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Talking of a rally, one should be due now. The cascading fall over the past few weeks should pause and a weak uptrend will begin. The market cannot stay still, especially at a volatile time like this and so the pulls and pressures between bulls and bears will ensure up and down moves. I mentioned in the previous issue that after a huge decline since the middle of May, it is time for the market to stage a small rally. I also wrote that this would be a short-term scenario, clarifying that the coming bounce, like the previous ones, will not last. It seemed to me that “the medium-term trend has clearly turned downward and we should get another steep move down soon.”
The Sensex rallied from the close of 15,189 on 13th June, when my last piece was written, to 15,696 on 17th June. However, this move fizzled out and a steep decline began, all the way down to an intra-day 13,731 on 25th June, taking support at the previous bottom of 13,779 made on 17th August 2007 at the height of the subprime crisis. (By the way, the low of Dow Jones Industrial Average around that time was 12,518. The Dow was 11,453 at the time of writing this piece. The Sensex has clearly done better than the Dow through the entire crisis). Let me end with a glimmer of hope. One of the best fund managers of the past few decades is value investor Jean-Marie Eveillard who runs the First Eagle Overseas Fund. A report on www.marketwatch.com states that he believes this to be the worst financial crisis since the Great Depression and that markets will inflict more pain before the adjustment process is complete. So where is he putting his money? He has bought lots of Japanese stocks. More important for us, he is looking at other countries in Asia, especially India. As the report puts it, “Later this summer, Eveillard will hear from one of the fund’s analysts about potential investments in India.”
Spend enough time comparing operational and financial data and you are likely to notice a simple truth: companies that manage their working capital well steadily become more valuable. Consider, for example, what happened when Allianz Capital Partners, a private equity firm, acquired Schmalenbach-Lubeca, a German packaging company, in 2000. Allianz soon realised that its acquisition, accustomed as it was to easy loans from its erstwhile parent, was managing its working capital poorly. The new owners set to work, methodically tackling each component of working capital. A few years later, they were able to sell Schmalenbach-Lubeca at a premium, a substantial part of which could be traced to two simple changes – replacing loans from the parent company with bank debt, which necessitated a disciplined approach to repayment, and optimising the balance between payments and collections, which improved cash flows.
Around the time that Allianz was overhauling Schmalenbach-Lubeca, Robert Nardelli was getting to grips with Home Depot. The company had grown rapidly in the 1990s – over the decade, $100 turned into almost $4,000 – but in the new millennium, growth had fizzled. In desperation, Home Depot’s board had turned to Nardelli, a veteran of GE’s power systems business. On the working capital front, the situation he faced was grim. An example was the way suppliers were selling the same things at different prices to nine different divisions. As one director put it, “We ordered $40 billion worth of merchandise with a system consisting of paper and pencil.” Nardelli’s tenure ended abruptly, so it is difficult to assess the efficacy of his strategy, but it seems safe to say that procurement and, by extension, working capital, was better managed when he left Home Depot than when he arrived.
Home Depot is based in the US, but to see what good working capital management can achieve, we need travel no farther than China. When the Hong Kong-based Lenovo group acquired IBM’s personal computer division in 2005, it paid $1.2 billion. To make the acquisition succeed, Lenovo had to find savings swiftly. The board challenged senior vice president Qiao Song: could he save $150 million in direct spending by building a new procurement team? He would have 18 months to pull this off and, while he was at it, deliver savings of $300 million more in annualised running costs. How Qiao Song succeeded is a story in itself. For our purposes, one message stands out – working capital management (particularly procurement) was crucial to Lenovo’s achievement.
It should be obvious by now that there is more to working capital than what a routine appraisal of near-term liquidity is likely to reveal. The next time you’re studying a company, look closely at the components of working capital. Interview suppliers, if you can. Get a feel of the company’s procurement practices. If the company works through distributors, make inquiries among local representatives. As Lenovo’s Qiao Song told an interviewer recently, “Rapid increase in size meant we would need additional structure and more stringent processes in order to handle greater volumes.” Only with carefully designed practices, like strong working capital management, is the company – and your investment in it – likely to grow.
Shreedhar Kanetkar welcomes your comments. Write to [email protected]
Bernstein starts by strongly defending all those who crafted the efficient market hypothesis (EMH), capital asset pricing model (CAPM) and modern portfolio theory (MPT), which have fetched several Nobel prizes for Markowitz, Scholes and others but which have been ridiculed by many successful practitioners as ivory tower finance. These theories were found to be too neat in the hurly-burly of the markets, based as they are on the assumption that all market players are rational and all prices incorporate all available information. Then came behavioural finance, pioneered by Daniel Kahneman, Amos Tversky, Richard Thaler and others, which underlined the crucial role of the individual investor’s psychology and the collective behaviour of the crowd which goes mad in bull markets, thereby significantly influencing investment outcome. This exposed the shortcomings of MPT, EMH and CAPM. They were branded as peddling ‘ivory tower finance’.
Since then, the two camps have been at loggerheads. Bernstein adds new light to the whole issue by narrating how the insights developed by the academics in the ‘ivory tower finance’ mould have been taken forward in the real world by Barclays Global Investors and Goldman Sachs Asset Management to develop winning strategies. This book is not as gripping as the earlier one. It is dry (the subject is) and the characters Bernstein describes are not colourful. But it is probably the only book so far which documents the recent history of applied financial innovation drawing from modern financial theory. It is a must for all serious students of finance, who must know that the whole topic is still evolving, as the title suggests. – D.B
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