The business of business...

Continuing with thoughts on business models...

To exist, businesses must deliver value to its customers - this is different from the debate on creating value for shareholders vs stakeholders. Preferably, value must be tangible, but in some cases, it is notional. The industry that best demonstrates value creation is IT. Just imagine the time and effort wasted on mundane tasks everyday if we didn't have Windows and Microsoft Office.

Of course, value creation is not as obvious in all cases. Entertainment and television, for example. Some people would argue that television is turning us into morons and is actually value destroying. Yet, the industry is exploding. This is a case of notional value, where people are ready to lap up any and every form of entertainment. It can be risky to bet on such models because they fundamentally rely on exploiting consumer preferences. Very similar to what the fashion industry does. The value created is not by clothing people but rather by making people feel that their clothes are better than others. This is also the business model of our local quack, palmist and other fortune tellers – they all make the consumer feel better.

The ability to deliver notional value on top of real value is the holy grail of a successful business. Which means, not only is the product good, but you also take pride in ownership. The ipod and iphone are perfect examples. World-class products enhanced by the “Apple” brand. Even here, the relative magnitude of the tangible and notional values matter. So long as the tangible value is much larger than the notional one, the business is stable. Microsoft, for example, probably has a negative notional value, but is yet a profitable business because it offers unmatched tangible value. On the other hand, FMCG products do have some tangible value, but rely heavy on notional value. I doubt if any of us can differentiate between two shampoos in a blind test.

The simplest way to check whether a business adds value is to ask if it helps people do stuff “faster, better and cheaper”. Ideally, all three aspects must be addressed but sometimes addressing even two is okay.

I mint?

Great ideas sound exactly like foolish ones - until they work that is. That's my favorite Scott Adams' quote.

The thought occurred to me when I saw the ad for imint on the back of a bus. It is a rewards system where you earn points every time you spend, which can be later redeemed for gifts or vouchers. Nothing radical about the concept itself. Credit cards have been doing this for a long time now. But here's what puzzled me. Is there an opportunity for a third-party to make a business out of it?

I dont know for a fact how imint works, but my guess is they have consolidated the rewards system of some retailers and cards so that the customer is able to get points for all transactions in a single "currency". So no more 100 points with ICICI, 250 points with HP, 50 points with Jet with none of them sufficient by themselves to do anything. Now, we get 450 imint points that is good enough to get a mug or something.

I guess imint adds some value thru the economies of scale it gets by consolidating the rewards system. So that explains why ICICI, HP and Air India have hopped on. Their points now make some sense to customers. But how would imint get new customers? For instance, why would HDFC or Jet sign on? Its destructive to both HDFC and ICICI because their customers wont see any difference in using either card, thus resulting in mutual cannibalization. In fact, I wont be surprised if ICICI has an deal that prevents imint from signing on competing financial institutions.

So how can imint grow? Well, by encouraging customers to spend more. That I think, personally, is a friggin stupid model to run a business.

Plane drivers

Are the pilots right?

Unions are a pain for any management, but to fire pilots for starting a union sounded extreme. Apparently, it was set off because the relations between management and pilots soured when Jet wanted to cut back on pilot pay.

However, I wasnt too comfortable with the idea of going on a pseudo strike and causing inconvenience to the general public let alone losses to Jet. But I was simply stunned when I learned that pilots make as much as 10L per month. Yes, per month. Some might make less but nothing below 3-5L. I heard Naresh Goyal on TV say that people making that kind of money shouldnt be exploiting rules intended for blue-collared workers. And that sounded logical. (Let me get this out of the way. I did feel pangs of jealousy on hearing the size of the pay packet.)

