The most important question

You've got to ask yourself one question: 'Do I feel lucky? Well, do you, punk?’ – Dirty Harry

Sound judgment is about asking the right questions. In turn, right questions are a function of our objective. For a speculator, with a timespan of listing day or weeks or months, question that matters most is “Do I feel lucky?”. For an investor, looking to own an understandable business over many years, most important question is “Who am I backing here?”. This is the zeroth bullet-point of my investment thesis. ?

Investors are passengers. Sure, we check tyres, fuel gauge, vehicle condition and route map before hopping on. But it’s really up to the driver how bumpy our ride is, how long it takes, whether we get cheated or whether we even make it. Route is often blocked, and not all drivers figure out Plan B. We get to nag occasionally, but drivers are used to ignoring backseat chatter. Truth be told, we’re on a ride we have little control over, apart from freedom to jump off the vehicle should it get too queasy.

Sure, this analogy might resonate, but can I be more specific about why this is my most important question?

A few big decisions each year …

Every business confronts a few big judgment calls each year, which are very different from everyday operational decisions. Some are about what not to do: drawing red lines on values (how euphemistic is that?); choosing to avoid fashionable yet risky segments; shooing away bankers bearing ‘transformational’ deals; dissuading managers from empire building outside the core. Some are about what to do: continuing investments in capacity expansion and R&D amidst recession; deploying surplus cash prudently; driving long gestation projects (e.g. new technology, rural push, international expansion); prioritizing employee health and partner payments during covid-lockdown; setting business margin of safety (not merely cash on balance sheet, but things like supply chain resilience); occasionally correcting senior-level hiring mistakes. No decision is easy and every decision is consequential. These are holistic judgment calls, made on incomplete information, keeping in mind what’s better for long-term health of business.

Disproportionately influence long-term trajectory …

In any industry, there are leaders and laggards. Where a company falls on this spectrum is determined by soundness of aforementioned big decisions. When demand rebounds post-crisis, one company is short of capacity while another isn’t. One has motivated employees and partners, while another shafted them to cut costs. One is perpetually fighting fires at a ‘transformational’ acquisition, while another grows its core with boring predictability. Amidst crisis, one is solely focused on business problems while another is scrambling for cash. One has a sharply defined brand that stands for something, while another is a diffused mess. One has a happy channel with consistent policies, while another never feels settled. One leads the way into adjacent spaces, while others play catch-up.

There’s usually a consistent pattern across decisions. Some just can’t get it right. Others make it look easy to do the right thing again and again. Net effect is multiplicative. When industry grows 10% a year, one makes a steady 15% look easy, while another struggles to unevenly maintain 7%. Over decadal timeframes, small differences in compounding lead to sizeable divergence in where businesses end up and how I fare as a passive co-owner.

And only one person can make those calls

While routine decisions can be made by line managers, big judgment calls bubble up to the very top. They need a bird’s eye view of the entire franchise and long-term impact on the same. They need to factor in fuzzy aspects like what the company stands for, how much risk is acceptable and where to operate on the spectrum from unethical to illegal. It becomes imperative, for the person at whom the buck stops, to have long-term orientation, skin in the game and perspective to determine what is best for the business, especially when short-term consequences are negative. Incentives need to be realigned so that others aren’t penalized for adverse consequences over the short run. Top person’s motivations and judgment shape the company’s identity, values, culture, risk, quality and prospects.

When I spot an outstanding business, there’s usually such a person with a long history of sound judgment behind that impressive track record. When I spot a laggard, I also spot the opposite characteristics in whoever is in charge. That’s why I view “who am I backing here” as my most important question.

I digress to clarify that I judge that person solely based on reality, not perception. It’s long-term business performance, not first-hand impressions, that I use as a barometer of sound judgment.

I deliberately avoided giving this person a label, although ‘promoter’ is the natural choice in the Indian context. However, it’s more complicated than that. Not every business has a promoter. Not all promoters are same. Occasionally, promoters can change abruptly. Some are promoters of multiple businesses, not just the one of interest to me. Some promoters aren’t very owner-like in behavior. Occasionally, lifer CEOs can turn out owner-like.

A generic, oversimplified label doesn’t do justice to all the situations that an investor encounters. So, the answer to my question takes many forms. Over the next few essays, I’ll elaborate on some common forms: focused owner, diffused owner, misaligned owner, no owner, new owner, manager (some of whom are owner-like), renter. Phew. These have varying impact on my professional wellbeing. Some forms are preferred, while others are highly avoidable. I’ll share my good-bad-ugly view on this spectrum of answers to “who am I backing here”, while offending as few people as I can.

(Being my most important question, I have to get into some depth on each ownership construct and what it means for a long-term investor. Please brace yourselves for boring, verbose write-ups. I’ll likely split this topic into multiple essays to make it more tolerable and publish a consolidated long-form at the end.)?