Free Cash Flow: The most important element in capital allocation is the generation of capital. The best way is by being profitable. Netcore has been profitable for the past 15 years. The free cash generated is what we have used for our business growth, investments and acquisitions. To generate free cash predictably for long periods of time, a business needs some combination of monopoly and moat. In Netcore, this comes via our email and SMS business. The cash generated has helped us invest in building the martech stack and expanding to new geographies, our acquisitions of Boxx, Hansel and Unbxd, and our investments in Profitwheel, EasyRewardz and Comsense.
New Growth Engines: To keep increasing free cash flow, new growth engines need to get created. Competition is never far away. Innovation is necessary to keep creating additional value for customers. Ideas like Email 2.0 and Loyalty 2.0 offer the potential to create new growth engines for Netcore. Email has not seen much innovation in the past decade or so. With ideas like AMP and Atomic Rewards, we should be able to make inroads into global customers and also switch spending from adtech (new customer acquisition) to martech (existing customer retention and growth).
Acquisitions: We will never be able to build everything that customers want internally. Hence, acquisitions will be an important mechanism for future growth. Getting acquisitions right is very important as companies like Danaher have shown, else they can be destroyers of capital. In future, we will need to think of Netcore as a “House of SaaS” – by building a large customer base, we will be able to continuously add new products (built internally or bought) and reduce sales and marketing costs by selling to the same buying centre in a company. Research has shown that two out of three acquisitions do not deliver the value that is anticipated. This is what we need to guard against. Every acquisition is a risk, but done in the right way and at the right price, it can be a powerful mechanism of growth and a new source of free cash in the future.
Going Public: Netcore is a private company. We also don’t have external investors. As such, it becomes hard to place a value on the stock. Becoming a public company will give us greater flexibility in capital allocation decisions. We can then use stock as a currency for acquisitions rather than just cash. This will help us think bigger in terms of scale.
Sasha Chapin on making normal conversations better: “Some people get frustrated with small talk because the words themselves are not enlightening. But they’re focusing on the wrong thing. The spoken content of small talk is, it’s true, mostly vapid. However, the relevant information underneath the spoken content is fascinating if you learn to care about it. What you’re doing is mutually establishing tone and finding boundaries. You’re getting a sense of the person’s mood, energy level, vibe, willingness to talk to you, style of talking, and so on, and they’re getting the same from you. Also, it’s a basic sanity check. The person you’re talking to, implicitly, is assessing whether you can do basic social norms—in this case, small talk. If you can’t pull it off, it’s probably not safe for them to share anything beyond their feelings about the weather.”
FT: “Just a decade after Crispr was invented, the first drug to make use of the revolutionary gene-editing technology will be with regulators by the end of the year, with the promise that it will eventually transform the treatment of genetic diseases. In 2012, Nobel Prize winners Jennifer Doudna and Emmanuelle Charpentier published a scientific paper proving a key part of the bacterial immune system could be used to cut DNA: disrupting, deleting or correcting genetic errors. Their discovery started a race by start-ups to create transformative — and possibly even curative — treatments, which has developed much faster than previous advances in biology.”
Tim O’Reilly: “Instead of thinking of the metaverse as a set of interconnected virtual places, we think of it as a communications medium? Using this metaphor, we see the metaverse as a continuation of a line that passes through messaging and email to “rendezvous”-type social apps like Zoom, Google Meet, Microsoft Teams, and, for wide broadcast, Twitch + Discord. This is a progression from text to images to video, and from store-and-forward networks to real time (and, for broadcast, “stored time,” which is a useful way of thinking about recorded video), but in each case, the interactions are not place based but happening in the ether between two or more connected people. The occasion is more the point than the place.”
Compounding: One of the greatest secrets in the world is the power of compounding. A 10% annual growth over 10 years means that $100 dollars becomes $260 – 2.6X. A 20% annual growth for the same period results in $620 – 6.2X. Over 20 years, the difference is stark; $670 vs $3700, over five times greater. In Netcore, we have grown per share value at 26% compounded over the past 10.5 years which has meant that $100 has become $1000 – 10X. If we can do this for another decade, that would mean 100X. So 10% over 20 years is 6.7X, 20% is 37X and 26% is 100X. Understanding the power of compounding is a must for entrepreneurs. As Morgan Hansel writes in his book “The Psychology of Money”: “If something compounds—if a little growth serves as the fuel for future growth—a small starting base can lead to results so extraordinary they seem to defy logic. It can be so logic-defying that you underestimate what’s possible, where growth comes from, and what it can lead to.”