So the point is, do employees with six-figure salaries really need unions?  Such people have high intellect and specialized skill sets that cannot be easily replaced. That also means they have plenty of employment options. Their thought process is broad enough to consider the possibility of job loss and save for the rainy day (which bluecollared workers may not or even cannot). But airlines is an oligopoly, and one that is not doing too well. As it is, you have no  more than 5-6 airlines in our country with the majority of them losing money. While airlines may not be able to join hands publicly, they can still work behind the scenes to keep salaries down. A couple of years ago, our own IT companies agreed not to poach from one another, and have repeatedly stated that rising employee salaries are a concern.  Whether such moves amount to collusion or cooperation is a matter of debate.

I think the pilots are right in forming a union to maintain the power balance, but in the process have shown that they are no more than simple plane drivers. That is, they are no different from a railway motorman or a crane operator  who will find himself at sea should he be let go. It is not a skillset that can be transferred to a different industry.

Consultants as Traffic Police

Consultants are arguably the most hated bunch of professionals around. While the financial engineers have stolen that crown momentarily, it won't be long before the trophy is passed back. Not just because the crisis will be forgotten, but also because every minute, consultants are coming up with ludicrous recommendations. Ludicrous when you look at them with 20/20 hindsight that is.

Every manager worth his salt hates to employ a consultant for it is a tacit admission of his own incompetence. Yet, the consulting profession continues to thrive and remains the most sought after career option for management graduates. What gives?

I was crawling in Mumbai traffic when it hit me. In front of me was a Santro sandwiched between a truck and a BEST bus. Now truck and bus drivers believe in extreme precision. They will drive by within an inch of your vehicle without skipping a beat. In this case though, both of them were generous enough to spare a couple of inches, but the Santro guy got all worked up. He kept nervously peering over the bonnet and looking through the side windows to make sure he was okay. I, of course, clearly saw that he just had to maintain his line and he was fine. For a minute I was amused, but soon realized it happened to me as well. Several times, in fact. Sitting inside the car, I find it incredibly difficult to accurately estimate the space available around the vehicle be it when making a sharp turn or parking in a tight spot. And that is what happens to organizations as well. People within find it difficult to clearly see the external environment. And their calls might result in a traffic pile up, or worse, a crash. The former causes organizations to lose its direction and momentum while the later pretty much kills them.

Time for your friendly neighborhood consultant to step in. He is not a Santro expert – you are – but he knows enough about it to guide it out of traffic. Which is what consultants often do; they bring in simplicity and clarity. In other words, the value added by a consultant comes from his perspective and not so much his competence. If he is a good one from McK, he will know the shortest route to the expressway. In that sense, he is no different from a traffic policeman. Of course, the recommendations would fail if something else comes up on the suggested route - another traffic snarl, for example. Or you ignore his idea and stick to your route and by some freak chance the traffic clears up. And when that happens, organizations ensure consultants dont go unpunished.

I have taken artistic liberties to make the analogy work and sincerely apologize if it caused offense to traffic policemen.

Tailpiece: It is much more difficult to estimate navigate sharp turns if you are driving a big car like Accord or Corolla. That explains whylarge organizations react sluggishly to changes in environment.

Outliers and Hofstede

MBA is a great leveler. The heady excitement of macroeconomics, finance and marketing is tempered by the fatal boredom of HR and OB. And one topic that inevitably gets raised in HR and OB is the Hofstede’s Index.

Geert Hofstede, a Dutchman, profiled the behavior of people in various countries and concluded that cultural differences can be explained on a four-point scale: Power Distance, Individualism vs. Collectivism, Masculinity vs. Femininity and Uncertainty Avoidance. B-schools and academia adore such neat models and, next to Porter’s Five Forces, Hofstede’s Index has to be the most frequently used tool to explain away the failures of MNCs. It makes you sound intelligent and gets you points for class participation. Beyond that, it seemed useless. Until I read Outliers.

Gladwell’s latest book attempts to search beyond the obvious traits of successful people – that is intelligence, hard work and perseverance. They are important, he agrees, but claims there is a little something, called luck, which actually catapults them into a different league. Like his previous books, Outliers makes for interesting reading, but what made me sit up and take notice was his analysis of plane crashes.

