Owners with the money, but who lack expertise or time to run the business, hire professional managers. The anxious vigilance of owners referred by Smith is to ensure that the business generates enough economic value for them-to put it simply, to see it’s earning a return on capital that exceeds costs.
Professional managers hired by owners are primarily the capital or asset allocators in the business. If capital allocation within the business is inefficient, then enough economic value won’t be generated. As rudimentary as it may sound, it’s surprising how awareness of high cost attached to equity capital is often missing in many suave, confident and crafty professional managers in corporate India.
Where there is awareness of high cost, there is often denial under the pretext that, unlike debt, equity is ‘patient money’ and can hold through a few bad years of business. This is a grave mistake, as prudent capital management is a culture that is essential for sustainable economic value generation in the long run.
Notwithstanding the recent supernormal market returns, the market has been ruthless in dealing with stocks that have failed to add reasonable economic value over time. These stocks have been silent wealth-destroyers for investors over the years.
Even stocks with strong pedigree haven’t been spared, be it a blue-chip mega-cap heritage FMCG company with diverse interests, a leading family-run 2-wheeler company, a tech company run by a philanthropic promoter, or an auto giant with a global footprint.The story is the same everywhere: if sustainable economic value isn’t generated within business, investors sack inept managers by pushing the ‘sale’ button for the stocks on their trading screen. The board of privately held companies may be somewhat more tolerant. But eventually, the result doesn’t change.Inefficient capital allocation of a corporate at the ground level starts with the budget exercise. A budget is a quantitative expression of a yearly (sometimes longer) plan of action by managers. The problem begins when individual incentives get linked to various numbers put up in the budget.
As the father of ‘agency theory’, Michael C Jensen once described, while formulating a budget, managers start lying and cheating, inflating targets beyond their capabilities, underestimating costs of doing business, which they themselves know to be unrealistic, setting colleagues against colleagues, and creating distrust and ill-will all around.
Thus, what starts as an accounting exercise suddenly becomes a cultural issue for the organisation to deal with, which countless hours of cultural workshops at exotic offsites cannot fix. Instead, these only add further strain on the budget.
So, what can be done? Delink individual bonuses from budget numbers (without diluting accountability) and link them to broader measures of economic value generation in business (stock options, etc.)
Top management should ensure that thorough deliberations, meticulous simulations, stringent stress tests and hard negotiations between stakeholders occur before finalising the numbers in the budget document.
Senior leadership must ensure that once a budget is approved, it remains sacrosanct.
A budget should help management guide shareholders with a 90-95% confidence level in what they are going to do in the next 12 months, failing which a trust deficit is inevitable regarding their competence. An efficient asset allocator must maintain the highest level of integrity in setting expectations. All visible business uncertainties should be factored into the budget, as no one likes negative surprises -especially the market.
It’s okay for managers not to promise a rose garden and instead caution shareholders that, ‘along with the sunshine, there’s got to be a little rain’. This act of, in Smith’s words, ‘anxious vigilance’ will only make them more trustworthy to shareholders. A trust premium in stock valuation is, after all, its most durable aspect.