It’s the Base Rate, Stupid!

Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.

In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.

~ Warren Buffett, in his 1995 letter to shareholders

Buffett called retailing as “have-to-be-smart-every-day business”, and retailers after retailers have proved that over the years, in India and abroad.

Anyways, twelve years after Buffett wrote the above lines to his shareholders, a retailer was born in India, whose “About Us” page reads today like this…

…went live in 2007 with the objective of making books easily available to anyone who had internet access. Today, we’re present across various categories including movies, music, games, mobiles, cameras, computers, healthcare and personal products, home appliances and electronics, stationery, perfumes, toys, apparels, shoes – and still counting!

Be it our path-breaking services like Cash on Delivery, a 30-day replacement policy, EMI options, free shipping – and of course the great prices that we offer, everything we do revolves around our obsession with providing our customers a memorable online shopping experience.

If you haven’t guessed it till now, this is how India’s leading online retailer “Flipkart” defines itself. So it says..

• We started with books, but now sell everything under the sun (see, we do run a “have-to-be-smart-every-day” business)
• Buy now and pay us cash later, sometimes in easy instalments (easy for you, not so for us)
• We also don’t charge for some costs we bear for you, like shipping
• We offer great prices (because, you see, we have no pricing power)

If you have been fed on the diet of the idea that businesses are meant to make money, and not burn them, Flipkart and many others like it are there to prove you wrong.

When the founder says ‘Profitability is not a focus area’, I feel I have done myself a great injustice all these years believing Warren Buffett, Charlie Munger, and Ben Graham…who have laid profits (and cash) as primary drivers of value creation in any business.

Make no mistake, I like Flipkart as a consumer for their service though not anymore for their prices (a very credible source – my wife – says many other sites offer better prices on products), and I believe they have really shaken the Indian e-commerce market with their offerings, the fact that it will remain a cash burning train is something that worries me – simply for the wrong message it is sending out to so many new entrepreneurs in India.

At 30-50% discounts on a regular basis, it’s difficult to make any margins and you can’t keep losing money forever. Then, a “war chest” of US$ 300 million+ only makes you crazier.

You increase discounts, kill thousands of small mom-and-pop stores who don’t have even a box of cash (forget a war chest), still make losses, create fancier presentations to promote the “India opportunity”, justify stupid valuations, and raise even more money to extend the craziness till eternity. That fits Buffett’s “gruesome business” definition to the tee.

Now, double the gruesomeness when you know that Flipkart’s co-founders took home a salary of Rs 10.25 crore each (US$ 1.7 million at then forex rates; Source: ET) in the six months ended March 2012, which was same as the annual salary of Jeff Bezos, the founder of Amazon, a company light years ahead of Flipkart in terms of sales, profits, customers, assets, service, and vision.

On his salary, the Flipkart CEO is reported to have said, “It’s proof that entrepreneurship in India, if done right, can be extremely rewarding.”

Rewarding for whom? Well, that’s the question.

Avoid “Have-to-be-Smart-Every-Day” Businesses

Will Flipkart fail? When will Flipkart fail?

I don’t have answers to any of these questions, and I care less.

I believe there is a great probability that Flipkart will someday list itself on the Indian stock markets – when the money is available and the IPO market is hot – and investors will lap up its shares thinking it’s the next great thing for the Indian business.

But this is what I tell my investor-readers daily – whether it’s retail (online or offline), or aviation, or any sector where companies have to be smart every day to just stay in their place (like a treadmill), staying away is a great decision.

There is also a great lesson in it for entrepreneurs.

Please listen to what Charlie Munger says, “You don’t have to pee on an electric fence to learn not to do it.”

As I see it, the Indian online retail / e-commerce market looks strikingly similar to the low-cost aviation market a few years ago. Airline operators were then making similar noise of how India’s huge consumer population and poor alternate mediums (like trains and buses) made low-cost airline such a highly profitable model in the long run.

We know what happened then. The reputation of the business – a commodity that bleeds its owners tonnes of cash – has survived, but the operators have all disappeared. The Indian online retail market seems to be taking a similar route.

This will also be the story of so many other businesses – large or small – from others sectors that…

• Are expanding aggressively on borrowed capital
• Are burning cash at rapid pace
• Are cutting prices to gain market share at the cost of profits
• Have promoters consistently diluting stake
• Have promoters who are overpaying themselves
• Have just the “future growth opportunity” to show for their vision and valuation

Remember the Base Rates

Prof. Sanjay Bakshi, a leading authority on Value Investing in India, recently shared a brilliant article he wrote on the various types of Indian promoters.

He categorized them as OO1, OO2 and OO2, where OO stands for ‘Owner-Operator’. Here is how he has described the OO3 promoters…

Owner-Operator 3 (OO3): An owner-operator who is passionate about the business but primarily runs it for his own benefit. He does not take minority shareholder interests into consideration. He is quite likely to be very aggressive when it comes to expansion is likely to make large gambles. When these gambles go right, he is likely to be treated as a hero, but it will only take one big mistake to destroy his career. He is quite open to using political clout to further his interests.

He is also open to recklessly use huge amounts of borrowed money to expand his empire. His focus is more on expire expansion, instead of low-risk expansion of per-share intrinsic business value. It is this type of owed-manager who is to be avoided at all costs. Becoming partners with such a person is risky.

Investors, however, often ignore this risk and get carried away by an OO3’s charisma, grand vision, and the crowds (investment as well as media) which follow him.

Online retailers like Flipkart fit the above description to the tee (except the part on using political clout). Given the economics of their business, things are not likely to change in the future.

If you are an investor, simply avoid such promoters and their businesses at all costs.

If you are an existing or a would-be entrepreneur in such a business, you must have gotten my message.

There are a lot of rash and fast growers in “sunrise” industries that look as if they could not fail. But the base rate of success for such companies is extremely low.

Here is what Prof. Bakshi said on base rates in his interview with Safal Niveshak…

One of the great lessons from studying history is to do with “base rates”. “Base rate” is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money.

But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run? If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks!

That’s the case, not just in India, but in every market, in different time periods. What you don’t see can really kill you! And people don’t see the base rates.

When you evaluate whether smoking is good for you or not, if you look at the average experience of 1,000 smokers and compare them with a 1,000 non-smokers, you’ll see what happens.

People don’t do that. They get influenced by individual stories like a smoker who lived till he was 95. Such a smoker will force many people to ignore base rates, and to focus on his story, to fool themselves into believing that smoking can’t be all that bad for them.

As an investor, here is what you must always remember – When the evidence of long-term success in a business is weak (like in retailing, airlines, and textiles – the “have-to-be-smart-every-day” businesses), you should stick with the base rates.

About the Author: Vishal is the Chief Tribesman at Safal Niveshak, where he works with small investors to help them become smart, independent, and successful in their stock market investing and personal finance decisions.