Here is a chilling recount of the 1990 Colombian Avianca plane crash in New York. The aircraft is desperately running out of fuel, but has not been given permission to land. The captain asks the first engineer to contact ATC and tell them it’s an emergency. The first officer contacts ATC, and among other things, mentions they are running out of fuel. Planes are expected to be low on fuel as they reach the destination so ATC doesn’t give this much weight. But rather inexplicably, the first engineer doesn’t push.

The situation makes no sense, until one looks at it through Hofstede’s index. Colombia is a country with relatively high power distance, where people are more respectful of authority. Hence, no questions were asked. If the first engineer was an American, Gladwell claims, the conversation would have taken a different course. Reading this sent a chill down my spine, but it seems airlines world over have recognized such manifestations of cultural differences in everyday interactions, and have taken measures to train their pilots and crew.

Jai Hofstede!

Consumer Insight

Carrying forward from the last post, there are two diametrically opposing views on this matter. One believes that consumers are really smart and will call your bluff the moment your product takes them for a ride. Examples include consumers dumping American made electronics and cars in favor of Japanese ones.

On the other hand, some believe that consumers are gullible and will willingly buy a golden noose only if you knew how to sell. Examples include Coke and credit cards. There was no "need" for cola. Someone made up with a drink and transformed it into a habit. If Fair and Lovely really worked, half of us in India would be swans now. Yet, the product continues to mint money for HUL, and has spawned a market for fairness creams.

How does one reconcile these two observations? The popular notion of succesful businesses is a neatly laid out set of numbers, projections and valuations, but any business is incomplete without the understanding of human psychology, which provides the most crucial insights. Mr Charles Revson, co-founder of Revlon famously said, “In our factory we make cosmetics. In the store we sell hope”. That's the key. What you are making and selling are often two different things.

Even in case of more mundane products like ball pens, consumers are buying expectations not products. And if the performance doesnt meet the expectations, well, you are screwed. And these expectations can stem from totally irrational notions. Chinese products are presumed cheap so its really tough for a Chinese manufacturer to sell premium products. In such situations, the solution is not in the 4Ps but rather in the other often neglected P - the Psychology of consumers.

Airline Strike

Private Airlines have decided to suspend operations on August 18 to protest jet fuel prices and surcharges. Their demands may be legitimate but going on a strike hardly feels like the right approach. Jet and Kingfisher have confirmed this, but low-cost airlines havent yet said anything. It is interesting to see if there will be any government intereference in this matter.

One might argue that these are private corporations, and the government should not interfere with their decision. Yet, airlines have become such an integral part of our economy that the 1-day suspension is definitely bound to have an impact on the economy. In addition, the legalities of airline operators getting together to suspend operations is doubtful. In most western countries, such a move would be termed "collusion" and attract the attention of trade regulators.

When calling to privatize PSUs, we must remember that the legal and regulatory system needs to robust enough to ensure that the nation is not at the mercy of capitalists.

MS Yahoo deal - Yahoo RIP

MS and Yahoo have entered into a deal to beat Google. While the details are not completely clear to me,  it seems like MS will essentially use the Bing architecture to power Yahoo searches. Consequently, the two cos will end up sharing revenues with Yahoo retaining ~90%.

Lets see how this will play out. Everytime you search for something on Yahoo, it is actually Bing that does the search and delivers the results. Now, search-based advertising means that ads will be automatically displayed based on search strings. So that will be done by Bing too. And of the revenues earned, Yahoo pays 10% to MS.

The only thing Yahoo had going for it is the #2 position in search and the resultant reveues from ads. That advantage is now erased 'coz it will depend on Bing to make money. I doubt if the agreement will restrict MS from competing in the ad space. So now MS gets to make its own ad money and also get money thru ads on Yahoo (although only a small %). But thats not the point.