Longevity: High growth can be done for a few years. The challenge is to sustain it over long periods of time. As a friend wrote to me recently, “The compounding formula is (1+r%)^n. People forget the “n” of compounding actually matters more than the “r”. Too many people focused on “r”, too few on “n”.” Compounding growth over long periods of time is what creates value. For that, a process and discipline is required not just in strategy and execution, but also in capital allocation. A few mistakes can wipe out years of growth. In Netcore, we have made our fair share of mistakes – which have hurt us. We could have done much better than our 10 years, 26% CAGR in per share value had we got martech automation right early on, and used the SaaS mindset to expand globally much before we did.
Luck: While one has to be smart to succeed, luck also plays an important role. Timing for decisions matters. In 1999, when I sold IndiaWorld for Rs 499 crore ($115 million), the timing was just right. Had I wanted a few months, I do not know what the value of the business would have been because the dotcom bubble burst. In fact, had I sold a few months earlier, I would have probably realised only a fraction of the value. The right timing meant that my initial investment of Rs 20 lakhs in IndiaWorld grew almost 2500X in five-and-a-half years, a CAGR of almost 300%.
Nikki Haley: “America knows how to prosper; we’ve done it better than any other country in history. Far from letting politicians control the economy from the top down, we’ve empowered citizens to create from the bottom up. We lead the world in science, technology, military strength and so much else not because Washington knows best, but because the American people have the freedom to constantly dream and do better. The last thing our leaders should do is direct the economy, subsidize special interests and tie strings to entire industries. Instead, we should make it easier to start businesses, clear hurdles that stifle innovation, and let job creators and families keep and spend their own money. Economic freedom is the proven path to beat communist China. If Washington keeps trying to pick winners and losers, America will lose.”
Rita McGrath: “We have a category of competition that is particularly germane today. These are oblique, or indirect, competitors. They may not make the same product or service you do. They may not be in your traditional “industry.” They may not be in your line of sight at all. And yet, they can make what you do unnecessary, unattractive or irrelevant. And they can do it in surprisingly short order. For instance, most newspaper companies were caught entirely by surprise by the rapid erosion of their classified-ads business once Internet-based advertising and free resources such as Craigslist provided the same benefit to users in a more convenient and easy to use approach.”
Gurcharan Das on India: “India’s greatest challenge is bad governance and weak institutions. Why should it take 15 years to get justice? Why are three-fourths of the persons in jail still awaiting trial? Why am I afraid to go near a police station? Why do one-third of India’s MPs and MLAs have a criminal record? The truth is that India at 75 is a sweet and sour story of private success and public failure. India has risen from below, through the energy and ingenuity of its people, almost despite the state. It is quite unlike the top-down success of East Asian countries, which was steered skilfully by the state. Unless India fixes its governance institutions, it will not become a developed country.”
Auri Hughes in May 2022: “This was started by a gentleman named Mark Leonard in ’95 and he was a venture capitalist 11 years and he acquired small software plays. Then he continuously did this for long periods of time and the business has just grown tremendously. Over years, it compounded something like, I think in the high 20 or 30 percent for over 10 years. He’s done this with a M&A strategy. I think this is profound because a lot of companies essentially destroy value with M&A and they’re not great capital allocators or they overpay or they promise synergies and things that don’t materialize and we see that later. But he has this wonderful strategy. One of the things that I think is unique is in CapIQ the share count when they went public was 21 million shares and today it’s still 21 million shares. They’ve earned a return on equity in the high 30s for a consistently long period of time. I think this is one of the best companies in the world a lot of people don’t know about. They are very disciplined and they have this process as well. I think the other unique thing to mention is as you get larger, you have to do more acquisitions to generate the same amount of earnings and return on equity because your capital base is growing. They’ve consistently been able to do this for a long period of time so I think Mark Leonard is just a master capital allocation.”
