Part A : Investing Lessons is featured based on the experiences drawn from the fiascos of the 17 PN4 companies. Now, we will turn our attention to the many management lessons that can be drawn from the experience of the 17 companies. The importance of management can be simply summed up in this way : whether a company merely survives, grows prosperously or fails disastrously depends on its management. Whether a company merely survives, grows successfully or fails miserably will then determine whether the shareholders or investors are subdued, laughing or crying. The performance of companies, in aggregate, will then also impact the broader economy. Had a large number of Malaysian companies been managed like the 17 PN4 companies, the Malaysian economy would have been in tatters by now.

Management Lesson 1:

Management Changes - Boon or Bane?

Many would naturally blame the disastrous performance of the companies on the harsh economic environment during the Great Asian Crisis of 1997/98. But based on the evidence, the management has to take the blame for leading the companies into such disastrous state. One need not look any further than at table 1, which is a summary of the 17-part series in i Capital, starting from the issue dated 13 Mar 2003 to the issue dated 10 Jul 2003, and at the way the management performed to realize its hand in steering the companies to their current predicament. However, this special analysis is not to finger point but rather to learn about managing companies.

Table 1 : Major Changes in Management and or Significant Shareholders

Alert subscribers would have noticed a common factor present in the downfall of a large majority of the 17 PN4 companies - changes in management and or significant shareholders. As summarized in table 1 above, these changes often entail either a change in strategic direction or focus, the embarkation on a trail of rapid expansion and diversification or worst of all, the occurrence of major shareholders stripping the assets, cashing out and leaving behind a faltering business. As such, these changes become critical turning points for the companies and thus, should not be taken lightly.

Let us take the example of CSM, by far the most 'active' among the 17 PN4 companies. The group had undergone multiple changes in both management and significant shareholders between 1995 and 2000. Within that 5-year period, the group also underwent major corporate restructuring, which included the 'swapping' of assets and divestment of its core businesses to entities of its majority shareholder, Cycle & Carriage Ltd (CCL). By the time CCL sold its CSM stake to Excoplex S/B for RM177.7 mln in Sep 97 and all 9 directors resigned in Mar 98, CSM was nothing more than a shell company with plenty of cash. The new major shareholder, Excoplex S/B, subsequently disposed CSM's remaining assets and changed its core business to that of a property developer. How did the new management fare? The figures alone say it all - see table 2. 1997 shows the fiscal year end before the arrival of Excoplex S/B while 2000 shows the fiscal year end after Excoplex S/B exit.

Table 2 : Financial highlights of CSM (RM mln)

This is just one of the many, many sad tales of management and or major shareholders inflicting irrecoverable financial damage on a previously resilient though not spectacular company. Remember the episodes that unfolded in Rekapacific, UCI, Promet, Autoways or even SCK Group ? With these in mind, is it fair to say that companies that undergo changes in management and or significant shareholders always end up worse off? Not really. Among the 17 PN4 companies, Repco was struggling with its automotive parts business in 1994 until the new management team came in in 1995 and led the group to greater heights via its foray into the gaming business in Sabah. However, those early success was more than undone by the same management team, thanks in no small part to their exploits in leveraged share trading.

Does this then mean that changes in management and or major shareholders are unhealthy and should be viewed with both apprehension and suspicion? Again it depends. The issue at hand is not in the change itself but the level of competence and integrity that goes along with it. This is where the quality of management comes to the fore. If the management's objective is to enhance shareholders' value and competently steers the company in that direction, there is no reason why their inclusion should not be welcomed. For the 17 PN4 companies, one could not find any evidence of such a happy ending. It is when the objectives of the management and or major shareholder diverge from those of the other shareholders or when the management's capability is in doubt that reservations are due.

However, common sense tells us that frequent changes in management and or significant shareholders would have had a detrimental effect on the companies concerned. Companies that undergo strategic changes of the magnitudes shown in table 1 would obviously suffer from confusion, low morale of staff, lack of continuity and focus, discontinued operations, unrealised potential from previous ventures and a high turnover of staff and senior management.

