The Leader: Fighting for Corporate Position, Size is Not Enough
Much has been written about the changing global power equilibrium in the world and the relative positioning of countries, particularly the US, China and to a lesser degree, India. Less well covered have been the shifts in power between nations’ corporations, themselves the key actors projecting a country’s economic power. The assumption is that Chinese companies are well on the way to dominating global industries too. Fundamentally, of course, country growth is correlated to corporate growth. However, achieving global corporate industry leadership requires more than an economically strong country of origin. Innovation and intellectual property, mature capital markets and a transparent market for corporate control are critical determinants. The development of these fundamental factors will be critical for the rise of India’s and China’s companies to take their place alongside the established global leaders. It will be even more important if valuations are to follow size.
Who has the World’s Most Valuable Companies?
In December 1989, at the end of the Cold War, the ten largest corporations in the world by market capitalisation were all American. Ten years later, US companies had ceded half of the top ten spots to international companies, mostly Japanese by origin. Moving the clock forward to the eve of the global financial crisis, December 2007, the Japanese companies have been replaced by Chinese ones. More recently though (as of mid-August 2012) US companies have appeared to have recovered their ground at the expense of Chinese competitors, regaining a total of eight of the top ten spots by market cap. The table below illustrates the shift in leadership over time.
This analysis illustrates a key fact: that national economic performance does not automatically translate into corporate valuation leadership. US corporate leadership during 1989 occurred in the middle of Japan’s asset price bubble, at a time when the Nikkei Index reached its all time high and Western newspaper editorials were predicting a wholesale takeover of the US by Japanese corporations. Yet, as of Dec 1989, there were no Japanese companies in the top ten. Similarly, the rankings in 1999, which include four Japanese companies, occurred at the end of Japan’s Lost Decade, nearly ten years after the bubble’s collapse. One key reason for this effect was the structure of Japan’s corporate landscape. For much of the past 50 years, Japanese companies were part of the so-called Keiretsu system, focused on business groups of major corporates across multiple industries with cross shareholdings, usually focused around a major bank or trading groups. This system insulated members from both stock market fluctuations and takeover attempts, effectively negating the market for corporate in control in Japan and creating a barrier to consolidation across major industries. The US on the other hand is one of the world’s most active M&A markets and companies employ mergers and acquisitions as key drivers of growth and shareholder value. Japan’s M&A activity did not pick up until some time after its bubble burst in 1991, and so Japan took some time to consolidate across key industries and create scaled industry leaders. This led to Japan’s prominence in the top ten in 1999.
More recent fluctuations on the top ten list highlight a different set of requirements for corporate leadership: the need for strong domestic investment and capital markets. China’s relative strength vs the US (in terms of GDP) has increased since 2007, yet the relative positioning of its corporate leaders appears to have waxed and waned. This change in position largely mirrors the relative performance of the countries’ capital markets, where China has recently faired poorly and US capital markets have benefited from a global “flight to quality” as Western investors have withdrawn capital from emerging markets in favour of US investments. This shift highlights the importance of developed and transparent capital markets on the one hand (capable of retaining and attracting global capital flows in times of uncertainty) and the need for sufficient domestic capital on the other hand (to provide the required levels of domestic corporate funding independent of international investor sentiment).
Building the World’s Largest Companies
By way of comparison, an analysis of the Fortune Global 500 list, which measures the largest global corporations by revenues, unsurprisingly provides a less volatile and more straightforward view on the shifting corporate dominance of countries. The composition of the top ten companies by revenues is somewhat skewed by the presence of major oil companies, which typically take up half of top ten slots in a given year. However, the table does demonstrate clearly the increasing scale of Chinese companies, none of which made the list before the end of the 2000s. With (domestic) revenue growth tied fairly closely to underlying macro-economic growth, Chinese companies’ presence on the whole Global 500 list (not just the top ten) has increased significantly, particularly during the past five years, largely at the expense of US and European companies. Looking at the entire Global 500 list provides a more balanced view of industry leadership sector-wise, as it includes a much broader range of industries than the oil and gas driven top ten. In this larger set, countries like Japan and India have seen the number of their companies on the list remain fairly stable over the same period. Indian companies in general remain underrepresented on the Global 500 list (relative to India’s size). Among countries with over one trillion dollars in annual GDP, only Russia and Mexico have a few mega-corporations, and over half of India’s eight companies on the list are oil and gas companies. While the factors regarding domestic liquidity and active markets for capital control certainly apply to India as well, there is an additional factor determining Indian corporations’ relative global positioning. India historically has had no lack of large corporations, with the country’s business environment traditionally having been dominated by numerous family-controlled conglomerates. In the absence of effective domestic market, financial and governance institutions, companies have a need to expand horizontally in order to do business effectively, creating sprawling empires and oligopolies enabled by India’s bureaucracy, or “License Raj”. Today, many of these companies still enjoy monopolistic positions in key industries, obviating the need for companies to innovate and develop new markets and customers for their products. America’s 20 largest companies include IP-led companies with a track record of innovation like Apple, IBM and HP. India and China’s largest companies are dominated by players in regulated industries and by state-owned enterprises. Over the long-run, companies will need to innovate in order to compete effectively and internationally, large domestic market and protected positions nationally non-withstanding.
Requirements for Leadership: What Will It Take?