The point is MS gets a much larger canvas to play on. The Bing "search system" will be used at least 4 times more than if Bing remained a standalone search engine. And all this data is available to MS, which means it can make Bing that much better. And once Bing starts getting better, and word spreads that Yahoo is actually "Bing", surfers like you and me will start searching on Bing directly rather than Yahoo (Some will go to Google, but hey, if they are still on Yahoo, they are probably gonna end up with Bing than Google). Consequently, Bing's market share will improve at the cost of Yahoo's, resulting in movement of customers from Yahoo to MS. Once Bing reaches a critical mass in the next 3-4 years, say 25% market share (standalone), it may damn well pull the plug on the deal.  In all probability, Yahoo would have stopped work on its search platform and would be left stranded. Meaning all remaining Yahoo customers will drift to MS or Google.

My feeling is MS couldnt have asked for a better deal - it gets to kill Yahoo, although not immediately, but hey, they dont have to pay a penny. Well for Yahoo, it is definitely suicide.

Value of a stock - Part II

Before we move forward, lets discuss the time value of money. This concept is at the core of financial valuations. It states that a $100 today is worth more than $100 a year from now. Why? You can put your $100 in a bank it will be $105 next year. That's the time value of money. In other words, there is an opportunity cost involved.

Back to our stock now. We've determined the return that we are expecting from the stock. And we have the price of the stock as it trades in the market. We can use the two to determine what should the price one year from now. If price is $10 and expected return is 10%, then price of stock 1 year from now is 10*(1+10%) = 10*1.1 = $11. In other words, if the stock price is $11, one year from now, you can pay $10 to buy it today.

A little digression to understand where a stock's value comes from. A company makes and sells products and earns revenue. Out of this, go expenses such as raw materials, salaries etc. If the company has any debt, it needs to pay interest on that. And what remains is the profit. Of course profits are taxed, so a portion of that goes to the govt. What remains after all these is called Profit After Tax (PAT) or Net Income (NI) is available for distribution among shareholders. In reality, of course, companies "reinvest" PAT, meaning they will use this money to fund further expansion and generate more revenues etc. For simplicity, lets say a company is "mature", meaning there are no opportunities of growth. It will just keep making and selling the exact # of units year after year. As a result, all PAT will be distributed as dividends to shareholders that is you and me:) In reality though PAT doesnt equal CASH - that's accounting for you, which is way out of the scope of this article. But understand that some adjustments are made to PAT to arrive at "Cash Flows (CF)".

Now it all comes together. Once you know the CFs of a company year after year, you can discount them all by the expected return rate to get today's value. But we only have data to calculate last year's CF. How do you know what the company makes in future years? This is where assumptions and projections come in. You look at the economy, industry etc., and predict that revenues, expenses will grow or shrink at a certain rate leaving you with a CF. This is one reason why analysts may have differing opinions about a stock's value - because they have different growth assumptions.  Once you buy a share of a company, you own it forever (or until the co shuts down). So you'd have to project CFs out to infinity. To make it mathematically manageable, you project it out 10 years or so, and use a geometric series formula to find the value at the end of 10 years. Now discount all these values to today and you have the value of the firm.

Now, if the firm has taken any debt, that will need to be repaid eventually. So subtract debt from the value of the firm and you have the "equity value" of the firm, which is what shareholders own. Simply, divide the equity value by the number of shares outstanding, and voila! you get value per share.

If this value is less than market price, the stock is overvalued. If it is greater than price, the stock is undervalued.

Value of a Stock – Part I

For a financial layman, like I was a year ago, the price of a stock is a mystery. Why does Microsoft trade at $25 whereas Google trades at $450? And why do analysts mean when they say Google is cheap at $450? Isn't MS dirt cheap at $25 then?

That's the first rule. The price by itself doesn't tell you anything. What you need to know is the price of a stock relative to its value – another term relentlessly abused by the financial press and analysts. Let me try and debunk this mystery.