Knowing the make or break role management plays, who decides or evaluates the competence and integrity of the new management and or major shareholders ? First, the other shareholders have a very important role to play in this. For example, major acquisitions need their approvals. They should scrutinise them in general meetings. If not in line with the company's interests, the other shareholders can object. We know that resorting to legal means may mean an empty victory or a fruitless and frustrating effort. We hope the incoming Prime Minister can make really effective changes to this dismal situation. He should make changes that will encourage the other shareholders to protest loudly and effectively. The new Prime Minister should make the armoury of legal and non-legal methods available to non-controlling shareholders truly effective. Secondly, the regulators should further increase the level of disclosure. While this has improved over the years, the level of disclosure is often not sufficient for the other shareholders to make an informed decision. Thirdly, the incumbent management and or major shareholder have a moral and social responsibility to ensure the company will be in good hands when they decide to exit the company or change the Board. In a general takeover situation, all the shareholders have a chance to sell at the same price. However, many of the changes in management and or shareholders are at levels that do not require a general takeover offer.

Management Lesson 2:

The "Focus or Diversify" Dilemma

To decide what is a focused company and what is a diversified group can end up in an unproductive debate over semantics. This is not our purpose. A company like BAT or MOX is obviously totally focused while few would argue that groups like Sime Darby, Hong Leong Industries and PPB Group are very diversified. The problem is that most companies are somewhere in between, which means that the difference between what is focused or diversified is often only a matter of degree.

The question of whether to focus on existing business or to diversify is not new and has bewildered many a management. Supporters of diversification would strongly advocate this business strategy, much in the same vein as the conventional fund managers do with stocks. The notion of spreading the company's business risks to avoid overexposure to a single sector seems attractive. Some managers would also add that diversification is useful in hedging against the cyclical nature of their existing business and would help smoothen its earnings. Others view diversification as a valid attempt in search of new sources of growth to compensate for the maturity or decline of their existing business. All of the above arguments for diversification seemed valid on the surface but when seriously examined, reality is more complex.

[1]. Magnifying Risks

Diversification per se may not reduce the company's business risks but may accentuate them. Take the example of Sateras Resources (Sateras). Throughout its history that spanned more than three decades, the group ventured into many unrelated businesses, ranging from its original business of manufacturing PVC resins to assembly and marketing of motor vehicles to property investment and development to logging of timber to manufacturing of fishing nets to distribution of water meters to cultivation of cocoa and the list goes on. In fact, the losses incurred in its first attempt back in the early Eighties were so severe that it was forced to sell its investments and assets to settle the group's liabilities. Having not learnt its lesson, the group embarked on another diversification spree in the 90s, funded by borrowings and issuance of shares that suffered the same fate. How did this happen ?

Its attempts failed because the group was haphazardly tip toeing from business to business without really seeing them to fruition and lacked the relevant experience, skills and financial resources. By spreading its wings across so many unrelated sectors of the economy, the group had not only overstretched its already thin management and financial resources but also made itself vulnerable to unexpected shocks or recessions. Many would agree that to carve out a competitive position in an industry is already tough enough but to manage so many unrelated businesses with such scant resources is corporate suicide. Perhaps this could explain the lackluster performance and mediocre returns generated. By having multiple businesses that are weak relative to its competitors as opposed to having a core business that is in the position of strength, the group is likened to a general deploying its limited troops far and wide and weakening itself.

[2]. Diluting Earnings

Instead of enhancing earnings, diversification may dilute it. For this, we will use Rekapacific as an example. The group expanded aggressively and by the mid-Nineties, it had multiple businesses. Table 3 shows its financial performance in 1994, a period when the country was experiencing a boom.

Table 3 : Financial performance of Rekapacific in 1994 (RM mln)

From the above table, one can see that the profitability of its gaming business, in terms of return on assets and profit margin, was much higher than the other businesses. Furthermore, the group's return on assets was a dismal 4%, highlighting the inefficiency in the utilization of its assets and poor capital allocation. If one strips out the contribution of its gaming division, the return on assets for the group would be even worse. The massive losses incurred under "investment holding" were due to Rekapacific's huge interest expenses, which were absorbed under this division. The dilutive effect of diversification is evident and one could just imagine the earnings had the group focused on the gaming business and not diversified into the other less attractive businesses. Imagine BAT or Carlsberg moving into businesses like construction, banking and so on. Their share prices would plunge.

