The biggest risk in business (and investing)

“When Bill Gates first met Warren Buffett, their host at dinner, Gates’ mother, asked everyone around the table to identify what they believed was the single most important factor in their success through life. Gates and Buffett gave the same one-word answer: Focus.”

Headlines are all about risk. Inflation. Recession. Stagflation. UK having summer for first time. Currency depreciation. QT. War. Covid 14th wave. Chip shortage. Ship traffic jam. Sleazy Youtubers. Flying Spicejet.

As a risk-obsessed investor, what do I think of these risks? Nothing.

Sure, I think about the last one, but that’s personal. Professionally, I don’t view these as material risks at all. Looking back over last fifteen years at Nalanda, these weren’t what hurt us. Main cause of harm lay elsewhere.

So, what’s risk?

How do we define risk? Risk is what prevents achievement of our primary objective. If my personal objective is to live a long and healthy life, risk is bad habits or dangerous pursuits. As my professional objective is to deliver adequate long-term returns, risk is whatever really hurts this. Over decades, investment returns are mostly, though not entirely, determined by business compounding. Entry valuation makes a difference, but valuation headwind/tailwind tends to be small relative to business compounding.

Please note that compounding ≠ growth. Compounding is about a business playing to its advantages, getting stronger within a good industry, continuing to earn healthy returns and redeploying/returning that money responsibly. Growth is somewhere in the picture, but as a numerical consequence, not a causal variable.

To summarize, my main risk is whatever interferes with long-run business compounding.

(As business compounding is determined by businesspeople, what follows will seemingly exonerate yours truly from accountability. That’s clearly false. I can do, and have done, damage by choosing wrong businesses or paying a stupid price for right businesses. This essay deliberately downplays this by assuming that I stuck to good businesses and focusing on subsequent business trajectory.)

Material and immaterial risks

Headline-risks mentioned in first para don’t materially affect long-run business compounding, due to several mitigants. They are external factors that tend to be mean-reverting. Over decadal timeframes, they’ll average out roughly in line with past decades, letting us look though cycles. Real world feedback loops autocorrect supply problems and commodity excesses, though it can sometimes take a while. Human ingenuity addresses seemingly intractable problems, including but not limited to lab-made viruses. As external risks are common to all businesses, they may even be a blessing to stronger ones. Good businesses, by definition, have an ability to pass on or better absorb input pressures. In an adverse demand or funding environment, it’s not hard to see why D-Mart will gain over less efficient peers or untenable quick-commerce businesses.

Macro-type risks should also not be a surprise to anyone with a sense of history, even though popular discourse appears shocked every time a downturn follows an upturn. If I am not incorporating cycles into assessment of business and valuation, I shouldn’t be in this job. The very purpose of margin of safety is to ensure a reasonable outcome despite unspecified headwinds and unforeseen shocks. The ebbs and flows of collective sentiment are merely the backdrop against which the play called investing is staged.

(I deliberately omitted ‘technology disruptions’ from external risks, as that’s better discussed as a separate topic. For investors limiting themselves to relatively slow-changing businesses, this tends to be rare and, frankly, overrated relative to what follows.)

If external factors aren’t a big deal, what is my most important risk?

Answer: Self-goals.

For good businesses, shooting oneself in the foot is the #1 risk to long-run business compounding. While this can take many forms, let me elaborate using one of the more popular ways in which this risk plays out. As my 8-year-old says whenever I start lecturing, “Documentary alert”. 

Curse of a wonderful business

Wonderful businesses come with a curse or three. These are: surplus cash, surplus time, surplus confidence. First, a dominant, lucrative business generates way more cash than can be redeployed to fund growth in the core. This is the most fundamental curse of a wonderful business, as idle cash is a devil’s workshop. Second, since such businesses have strong management, evolved processes and minimal firefighting, occupants of the top-floor at head-office have time to spare. While golf, running and yoga are noble ways to occupy spare time, meeting investment bankers isn’t. Third, buggy humans extrapolate from being good at one thing to being good at all things. Unfortunately, competence is domain specific. While protagonists are clearly good in one domain, it is misplaced confidence to believe that their abilities will extend to another country or category. A lot of good that is associated with a successful business is path dependent. Businesses get to #1 through a combination of skill and luck. They stay #1 because they are #1. It’s one thing to sustain leadership from a strong starting point. It’s a very different thing to succeed by acquiring some fringe company in Eastern Europe built by others in an alien context/culture. Unfortunately, that’s the sort of misadventure surplus cash, time and confidence results in.

