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Tell me where I am going to die, so I will never go there (September 9, 2016)

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The above quote is attributed to Charlie Munger, universally acknowledged as amongst the wisest men in Investing.   I believe he meant that some industries have such pathetic economics and underlying drivers, that you may get lucky trading, but are unlikely to make money staying invested for the long haul.

Consider the case of “Construction” in India.  My Private Equity career afforded me a ring side seat of unfolding Value Destruction as Board member of a construction firm.

  • Every contract went to the lowest bidder with no ability to differentiate execution.
  • Change in scope or unforeseen execution challenges (eg no right of way) meant delays in execution and long arbitration on fair payments
  • Customers (primarily Govt. entities) had to be cajoled, often and begged, to measure work done, approve invoices, and release payments.
  • A change in Govt. at the State resulted in signed contracts being dishonoured after Investments were made.
  • No compensation was made for delayed payments; hence, interest costs were always above budget.

In summary, other than the large opportunity, there was no other reason to venture close to a Construction stock.

The charts below adequately explain why Construction stocks are an elephant graveyard.  Other than the period of euphoria in 2008, construction stocks have massively destroyed value for shareholders.   Not surprisingly so.

  • The best company in the sector struggles to make a 10% Operating margin
  • With the Govt. as the primary customer, Working Capital cycles are over 8 months.
  • Any margin earned is consumed by interest costs and
  • Hence ROEs are below cost of capital

sensex-vs-epc-companies

aggregate-return-on-equity

aggregate-net-working-capital-days

The recent Govt. move to release money stuck in arbitration is a very important step in revival of the fortunes of this sector.  Stocks have rallied, some over 50% in less than a week.   Many knowledgeable observers comment that amongst the biggest achievements of the Modi Govt. is the almost elimination of corruption at the Centre.  If this trend is sustainable, this augurs well for the future of the construction sector as governance standards should see significant improvement.

However, we are not inclined to swing as we believe the odds are against the sector being a long term value creator.

  • The largest share of value in any firm lies in its “terminal value”.   Are changes we are witnessing at present structural? Will they sustain over Govt. and ministerial changes?  Will governance in awarding contracts ever improve? Why do our roads still have pot holes?
  • Low barriers to entry mean that margins are unlikely to improve sustainably.  Generation of a 15% ROE would mean a significant reduction in Capital intensity, which primarily means shrinking the NWC cycle from 8 months to 3 months. That is a tall order given inherent nature of the business.
  • Basic human character never changes.  We can have time periods of good behaviour because one is being watched. However, structural rooting out of corruption from our gene pool requires changes in behaviour.  Unless we stop paying petty bribes, as a society, we will never get corruption out of our genes.

The current momentum in Construction could may make the sector outperform; however, with so many structural head winds,  we never know what event risk will cause these companies distress.  So, even at the risk of missing out, we will consciously stay away and focus on companies with higher probability of success.

Outcomes are critical.  However, outcomes can be deceiving if not measured over the long term.  We believe that by following a process that chooses companies based on the long term quality of growth and earnings, we are more likely to outperform the markets in the long term, even as we have periods of relative underperformance.

One needs to stay true to a time tested belief and not abandon it for short term gains.

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