Buying a stock is an investment so you expect some returns. Think of a bank term deposit. Let's say, you put in $1000 for a year, the bank pays you some interest. The interest is your return from the deposit. Of course, the big difference between the two is that the returns of a stock are not well-defined. Let's dig deeper.

If you hold a stock, your return can either be capital gains or dividends. Capital gains are simply the profits you make when you sell the stock at a price higher than what you paid to purchase it. For example, if you buy MS at $25 and sell at $40, your capital gains are $15. Dividends are cash payments made to you by the company at regular intervals, usually annually or quarterly. For example, MS recently announced a quarterly dividend of $0.13 per share.

Now that we know the types of returns, the big question is, how do you know if a stock will deliver any returns? And are those returns good enough? Let me answer the second question first. Your stock has to at least beat the 5% APR offered by your bank, if not, what's the point? Might as well invest your money in bank deposits and sleep in peace. But, are you happy if the stock returns exactly 5%? No, because you are taking on an appreciably higher risk by investing in the market. When you take that kind of a risk, you expect to get rewarded. So the return from a stock has to be definitely higher than your bank rate. But, how much higher?

For a moment, let's set our stock aside and take the stock market as a whole (or simply the "market'). The market is represented by indexes such as Dow Jones, NASDAQ and S&P 500 – there are many more, but these are the popular ones. These indexes are comprised of multiple stocks from various industries. So you will have stocks from FMCG, tech, telecom, infrastructure etc. Some of these cos will be good, some bad, some growing and some declining. Let's say you want to invest your money in the "market" - in other words, think that you are buying 1 stock of the S&P 500 index. What should be your return? There are ways to derive this, but the simplest way is to look at the returns delivered by S&P 500 in the past. Take the year-end values of S&P 500 over the past 30 years, find out the annual return (annual growth, to put it crudely). Now, determine the difference between the S&P return and your bank rate. This delta is called the Market Risk Premium, which is the additional return you are expecting because you took the additional risk of investing in the stock market rather than the safer term deposit.

But remember that the stock market has many companies so the negative effects of some stocks are offset by the positive effects of others. For every Sun that fails, there is an Apple or a Google that delivers stellar performance. So the risk of investing in the "market" is different from that of buying a specific stock. Some stocks are safer than the market and others are riskier. For example, P&G has been making hair and body care products since forever. And unless we dramatically change our ways of personal hygiene, it is fair to assume that P&G will continue to sell its products. So, it is a safer bet. Contrast it with Google, which is threatening MS and Apple today, but could just as easily be threatened by Facebook or MySpace. Therefore, Google is riskier than the market.

To determine the relative risk of a stock versus the market, analysts use a term called Beta. Without getting into the details, it is a factor to arrive at the risk premium for your stock, which is a product of your stock's beta and the Market Risk Premium. (By the way, the Beta of the market is 1.) Beta for cos such as Google will be >1, and that of Unilever etc is <1. Now add this to your bank rate to find out the return you must get from the stock. Let's take an example.

Say, annual returns of S&P over last 30 years is 8%

Beta of Google is 1.17

Your bank deposit rate is 5% (Technically, this should be the rate on US treasury bonds, but this is a fair approximation.)

Therefore, Market Risk Premium (MRP) = 8% - 5% = 3%

Risk premium for Google = Beta * MRP = 1.17 * 3% = 3.51%

So expected return for Google = 5% + 3.51% = 8.51%

In other words, Google is an attractive stock, if and only if, it offers returns above 8.51%. The next part will discuss how to determine this.