How it starts

How does this unholy trinity turn into a self-goal? Promoters and senior management start from the legitimate question “what else can we do”. Reasonable extensions to the core are quickly tackled. Long-gestation options and in-house moonshot projects are seeded. Still, a lot of spare cash and time remains. Correct, but unfashionable, answer is to dividend out surplus cash and hit the links. But that rankles: “Surely, someone as awesome as us can do more”. 24-year-old analysts berate any company that opts for luddite dividends over unbridled expansion. Investment bankers show up with shiny cufflinks and shinier targets. Words like cusp, transformation, orbit and synergy litter the conference room. Nextgen of promoter family is on board. Empire building excites senior managers. Key promoter follows, even if reluctantly. Before you can say EPS-accretive, a thousand crore deal is inked, passed off as an adjacency despite differences in location, scope and dynamics.

(I use large M&A as a placeholder, but distraction can be any substantial venture outside the core.)

Honeymoon from hell

In business and investing, congratulations are issued when a deal is closed. Empirical M&A odds suggest condolences instead. Before ink dries, managers at acquired company update LinkedIn profiles. Competitors prey on employees and customers, both insecure about ownership change. Front-loaded sales and window-dressed accounts start to unravel. Monthly MIS reports seem less rosy than pitchbook forecasts. Costs are stubborn and growth is elusive. If they were easy, wouldn’t they have been achieved previously? As acquired managers make up excuses, new owners don’t have the context to see through them, let alone troubleshoot problems. Implementing a turnaround at the wrong end of a 24-hour flight is irksome. Even if flight is shorter, acquired entity is in a new area where promoters aren’t sure footed. Acquiree’s approach, culture, policies and people are impossible to reconcile with the parent. Only option is surgery – sack senior managers, impose own people, let them learn the ropes while firefighting and slowly make the baby look like the parent. But this takes years and billions. Buyer’s remorse kicks in, but psychology of sunk cost and public commitment make it impossible to divest a dud. A long war drains cash and time, hopefully confidence too. All this for returns worse than a bank FD.

The real damage: opportunity loss in core

While story is already scary, we haven’t even got to the fun part. No human can take on a second task without the first task suffering. This gets worse when second task is as daunting as fixing a failed acquisition. This distracts promoters and senior management from the core business. Trajectory of any business is disproportionately influenced by a few big decisions that can only be taken at the very top. These may pertain to handling a shock (e.g. covid/lockdown) or sign-offs on crucial projects or response to sudden competitive spike. As promoters are too distracted to apply their mind to such judgment calls, core business slips. I have seen cases where a business that comfortable outgrew industry by 5% a year when focused, started lagging the industry by 5% a year when distracted. This huge swing is often unnoticed as it is relative to a counterfactual (what would’ve happened had we not made that acquisition). Tale of slow-boiling frog plays out.

Here's a secret: opportunity loss in core business is >10x worse than direct M&A damage.

Imagine a business worth 20,000cr. If it compounds 15% a year for a decade, it is worth 80,000 cr. If distractions reduce this to 10%, it is worth 50,000 cr (likely lower, as a laggard business will have lower margins, prospects and valuations). A 1000 cr acquisition caused >30,000 cr opportunity loss. By the time tail is amputated, it has wagged the dog sick.

Acquisitions do end up transformational. Just not in the direction promised by bankers. Typically, large acquisitions and other such needless self-goals ruin a decade of business compounding. In terms of investment returns, many billions of dollars of value has been lost, just in mid-sized companies that I directly track.

