The Frog Prince : Morgan Stanley Research

The Frog Prince
In the fairy tale, The Frog Prince, a magical kiss transforms the cursed frog
into a handsome prince. In a similar vein, Warren Buffett, in his inimitable
style, describes acquisition hungry CEOs as being “mesmerized by their
childhood reading of the frog kissing princess. Remembering her success
they pay dearly for the right to kiss corporate toads, expecting wondrous
transfigurations”1
. Buffett might as well have been talking about promised
corporate turnaround stories.
Legendary fund manager, Anthony Bolton in his book ‘Investing against the
tide’, has devoted a chapter to ‘My favourite type of share’. Expectedly, these
are turnaround stocks that he invested in before the market fully appreciated
the change. Successful corporate turnaround stories always make for
interesting reading, such as Steve Jobs’ return to build Apple into one of the
world’s greatest corporations which will soon be made into a motion picture
or Lee Iacocca’s bestseller about battle for Chrysler’s survival. Straight-forward
as it may sound, as portfolio managers we can assure you that predicting such
winners is far from easy. Stock investors stand to reap outsized returns if they
get it right but such opportunities are few and far. Many stocks are pitched as
turnaround stories but the experience is that maybe one in ten actually lives up
to the hype. Given the odds, the risk is that in pursuit of that elusive multibagger, one ends up buying many duds. The real skill then is to find the prince
without having to kiss a hundred frogs.
From our toad-kissing experiences, there have been certain signposts that have
helped us improve our odds of unearthing some of these turnaround stories
while helping sieve out the duds. In most cases, turnarounds are associated
with new management teams or some sort of leadership change. As portfolio
managers, we assign a high weightage to face to face meetings with the CEO
and the management team. Listening to them to gain an understanding
of management strategy is especially important in these situations. This is
different from a normal maintenance meeting with a management whose
stock you already own and would then focus just on the current issues. Here is
the ‘turnaround checklist’ that we carry to these meetings.
•  Diagnosis: What’s working, what needs to be fixed? CEOs that attribute
all the woes to the macro-economic situation or those who want to
overhaul the entire organisational structures and processes haven’t
adequately diagnosed the problem. The idea is to look for surgeons with
scalpels rather than butchers with knives.

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•  Focus: As investors, we are aware that we cannot
formulate business strategy but we are keen to understand
how management thinks about it. Most of us are not good
chefs but we can tell good food from bad. Specifically,
look for a “black-list” of products, services or geographies
that are clearly off the table in medium term business
plans. Exclusion makes the current focus sharper. Again,
management teams that are not able to clearly lay down
their black-lists dampen our enthusiasm.
• The To-Do List: A peek at the CEO’s ‘To-Do’ list is
vital. It has to be precise. Too vague or long a list is
again a symptom of insufficient diagnosis. Also, having
smelt a lot of bad food, we can straight away sniff out
one that has been produced in a factory i.e. a consulting
company’s standard language and slide deck. We are
sceptical of management teams who tell us that they
have hired an army of consultants to tell them how to
engineer the turnaround.
• Competition – aware? The turnaround stories typically
lag their peers on most business metrics. We would like
to know if they have analysed competitors’ strengths and
weaknesses, not that we recommend blind emulation.
Neither “competition-awed” nor “competition-dismissive”
managements are likely to succeed. Seek out “competitionaware” management teams.
•  History: If we have known or interacted with the new
management team in their earlier avatars, it helps. We normally
look up their performance history in their past organisations or
divisions within the company. In our experience, people and
their management styles seldom change.
•  Measuring Yardstick: We try to close most meetings
by asking the management to give us metrics to track
their success by. We also try to get a time-line for this
improvement. This is the most important aspect of the
interaction. We need a tangible, quantifiable set of metrics
to act as a barometer to measure the promised turnaround.
We have seen a lot of managements fumble with this –
either the metrics are woolly like ‘significant stakeholder
value addition’ or they have ‘aspirational targets’ like a
topline number without a timeline to it.
•  Follow Up: Agreeing on the metrics and their trajectory
(could be Return on Assets, revenue growth relative to the
industry, margins, free cash generation/debt reduction,
employee attrition, etc. or a combination of these) is the
critical take-away from the meeting. This makes subsequent
interactions meaningful as they revolve around these predecided variables. In many cases, the metrics don’t meet up
to the originally envisaged trajectory but good managements
can quickly do an attribution analysis of what helped and
what hurt them in their journey. We have seldom sold
stocks just because they were not able to meet up to with the
promised metrics. We are looking more for the attribution
analysis and course correction if need be, in subsequent
meetings. Shifting goal-posts however are a cause for worry.
Equally important is a recognition of sector or market
tailwinds that might have helped the CEO to achieve better
than expected results, i.e. the classic skill versus luck analysis.
We are reminded of our meeting with the then new
management team of IndusInd Bank in August 2009. Having
known and interacted with Mr. Romesh Sobti, MD and
CEO, in his previous organisation did help in the eventual
decision making but what floored us in that first meeting
was the clarity of strategy, a clearly defined To-Do list and a
willingness to spell out metrics by which the management
ought to be measured. Interestingly,
when we subscribed to the institutional placement for INR
87.50 per share in August 2009, some elements of the new
management’s strategy and operational turnaround were
already getting discounted in the price as the stock was up
about 50% in the preceding three months. Despite having
missed the first 50%, the stock proved to be a multi-bagger
for us in the subsequent four years. The learning is that when
dealing with turnaround, wait for clarity and may be even
some confirmation of your original investment thesis. Trying
to catch the absolute low point, when there is little else other
than expectation to work with, can prove risky and lower the
odds. If you really get on to a good story, albeit slightly late,
there is enough money to be made on it.