A couple of months back, I was sitting with one of the biggest commodity industrialists of the country, when he remarked, “We are a very ‘focused’ group. We don’t get into businesses or activities we don’t know”. My response then came as a bit of a shock to him: “Then the problem is with you (or your knowledge), not with the business.” The context was a discussion of the full range of Treasury activities that a company should invest in.
The background to the conversation holds the key to the point of this piece. The company was just another (commodity) player, with good financial (management) skills, conservative management and excellent Project Management skills. In the recent commodity boom across a broad spectrum of products this company has been one of the most “fortunate”. It has grown by leaps and bounds, not only in its domestic operations, but also in exports (to China, but naturally) and in its international operations (through some acquisitions in third countries).
This has triggered off a growth spree. What used to be a single-plant operation with a simple processing operation (buy inputs from one place, process, sell mostly to Indian customers) is now a multi-input, multi-location, multi-currency/ country, operation that is run by the same intellectual core of 4-6 people, who used to run the previous single-plant operation.
The increase in complexity is enormous. Barely 4 years ago, the company bought all its inputs from India, and sold its final produce in the domestic market. Now, a sudden but temporary adverse movement in an ASEAN currency like the (Malaysian) ringgit, will leave a gaping hole in the company’s cashflow.
Take the steel sector. Suddenly, steel companies are importing Coking Coal, Nickel, Chromium in quantities (and values) that are equal to their entire turnover a few years back. The consequent risk due to commodity price volatility is equal to their entire bottomlines today. In other words, if there is a series of adverse movements in a currency (like the Rupiah), a commodity (Nickel/ Chromium/ Coking Coal), a labour/ political problem in a country of production/ export, you could suddenly see the entire bottomline (or even a chunk of the Net Worth) of a company go up in smoke, with not a ripple worth reporting in the respective economies/ markets where the company is operating.
The point I am making is this: that as Indian companies “globalise”, they take on risks that they were not paying attention to earlier (and in many cases, where they have limited skills even now). Along with risk, they are sometimes presented with opportunities from outside their “sector”.
To take the steel example above, a globalising steel company is faced, willy nilly, by new threats from volatility of the currency, the commodity…… besides the normal fluctuations in interest rates and other input costs. In managing these threats, it is sometimes presented with opportunities as well. That is when it finds its traditional definition of “focus” challenged. What I heard this industrialist say, is that he would eschew opportunities that were outside the scope of his “business” and therefore not part of his focus.
Risks do not seek an invitation before impacting your business. A growing company that is also globalising, needs to build skills in understanding the various risks that will enter its business domain. From the SARS virus, to the ripple effect of the tsunami, to more everyday concerns like volatile currency/ commodity price volatility, all this and more will be par for the course for the international risk manager.
The flip side of this coin is opportunity. In building these skills, why does the company then turn around and say, “but our business is steel, we will only make money out of steel”. What if the next big trend is not coming in your sector. Does your Chief Economist/ Treasury Head sit back and say, “I will not make this money, because my business is steel.”
The point I am making may seem obvious, but you would be surprised at how many entrepreneurs fall for the flawed argument. Like the “Devil quoting the scriptures”, companies hide behind this definition of “focus” to keep their skill-sets narrow, ie, to avoid wading into risk, to seek opportunity.
A little story I heard about Delphi might help make my point. In the middle of the Brazilian (Real) crisis of 2002, the company moved nearly half a billion dollars into the bankrupt economy, betting on a turnaround. Its escape hatch: even if the economy stayed under, Delphi would find a use for the Real, by converting its liquid holdings into long-term investments.
Delphi did not sit back and say, “we are an auto company”. Incidental to that (auto) business, they had to build skills in understanding the currencies and the countries they were operating in. Consequent to such an understanding, they could take a view that the Brazilian crisis would (in time) blow over, a local assessment that proved superior to the broader market’s view on the country/currency.
This was a punt that worked. There are punts that don’t work. In every case, there is a fine balance that a company needs to define for itself. That is, to understand and handle the risks that it faces as part of its business, a company must build skills to survive. Increasingly, good companies define their “businesses” in terms of these critical skill-sets, rather than the product-market spaces (steel, aluminum, auto, FMCG, whatever) that these companies operate in.
Is Delphi a currency speculator? No, it just took advantage of a local insight, which gave it access to superior information (and consequent) assessment. It also took advantage of a fortuitous situation it found itself in – the ability to convert a liquid holding into a long-term “investment” that would reduce the holding cost of the “view” the company had taken.
The actual source of the profit came from superior risk-assessment skills, which should usually be used defensively, ie, to neutralize operating or financial risk. Sometimes, however, it can be converted to opportunity.
For investors and analysts though, this makes it more difficult to understand a company’s “core earnings”. Often the market will turn up its nose at a company’s “quality of earnings”, until the company is able to prove the sustainability of such cashflows. That does not lower the strategic importance of such skill-sets. In an increasingly dangerous, integrated and volatile world, such skills (and with it, the corporate attitude) could actually be the differentiators that build great companies.
Yet another argument against sticking to a defined “focus area” is that often it is subject to a known irrationality, often called Mental Accounting. This is nothing but our tendency to think in “buckets”. For example, if you make a loss in nickel buying (against a standard ‘bottom’ target price of nickel), you want to recover that loss from Nickel trading. Why?
I am reminded of an American professor who would fool his natural “loss aversion” by deciding to “donate”, say, $2000 to a distant charity. Then, every time he lost money to life’s little irritants (a New York cabbie on a rainy night, maybe), he would deduct his “loss” from the amount he was to pay his charity. Somehow, he says, it makes him feel better. Try it!
In line with this I argued that the company should debit a special account with all its (notional) “losses” and to calculate its Nickel cost as if it has obtained its Nickel at the lowest possible cost. Then hand over the deficit to its Risk Function, with the mandate to neutralize the deficit with “whatever means possible”. The Risk Manager could then use the company’s large cash surpluses, its substantial debt capacity and its well-rated Balance Sheet to capitalize on opportunity wherever it happens. But this would require that the company define its business a lot more broadly than “steel”. What’s more, such a definition of “business” would perforce be fuzzy, with periodic shouts of “focus” going up every time the Risk Manager miscalculates.
Knowing large companies, this is a difficult, even if superior, existence.