(I haven’t named names for obvious reasons. I encourage you to check out aggregate experience & RoI of overseas acquisitions done by Indian companies in sectors such as consumer brands, engineering, auto-comp, IT and pharma. Reality is likely worse than my narrative so far.)

Other flavors of self-goals

While ‘transformational’ acquisitions make for vivid storytelling, they aren’t the only type of self-goal. The general problem of distraction away from the core happens via other routes too. Companies ‘organically’ stray into very different businesses pretending they’re adjacent. Services businesses suffered as they thought tech-products were the same thing. Generating employment for next-gen of unwieldy family has led to explosion of pet projects and unwieldy brand portfolio, leading to neglect of strong brands. VC programs led to neglect of in-house ventures to the point where VC-funded companies ironically ate their lunch. Conglomerate owners found it hypocritical to say no to managers wanting to enter a new domain, leading to each entity becoming a mini-conglomerate. Entire earnings-calls get wasted discussing shiny new things, as my short-termist peers reinforce the wrong message that such nonsense is valued by markets. Even without a specific distraction, unholy trinity occasionally results in complacency and bureaucracy, letting better-run competitors nibble away market-share.

In each case, business in question ended up lagging its industry, undoing decades of focus. Compounding perceptibly slowed down, resulting in substantial value loss. In some cases, the core never recovered its former glory. Shareholders, both controlling and minority, lost out over the long-run as defocused businesses ended up way short of what could have been.

Conclusion

While no serious investor thinks of risk as Greek-letters, it is also incorrect to define it merely as losing money. Outcomes that make money may still be inadequate. As a group, we struggle to beat a passive alternative that compounds at low-double-digit cagr. Even the rare few who beat it do so by a small margin. We need every tailwind we can get and even small but sustained headwinds pose serious risk.

I believe that best investing odds lie in good businesses, sensibly purchased, held for long. While capital-losses are rare in this construct, business outcomes can still fall well short of full potential. #1 reason why this happens is self-goals. #1 cause of self-goal is distractions that take away from single-minded focus on the core. #1 cause of distraction is (large) M&A. However, there are many other causes too, as I have outlined.

In each case, the source of distraction directly bleeds the business by making it operate from a position of weakness in a new area. However, larger damage occurs indirectly due to reduced compounding in the core as defocused senior management slips up. Worse, this happens on the sly, as it is hard to measure damage relative a counterfactual what-if-we-hadn’t alternative. Over many years, this equates to negative compounding, which may well be the most corrosive force around.

Let me end with some gratuitous advice.

To businesspeople: If you run a good business, favorably positioned and earning healthy returns, you are already one in a million. Without taking away from your skill and effort, you are very lucky. With focused execution, business value will increase by an order of magnitude every 1-2 decades. That’s 100x in a generation. Your family will get seriously rich slowly but surely, in both money and respect. It is yours to lose. The only way you can lose it is to take on needless distractions that dilute your focus. Please evaluate each non-core opportunity not merely in isolation, but against what it will cost you to fall short of full potential in your ultra-valuable core business. Your bar for opening up a new front should be very high. Ask yourself why you would be a better owner of another business, or why your competitive advantages should automatically extend to a new domain. Even in rare compelling cases, keep the new venture small enough and ring-fenced enough to protect your core, should things inevitably go South.

To fellow investors: Some of us misguidedly love the phrase ‘value-add’. It’s silly to think that generalists without business expertise can help good businesses get better. However, we can prevent them from getting worse. What we lack in expertise, we make up for in perspective that comes from studying all businesses over all of history. This is best used to nudge our companies into avoiding historically adverse patterns of behavior. Self-goals top this list. M&A isn’t to be cheered. Nor is diversification or pet projects in questionable ‘adjacencies’. We are better off sounding like a broken record (kids can google the reference) on the value of focus and how much value is destroyed even by a small slip-up in the core. Our main value-add is damage control. We should do this partly because it is the right thing to do. But we should really do this because uninterrupted business compounding is our best hope for delivering adequate investment returns.

Benjamin Graham said, "The investor's chief problem, even his worst enemy, is likely to be himself”. The same also applies to those owning and running good businesses.