What Rekapacific experienced is not a monopoly of the 17 PN4 companies. For example, Genting and its numerous non-casino diversifications over the past twenty years have seen more duds than success. Recovery in one sector is offset by the decline in another. Unless one can get all or most of its businesses growing at the same time or at a faster rate than the declining ones, the company's overall earnings would not improve. If the return on capital employed is attractive, stagnant earnings may not be that inferior. But management is often blinded by the obsession to be .bigger' and in the process, ignoring the overall rate of return of its varied operations. The key point is not to focus on the regular acquisitions and disposals but on improving operational efficiencies, asset utilization and capital allocation. As in the case of Rekapacific, the resources expended in the other less profitable segments could have been utilized instead to strengthen its competitive position or it could pare down its debts to improve the overall profitability and strength of the group. If there is excess cash, the company could then give it back to shareholders as dividends rather than invest in low-yielding ventures. It is puzzling why so many companies insist on diversifying when it clearly diverges from the path of enhancing shareholders' value.

[3]. Core Competencies

In the hope of finding another source of growth, many resort to diversification. Managed well, the group as a whole would benefit; otherwise, the consequences can be severe. Take the several PN4 companies for instance. Although their respective core businesses were faltering, they were still generating profits. But when Jutajaya, Southern Plastics, SCK Group and Autoways each decided to diversify into unrelated and unfamiliar businesses, they only ended up in a sea of red for their efforts. Jutajaya, Autoways and SCK Group jumped into the then much-favoured construction industry while Southern Plastics moved into timber trading and property development. Nauticalink, with its core business being in the provision of ferry services, decided to try its luck in the business of franchised restaurants. Even Sime Darby had to learn a brutal lesson when it bit more than it can chew when it bought UMBC, a major banking group.

For a start, their lack of experience and know-how in the new businesses proved to be a major stumbling block. Secondly, the new ventures were totally unrelated to their existing business with no benefits of integration like economies of scale or operational efficiency. Thirdly, their poor competitive position vis-à-vis the existing players meant that their odds of success were heavily stacked against them. Fourthly and more importantly, their aggressive expansion and capital-intensive ventures created a huge and unbearable strain on their already wobbly balance sheets and cash flows. These ultimately affected their entire operations, including their profitable core business. By the time the Great Asian Crisis hit our shores, these companies were left floundering amidst the tide of losses.

[4]. Focus or Diversify ?

Given these arguments, are we saying that diversification does not work and that management should avoid this strategy altogether ? A simple question with no simple answers. Imagine the tin mining companies that ran out of tin or the rubber plantation companies that saw the economics of their business deteriorating and did not diversify. But one could counter with multi-business companies like MRCB, Hong Leong Industries, Renong, Hume, etc that suffered from diversification and cite the successes of focused companies like OYL, MOX, Nestle, Public Bank or even Inti. While it is much easier to cite examples of focused companies that have succeeded, whether locally or globally, there are also fine examples of companies that have diversified with success - General Electric in the US is a classic case and to a lesser degree, our own PPB Group.

The usual question to ask in this debate is, what are the underlying traits that distinguish them from the rest ? At Capital Dynamics, we believe that a more basic and productive question to ask is this : when should a company focus, when should it diversify and should its management be dogmatic over such an issue. The simple advice from icapital.biz is this : know what you know and know what you do not know and then have the discipline to stick to this rule. What do we mean ?

Antah diversified and diversified and got clobbered. Measurex (now known as Paxelent Corporation) stayed focus on its core business and also got clobbered. Microsoft stayed focus while GE has a remarkable collection of businesses - both are hugely successful. To explain this paradox and our advice, we turn to our old friend, Warren Buffett. His company, Berkshire Hathaway, has expanded and diversified and grown to be a huge group, made up of many businesses, ranging from many forms of insurance to shoes to furniture to candies to flight training to newspapers and more. By conventional definition, it is a conglomerate and one that is consistently successful. His method of diversification teaches us a lot about when to stay focus and when to diversify. He only buys companies where there is already management in place. Berkshire Hathaway does not supply management. In fact, as a holding company, Berkshire Hathaway has less than 10 staff. He stays focus not by type of business or geographical region but by the availability of superior management, even though he may diversify in terms of business-type or geographical regions. What Buffet does is to focus on allocating capital efficiently and leaving the managing to those who know the respective businesses best. He knows that he does not know how to sell furniture or make shoes or to run a flight training business. He leaves them to what he calls "outstanding managers". It is an approach that i Capital has termed as "focused diversification". A management that knows and stays within its circle of competence runs each business.

Warren Buffett and Berkshire Hathaway are famous for their investment success. But they also offer valuable management lessons to our so-called corporate captains, regulators and policymakers.