Never did I realize growing up that the subject I hated most would prove to be the most useful. No, I am not speaking about mathematics. Luckily, I was rather decent at the subject that many of my friends dreaded. The subject that I feared was none other than history. With its innumerable dates of battles and names of kings, it seemed not only boring but also terrifying when tests came around.
Now that I don’t face the pressure to memorize for tests, I have learned to love history. In fact, the first thing I do before investing in a company is study its past. This exercise gives me clarity on the quality of the company’s business and the capabilities of its leadership, the two most important drivers of value creation and stock market performance. I have come to believe that reconstructing and understanding a company’s history forms the very first principle of fundamental investing.
A Bad History
As an investor, I have analyzed hundreds of companies. On one occasion, I zeroed in on an Indian pharmaceutical company. On paper, it looked impressive. The company was growing rapidly, it had high profitability and an impressive pipeline of drugs that it was planning to launch in developed markets. I sought a meeting with senior management, and the chief financial officer briefed me about the company.
The CFO spun me a tale of his company’s rapid growth. He described the acquisition of several businesses in many geographies. I asked the gentleman questions about each acquisition. I wanted to know the rationale for each acquisition. I wanted to know how things transpired after the acquisition. Did the actual synergies turn out to be less or more than the anticipated ones? What did the CFO and his colleagues learn from each acquisition?
How to Keep Your Business in Sync With a Changing World
During my conversation with the CFO, I realized that the management team put a premium on growing rapidly. Mergers and acquisitions were its favored method and had become second nature to the company. However, the M&A strategy seemed to be poorly thought through. Many of the past acquisitions by the company had not worked out well. More importantly, the management team had not really learned from its mistakes.
I concluded that the senior management was incentivized to show top-line growth, which in the investment world refers to a company’s revenues or gross sales. However, sustainable and profitable growth is what matters and the management team did not seem to be focused on it. There was another fly in the ointment. The company was not developing any core competency to distinguish itself from its peers. It was clear that more focused competitors would one day eat its lunch, so I passed on the opportunity to invest in the company. It is a decision that time has since vindicated.
A Good History
In one of my fishing-for-investment expeditions, I ran into yet another pharmaceutical company with relatively small market capitalization. In investor speak, I came across a small cap pharma company exporting to an emerging market. Normally, such markets are sketchy high receivables, the term accountants use for bills due from a company’s customers. In emerging markets, not only does it take a long time to collect receivables, but there is also a high default rate because some customers refuse or are unable to pay.
The small cap pharma company had piqued my fancy because it had negative working capital — a term investors use for the capital a business needs for its day-to-day operations. The company had negative working capital because its customers were paying in advance before getting their drugs. Such a phenomenon is unheard of. Therefore, I had many questions for the founder who turned out to be a poor communicator prone to going off on tangents. I had to constantly drag him back to the issues in question.
As usual, the most important issue for me was the founder’s and his company’s history. I wanted to learn how the company began, how it evolved, and why its market capital was a few hundred million dollars instead of a few billion. After all, the company had been listed on the stock market for 20 years. What the founder told me is the most fascinating story I have ever heard.
It turned out that the founder listed the company on the stock exchange because he had no money to set up his first factory. I almost fell out of my chair when I heard this. As an investor, I would have expected the founder to go to venture capitalists or private equity shops. Approaching a bank for a loan was another possibility that I could countenance. However, going to the public market right from the get go is something that never occurred to me.
The founder calmly pointed out to me that my assumptions were flawed. Two decades ago, there was no venture capital or private equity in his country, and bank loans were expensive for small operators. Often, businesses had to bribe bank managers as well. In contrast, accessing capital through the stock market was cheaper. Of course, the downside was that the founder had to dilute his equity stake.
Listing the company on the stock market was only the first hurdle for the founder. It transpired that he had the wrong partners. After an initial growth phase, the company hit choppy waters. Overseas distributors simply did not pay the money they owed, causing the company in turn to default on its debts. This was a time when this extraordinary company went through a near-death moment. The partners dropped out and creditors turned on the screws. If the founder was a lesser man, he would have thrown in the towel. Instead, he moved to Africa.
On a new continent, this intrepid entrepreneur set up a restaurant. Many people from his country came there to eat. Among his customers, he identified those who could be clients for his pharmaceutical business. The founder started selling directly to them, cutting out all middlemen. Soon, these new customers brought in enough cash to support the pharma company’s operations. The founder then closed the restaurant and went back full time to his pharmaceuticals business.
After Africa, the founder eyed Latin America. Here again, he found that distributors often paid late or did not pay at all. So, he found some poor teenagers with fire in their bellies in his country and paid for their Spanish lessons. They went on to become his distributors and partners. Today, they pay him in advance for his drugs, eliminating much of his business risk.
The history of the founder and his company taught me a few business lessons that I had failed to learn either at Wharton or McKinsey. First, fire in the belly matters more than polish when it comes to entrepreneurship. It is better to invest in a founder who can fall off the saddle and then climb back again instead of someone who wears a nice suit and speaks in smooth cadences.
Second, in the pharmaceutical business, it is not just research that matters. Distribution is key, especially in those emerging markets where life is a bit rough, laws often exist only on paper and business operates only on trust. Finally, the financials of a company only make sense when investors understand its fundamentals. Only then can they model the future and make prudent decisions.
The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.
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