company, nor is it usually sought and publicized. One way to achieve greater transparency is to make it necessary for all companies with, say, a turnover greater than Rs10 crore, to publish their accounts in a manner similar to listed companies. These companies need not be bound by governance standards similar to those required by a listed company.
This transparency will, at least in part, make more visible the true profitability of some of its products. Through this investors in listed companies, who realize that their business is actually rather less unprofitable than rivals, may choose to take a longer-term view of investments than they otherwise might have. Visibility into financials can partly mitigate the situation, where promising and well-managed investments in projects and brands, made by companies listed in India, are swamped by companies with seemingly endless deep pockets and less financial transparency and have to exit the market.
One recognizes that this is an unusual recommendation. Some would argue that companies have a right to keep their losses and investment strategies private, as long as they do not access public markets. I would also agree that if a company has no exposure to the market or no competitor, there may be limited value from such information being made public. However, for companies with significant market or operating presence, this argument would not hold and anyway the companies that would object most strenuously to this would be those whose inefficiencies would be brought under the scanner. It is certainly beneficial to investors in listed companies to know how their large unlisted competitors are doing. There can be, to my mind, some case that the public good is actually served by having such financial information. One would hope that the media would make a greater effort to bring the financials of such companies under scrutiny similar to, if not as exhaustive, as that for listed companies. This column is, therefore, not a call for the erstwhile “level playing field”, made famous in the 1990s. This columnist believes that it is perfectly fair for companies to use their deep pockets and strong resources to crowd out others, acquire them or simply indulge in seemingly value-eroding activities if their shareholders choose to do so. All that is being sought is that investors know that this is being done, so that entrepreneurship in India is not killed off by lack of visibility around relative performance.
Even if regulatory change is not achieved, one hopes that both shareholders and boards look out for such situations and make a greater effort to seek all such information about such unlisted companies before making investment decisions. The apparently dud investment rejected by the board could just have been the next Indian superbrand.
In today’s dispensation, though, almost noone will ever know.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He will write on issues related to governance. The views expressed in this column are personal. Write to him at firstname.lastname@example.org