I was listening to an interview of one of the CEOs of a textile company. He started to state that “We are going to incur capital expenditure of XXX. This would enable us to become the largest player in the textile industry”. While some people hailed it as a great move and were happy that the company would become the largest in its space, the question which was coming to my mind was: And then, WHAT?
With average return on capital employed for the industry being less than 10% over the last 15 years, any increase in capital expenditure would have been like depositing more money in a savings account, while the rate of interest not showing even a marginal sign of improvement.
Some of the industries like Airlines, Retail, Metals & Mining and Textiles have had average ROCE < 10% over the last 15 years. Hence, any capital invested in such industries would NOT have been accretive to the stakeholders, unless the captioned company being the lowest cost producer. Considering the government yield at 8%, it would be imprudent to invest in such an industry when the underlying economies are not supportive. After all, according to Warren Buffett, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”.
And then, WHAT also enables to think about the 2nd and the 3rd order derivatives.
When a company incurs capital expenditure in a commoditized industry, i.e. an industry without any pricing power; the following things happen:
- Immediate effect: The company’s revenue increases for a short-term period. The management and stakeholders feel happy initially. Perhaps, also due to misaligned incentives of the management in majority of the cases.
- 2nd order effect: Other competitors also step-up the ante and incur similar or higher capital expenditure.
- 3rd order effect: Greater capital expenditure across all the players in the industry results in lowering of prices across the industry and the decreased price becomes the baseline price for the industry. Hence, infusion of capital by the all industry players over the course of time only benefits the end-consumer. The companies are left high and dry with the same cycle to be repeated with more severity in future.
Acquisitions announced by companies also need to be questioned – “And then, WHAT?”
Since, most of the acquisitions undertaken during the boom periods turn out to be duds. One of the largest acquisitions though propelled the Indian parent to become the top 5 global metal majors, market capitalization after the acquisition almost halved, thereby causing serious dent to the stakeholders’ wealth. Perhaps, management in the zeal of becoming one of the largest players in the industry failed to ask, “And then, WHAT?”
And then, WHAT enables to think long term
After all, one of my ex-bosses during the year-end appraisal often used to quote: “Life is a marathon and not a sprint”
Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.