When I reflect on my investment career, a few experiences stand apart from the rest. One occurred during a trip to India in 2003. While there, I met with the chief financial officer (CFO) of a publicly-listed hotel company. I was intrigued because the hotel chain enjoyed high rates of return on invested capital (“ROIC”), a characteristic often associated with “high quality” companies – the ratio can indicate whether a company deploys its capital in an efficient and profitable fashion.
I spent the meeting probing the company’s business model, and the reasons behind its attractive ROIC. It soon became evident that the company’s returns were attributable to the very high rates it charged for its hotel rooms. I thought those rates were excessive, especially relative to local income levels – I could not understand how Indian tourists and business travelers could afford such prices, and I thought they might choke off nascent demand. However, my concern came to a head when I inquired about the company’s growth plans. The CFO responded that the hotel chain would pursue only limited expansion. I questioned this strategy: India was a large and rapidly growing nation, and my research indicated that the supply of formal hotel rooms was shockingly small relative to potential demand. The CFO was keen to explain that the company (and the rest of the hospitality industry) was happy to exploit this situation. By constraining supply, the company (and the industry) could maintain scarcity, and charge elevated rates for years to come. This would of course ensure a high ROIC for the company; but as to whether the market would ever be developed properly, the CFO was indifferent.
That conversation permanently altered my view on investment in developing markets. Prior to that moment, I heavily favored companies that demonstrated highly efficient use of capital. Yet I found the meeting frustrating: the company was profitable, and well run. By all rights it should have led the modernization of India’s hospitality industry. Instead, the company was content to rest on its laurels, reaping the excess profits associated with scarcity. If the company operated in a mature economy, that strategy might have made sense. In India it seemed misguided. The market was bourgeoning, and starved of supply. I could not understand how the company could be complacent in light of such opportunity – even as its ROICs would look great on paper.
From that day forward, I have placed greater emphasis on identifying companies that maintain steady investment programs. I prefer companies that are committed to the careful but consistent development of the markets in which they operate. My premise is that such companies are more likely to generate sustained, long-term growth. To be sure, aggressive capital expenditures can be the bane of investors: they can depress free cash flow; they can give rise to new financial burdens; they can undermine profitability if executed poorly. But the opposite approach – investing in companies that constrain investment so as to flatter returns – is not an attractive alternative. Doing so often means investing in smaller companies content to operate in under-developed markets; they are happy to “milk” short-term profits at the expense of long-term investment. By constraining capital investment, they can cultivate scarcity and inflate prices, thus earning super-normal profits. Their returns appear attractive enough, but they usually short-change the potential of a developing market.
Economic theory suggests that competition will eventually erode abnormal profits. However, in developing countries, capital is often difficult to access. This acts as a de-facto barrier to competition, as new entrants struggle to obtain sufficient capital on reasonable terms. An established company can thus exploit a market far longer than would otherwise be efficient. In my view, this makes nearly everyone worse off. Customers are stuck with scarcity, and with prices that aren’t competitive. The broader economy suffers as it inherits a sub-par industry – one characterized by sub-scale infrastructure, bottlenecks, “rent-seeking” behavior, and other inefficiencies. Investors may gravitate toward the company’s high ROIC. Yet they are likely to be stuck with a “permanent small cap”: a company that does not invest steadily in its own future will not offer the sort of scalable, sustained growth that characterizes a core holding.
Next week I will continue this commentary. I’ll provide data on the “BRIICS” (Brazil, Russia, India, Indonesia, China and South Africa), and use it to explore some of the assertions I make above. I’ll examine those countries’ investment patterns, measuring whether they have invested in a manner consistent with long-term development. I will also examine a few measures of long-run success, to see if there is any correlation with such investment. Lastly, I’ll touch upon China’s elevated (some would say breakneck) pace of investment, and what it means for the future of that country.Andrew Foster
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.