I wrote this ten days ago for a highly-respected US-based institutional investor and thought of sharing a slightly modified version of it with my students in class and over here.
Thanks again Prof.
I recently sold a strongly performing battery manufacturer *solely* because I felt he fell into what you classify as the OO3 bucket. In short time since, it has gone up again leaving me thinking if I was wrong. Your article gives me confidence I was probably right (and I don’t feel like I missed out on the gains).
As I read your points under ‘Capital stewardship’, I recalled reading parts of “The Outsider – 8 Unconventional CEOs”. Have you read the book?
Of course. That’s a great book Prem.
Nice pointer Prem, being in the same boat and sold the battery manufacturer too. The initial position was taken on the premise of a strong foreign entity being their partner will restore some control on the capital stewardship and management compensation, however as Prof. highlights, political clout laden promoters sometimes think too big of themselves. Better to avoid returns from such counters.
I did the same. Sold off the battery manufacturer. Future will show if I was correct.
do u mean amara raja? 😛
m holding it but wondering wat m i holding..typical type OO3…
How would you classify entrepreneurs who milk a legacy that they have been left behind without any ambition/vision to scale it up ? For eg., a second generation of a business – which is still a good business but has slowed down considerably. In the ultra long run, it might destroy value but what about the medium term – 3-5 years
Dear Prof.Bakshi, thanks for sharing this, it helps be sober and keep perspective when investing. I personally experienced a type 003 promoter, a well known brand that was incredibly successful in one area over 2 decades. But the business became commoditized, although it generated huge cash flow. This promoter and his son were incredibly ambitious, and started diversifying into multiple areas to become famous. They used the cash flow from the existing business, and also borrowed big time for expansion into areas that they were not competent at, but were currently trendy. Within 4 years, only a skeleton of the original business remains, and the stock is now 1/100th of its peak value. Shareholders were destroyed, many careers of employees were destroyed….
Rajaram, Warren Buffett related a story in his 1995 letter on similar lines. He wrote:
“I can’t resist repeating a tale told me last year by a corporate executive. The business he grew up in was a fine one, with a long-time record of leadership in its industry. Its main product, however, was distressingly glamorless. So several decades ago, the company hired a management consultant who – naturally – advised diversification, the then-current fad. (“Focus” was not yet in style.) Before long, the company acquired a number of businesses, each after the consulting firm had gone through a long – and expensive – acquisition study. And the outcome? Said the executive sadly, “When we started, we were getting 100% of our earnings from the original business. After ten years, we were getting 150%.”
Fully Agree that OO3 type should be strictly avoided for straight equity. What’s your view in case of special situations investment in companies run by OO3 type promoters, where the time period is only 3-6 months.
A one-night stand with the wrong kind of partner can still get you into trouble. Promoters with wrong intentions have announced buybacks without intentions of carrying them out. De-listings have taken place at surprisingly low prices because there were some dealings “behind the scene.”
I recall an instance of a distressed company being acquired by a then prosperous company through a preferential allotment of shares. The allotment triggered an open offer for the target company and the offer was made. As part of the deal as explained in the public announcement, the preference shares of the distressed company were to be concerted into its equity shares at a specified swap ratio. The preferred was selling at a deep discount to the equity. The spread was so lucrative that it offered a 52% flat return over 6 months.
About 21 months later, the deal was cancelled. By then the financial situation of the acquirer was worse than it was before the acquisition, and that of the target was terrible.
Having said that, if you are sure that you have a solid contract, with SEBI’s protection and a deadline that won’t be missed beyond a reasonable time, go for it.
Thanks a lot Sir, off late my thinking was leaning towards avoiding OO3 managment even cases of special situations, except for very few cases of open offers.
In one of your post you talked about return per unit of risk. In a very short period of my experience with special situations investment with pathetic managements is that return per unit of risk declines when ever I invest with such management. Thanks again.
I think you meant return per unit of stress:
Yes, I meant return per unit of stress and I appreciate that post better now. Thanks a lot….
Why do the private equity guys still go and invest in several of the OO3 businesses? They should rather groom OO1 raw material when they see it.
Why do our banks lend to OO3 types?
How to influence some OO2 guys to become OO1 or become even better stewards of capital?
Caution on OO1: Wanting to create something great, being long term oriented, being ethical, etc do not automatically guarantee that an OO1 will have the “intellectual capacity” to take his/her business to commanding heights.
Many entrepreneurs who scale to $100M may not scale to $1B and those who scale to $1B may not scale to $10B. Thus, they may underperform.
We are seeing this over the past decade as Infy failed to become a true peer of global consultancies like IBM or Accenture. The leadership simply does not have what it takes, even though it is OO1.
Thank you Prof for the very interesting article!
For all investing purposes can we club OO2 with OO1 category? In your experience what differences have you seen in outcomes of investing with these two different types of promoters?
With your example of Unitech vs Hawkins, the difference between OO1 and OO3 is very clear to me. Thank you for the great example!
For investment purposes, we should club OO1 and OO2 because there are so few OO1’s out there. The reason why this is important is because I hear a lot of criticism about how well the promoters of some family-owned businesses in India are paid. Typically, the criticism mentions total remuneration paid to promoters as a percentage of revenues. There is very little, if any, discussion about how much wealth these promoters have created for minority stockholders over the last decade or so, where that wealth was created through the growth in the underlying value of a high-quality business recognized by the stock market.
Sure, other things remaining unchanged, we all would prefer to partner with an OO1. That’s what Mr. Buffett does in his most of his acquisitions. A typical BRK acquisition involves the acquisition of an outstanding business created and run over decades by an OO1.
But there aren’t very many OO1’s out there (or perhaps, I haven’t found many) so a refusal to invest with OO2’s carries large opportunity costs.
One last point, which has little to do with your question but I thought of mentioning it here. The chief difference between an OO2 and OO3 is that the former makes money with investors, while the latter usually makes money off investors (both equity and debt) and the state. So, for long-term investors, its very important to be able to identify an OO3, and watch him from a safe distance.
Thank you Prof for the great lecture, one of many.
I wish I could have joined your class, but unfortunately I live quite far away from the U.S.
I have a practical question though, maybe even technical in nature:
How can a small individual investor, like me, invest in a specific company in the stock exchanges in India? I understand that the markets in India aren’t exactly open for foreigners.
[…] https://fundooprofessor.wordpress.com/2013/10/12/oo1-to-oo3/ […]
i wonder would V Guard be a OO3 company? It has grown well but recently V-Guard ceo buys BMW car from company money. Check out page 68-70 of company annual report ( http://www.vguard.in/pdfs/Annual-Report-2012-13.pdf )
Not sure about V Guard, but this one, about Ispat, takes the cake.
Dear Prof, Interesting article and thought provoking. Is there a shift possible between O2 to O3 and viceversa?
The drop box link does not work 😦
Can you please fix this ?
It worked but I have put an alternate link anyway.
that alternate link is also not working . for tcil ppt those links are not working
Both are working. I just checked.
[…] I now have a management quality checklist (which covers operating skills, capital allocation skills and integrity), which keeps getting tweaked over time. Some of it was published here. […]
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