Indian and Chinese corporations will continue to grow, leveraging their domestic market leadership positions and driven by strong local demand growth. Over the mid-to long term though, these companies will need to compete internationally to sustain their growth, requiring access to multiple additional capabilities and assets, many of which are currently outside of the scope of operations for large scale Indian and Chinese corporations. These include:
- Investment and Capital. Indian and Chinese companies will require access to significant pools of capital to finance their plans. In a previous Sign of the Times (May 2012), we had written about the capital gap facing Indian companies in particular between now and 2020. However, companies in both countries will require smart and long-term investors willing to make the upfront investments to allow these companies to scale, reposition and restructure themselves for effective global competition. Highly selective and savvy international investors will be identify early the great companies in each market.
- Transfer of Know-How and the Creation of IP.
International competition requires international standards, technology and know-how, and Indian and Chinese companies have steadily been building these through a combination of tech transfers and internal development. International leadership, however, will require the creation of real IP. The presence of four US technology companies in the top ten market cap ranking (Apple, Microsoft, IBM and Google) demonstrates this point succinctly. The largest non-US technology company, Samsung – at number 28 – has a 2012 R&D budget of nearly US$12bn. Indian and Chinese companies will need to make significant upfront investments in intellectual property and innovation in order to create the potential for market leadership.
- Clear Corporate Governance Driving Scaling through M&A.
As mentioned above, a transparent and liquid market for corporate control is a key driver of scale and strategic diversification across most industries. This in turn requires a wide range of conditions to be fulfilled, including, among other things, clear securities regulations supportive of M&A activities, active and involved shareholder bases supportive of M&A restructurings, clear corporate governance and transparent systems and controls, with the latter two being with the control of individual companies. Effective M&A markets require strong board governance, which enables decision making in the best interest of all shareholders. The paltry amount of domestic M&A in India in particular (c.US$35bn in 2012, compared to nearly US$1,000bn in the US) can partially be explained by the presence of dominant promoters in large companies who are unwilling to consider selling “their” companies, despite the fact that many have long ceded majority control to public shareholders.
- Ease of the Flow of Domestic Savings into Investments.
Equity market growth and increased flow of value implies the allocation of significant new capital from domestic and international sources. For the former to be tapped, India and China will need to reallocate growing pools of domestic savings into equity markets. In China, which has one of the world’s highest savings rates, this implies attracting domestic investment into a broad range of sectors. Current domestic investment options are limited, partially explaining China’s real estate bubble. Equity investing will need to be made more attractive through tax breaks in order to attract the required capital to grow markets domestically. In India today, only 8% of India’s US$800bn of household wealth in held in equity markets, compared to 14% in China and 42% in the US. At current levels of GDP/market cap ratio, by some estimates Indian firms will require an additional US$2.9 trillion in funding between 2010 and 2020, creating a potentially significant funding gap that will require increased household participation to fill, both by way of increasing household wealth overall as well as significantly higher allocations to equity markets.
- Developing these capabilities is not a foregone conclusion, and Indian and Chinese companies seeking to build international positions will likely need to partner with international companies and investors to develop the required assets. Ironically, the US companies they are seeking to displace are best suited to help their development across a number of these fronts. The increasing volume of outbound M&A from India and China to the US indicates that a growing number of companies in these countries are counting on US companies to, among other things, improve their global competitiveness and market access. Ultimately, over the longer term, Indian and Chinese companies competing in international markets will have no choice but to build these capabilities, as international corporations continue to evolve and raise the bar for effective competition. The winners in India and China therefore will be the companies that begin this process early enough to close the otherwise widening gap.
Conclusion: Implications for Indian and Chinese Corporation
Growing Indian and Chinese companies seeking to leverage strong domestic positions to grow and compete in international markets today will need to consider the following implications.
- Scaled Revenues Don’t Guarantee Scaled Value. An obvious point but one that empire-building business leaders around the world have often forgotten. China has been particularly prone to building scale rather than proftibalility as measured by international standards. Creating the most valuable business possible will require a cultural shift beyond scale to profitability, growth and sustainability. Indians on the other hand have largely pursued cash-generative growth at the expense of scale. This calls for another cultural shift which will require the support of active capital markets.
- Value Maximisation Requires Building Performance Drivers.
Business leaders in India and China seeking to maximise market capitalisation (and shareholder returns) will need to the build the fundamental drivers of performance to optimise the four factors listed above (scale, profitability, growth and sustainability) and manage their organisations around these drivers. This will require a more balanced build-out which initially will be more costly due to its investment in management, skills, brand and other less tangible factors.
- Significant Financial, Strategic and Organisational Requirements.
This strategy requires significant and long-term investments to enable innovation, effective participation as a competitor and partner in global markets and the capability and resources to participate in local and international industry consolidation. Both countries have failed to attract capital to their corporations either due to numerous factors including policy issues (India) or a lack of trust in the efficient working of the capital markets (China).
- Execution Requires Openness.
Successfully executing a strategy of this nature requires an organisation that is open to the outside innovation, talent, and investors, which in turn requires chief executive officers and boards to be open to the outside, too. This poses a significant challenge for some industries in China (mining, infrastructure and trade) where state backed companies have been able to compete without facing international competition or pressures. . It has been a challenge for the Indian government in recent times (taxation policy in particular served to highlight critical issues in the government) but less of a challenge for Indian entrepreneurs and managers who are often well-exposed to the outside world and used to working hard to prove their value.
- India and China – Same Challenges, Different Considerations. The above is equally true for both Chinese and Indian corporates, although each country’s companies have their own specific challenges to contend with as well.
The road to maturity in value creation will be an exciting one for India and China’s corporations, policy makers and investors, with its share of drama. As the last year in both countries has shown, creating value requires long term vision on the part of investors and either the patience to ride out the inevitable mishaps or the flexibility to make tough short term decisions to enter and exit from their positions.
©2012 Greater Pacific Capital