To be continued…

India...10 years from now

These days, nothing written about about India, particularly in India, is complete without a mention of how India will beat China, sooner than later, in the race for global domination. There are some very valid underlying assumptions that lead business pundits to make these conclusions. But, several others are ignored, ones that could compound over the years and negate everything we have achieved so far.Almost everyone agrees the present trend of growth driven by capitalism started with the economic reforms in 1991. Which means, we are new to economic growth, still learning how to sustain it, and not even close to figuring out how to do it right. For now, we are trying our best to emulate the developed nations. In other words, we are playing catch up, and nothing wrong with that. So long as we realize this is lap 2 of a 50 lap race and we should try and sustain the momentum rather than go all out.But, there are so many opportunities for growth, you say? Why not whiz past the competition to the checkered flag? Well, the prosperity experienced by India is a direct and sole consequence of the IT boom. And if you ask me, the IT boom was one of the most fortunate accidents that ever happened to a nation.  Think abou this: What have we done to deserve the benefits of the boom? Our English language skills, the main reason why India is such a lucrative offshore destination, are the legacy of the British, yes, the same ones who we so proudly drove out of our country. Sure, we had enterprizing young men who foresaw the opportunity and mobilized millions of middle-class English-speaking graduates from factories and warehouses into air-conditioned offices, but even after being involved in the IT revolution for a decade now, we are yet to invent a single IT product or software. The only area where our creativity has shown results is in our ingenuity to develop new ways of propagating piracy.

Let's do a reality check here. Our infrastructure: deplorable; education system: miserable; political and bureaucratic structure: rotten; social values: outdated; health care: nonexistent; law and order: unreliable. It is pretty clear the current economic growth is despite these ills, and not because of them. And that's the big difference. These factors are the cornerstones of sustainable longterm prosperity, and if you look at the ten most developed or richest countries in the world, you will see each of these factors is actively supports and sustains, barring the political system, of course, which has its own ways. The question, then, is what is India doing to change this situation? The answer is painfully obvious: nothing.

Plans to make Mumbai a Shanghai have been on paper for years now and by the time it gets approved, the plan will already be outdated. The decision to privatize Delhi and Mumbai airports was met with staunch opposition that raised an unbearable stench, but thankfully, sense prevailed. Most of India still uses the railways as the primary mode of travel, and despite the stellar financial figures, the railways is in a terrible condition. Can you imagine the ensuing outburst if the government were to privatize railways? The recent boom in the domestic airline travel might indicate prosperity, but our airports are badly equipped to handle existing flight traffic, let alone future increases. And what about our reliance on oil? Thanks to the auto boom, our consumption of oil keeps rising, but what is our contigency plan if a crisis were to erupt in the middle east? When Ahmedijinad may use the bomb is anyone's guess. Some more signs of an impending disaster:

1. Nandigram. No due diligence was done before identifying a SEZ that underlines the incompetency of our governments, and the over-reaction to the incident shows our outdated thinking.

2. Walmart. The central Government opposes Walmart's entry because the retail giant might put several middlemen and distributors out of work. Certainly, a sizeable percentage of the population, but what about the millions of consumers and farmers who will stand to gain from lowered prices and efficient supply chains? And even worse, why stop Walmart, but not Reliance which has exactly the same plans?

3. Political structure. Murli Manohar Joshi created a ruckus by reducing fees at IIMs to 20,000 and now it's Arjun Singh's turn to make some noise by announcing new quotas. These moves only manage to jeopardize the future of thousands of students, some of whom might be the next Jack Welch or Narayana Murthy.

So where are we headed? I can see these social and political ills closing in on the economic growth we are having. We already have a big divide in the economic power of urban and rural India. Without radical social and political changes, this divide will widen further, and could lead to an economic debacle like the one we witnessed in Indonesia and Argentina. Even worse, such a situation could perpetuate political chaos and unrest, and the clock on our progress will be turned back by 50 years.

Having said that, I recently read a book called Moral Consequences of Economic Growth by Benjamin Friedman, where the author promotes the view that economic prosperity will lead to social and moral progress. He backs this up with several well-researched and nicely articulated examples. Let's all pray the current economic growth will continue despite the ills, and consequently rid us of these.