Bill Mann (continuing the same conversation): “If you ever get a chance to go to the Constellation Software front page of their website, they are first and foremost interested in getting introductions to vertical management software companies that are interested in selling. This company is built for capital allocation. Because if you think about it, there’s no such thing as let’s go upload the Constellation Software suite. It doesn’t exist. They’re a series of small companies and they use the returns from those companies as force multipliers for other companies that they are interested in buying. They do them by the dozens each year at this point.”
Simon Handrahan in October 2021 aggregated wisdom from the shareholder letters written by Mark Leonard. A sample:
“We have an objective of generating average annual revenue growth per share and average annual EBITDA growth per share of at least 20% for the five year period… I recently ran a screen of public companies… that met these criteria for the last 5 year period. I discovered that less than 1% of companies qualified.”
“We’ve handled our geometric growth to date by largely abdicating management to the general managers of each of our vertical businesses. CSI. We count on the fact that with each new acquisition will come general managers who are steeped in their verticals…”
“… our senior managers consistently generate rates of return in excess of 25% on the capital that they deploy. As investors you’ll know that this is wildly difficult to achieve. How do we keep these multi-talented managers? Hopefully we provide an environment that is fulfilling, colleagues that are both challenging and entertaining, and work that is meaningful. We also pay them well.”
“When we acquire an underperforming company Growth suffers. …we generally grow our acquired businesses, frequently providing additional products for them to sell into their installed base, and bringing our increased scale and best practices to bear upon their business…. the reduction of an acquired business to a profitable Core will leave us with a smaller, but usually more profitable business.”
There is a lot to learn from the likes of Berkshire Hathaway, TransDigm, Teledyne, Constellation Software and businesses like them. As a latecomer to the world of capital allocation, I will summarise my learnings and how these could be applied to Netcore to deliver exceptional returns in the years to come.
Mohit Satyanand: “How independent are the 80% of our citizens who depend on the government for food grain? How independent are we when we depend on China, an active aggressor at our borders, for Active Pharmaceutical Ingredients, for our mobile phones, and the flags fluttering in our streets? How independent are we when depend on a rogue nation for the bulk of our ordinance goods?”
Niranjan Rajadhyaksha: “One way of looking at the Indian development journey over the past 75 years is in terms of breaking structural shackles to growth. India has broken free of three important constraints—the food constraint, the domestic savings constraint and the foreign exchange constraint. One major structural constraint that persists is energy. India is deficient in energy, and prone to economic stress whenever global energy prices rise. The planned switch to green energy in response to climate change offers a window of opportunity to break the energy constraint. The final question is one of political economy—will India resemble East Asia or Latin America? The countries in East Asia have managed to achieve inclusive growth through the creation of competitive enterprises as well as quality jobs for citizens. Public finances have been managed well. Latin America has tended to grow with wide income disparities, macroeconomic imbalances and social tensions. Where will India find itself in 2047? The answer is not yet clear.”
Ruchir Sharma: “To grow faster than 5 per cent, India would have to adopt more radical reform. Only 20 per cent of women are formally employed and doubling that to 40 per cent — merely average for a lower-middle income country such as India — would be transformational. So would encouraging internal migration to better jobs, as China did, given that nine out of 10 rural Indians still live in the district where they were born. But India is as diverse and democratic as China is homogeneous and autocratic: imposing disruptive reform is not on the cards. More likely, 5 per cent growth is now the base case. Even at that pace India will be a breakout star in a slowing world: on track to surpass the UK, Germany and Japan to become the third-largest economy by 2032. At that point India may not yet be a middle-income country, but it will be moving in the right direction, rising gradually in the world.”
In software, one of the companies regularly mentioned in capital allocation conversations is Constellation Software. In its own words: “Constellation Software is a leading provider of software and services to a select group of public and private sector markets. We acquire, manage and build industry specific software businesses which provide specialized, mission-critical software solutions that address the particular needs of our customers. Our businesses continuously develop innovative solutions that enable our customers to achieve their objectives. With over 125,000 customers in over 100 countries and a proven track record of solid growth, we’re establishing a broad portfolio of software businesses to provide our customers and shareholders with exceptional returns.” The CEO is Mark Leonard, and the company is headquartered in Toronto, Canada.
From a recent commentary in Rational Thinking: “Under [Constellation Software’s CEO Mark Leonard’s] reign, the company has compounded at about 40% for almost two decades! … Constellation’s business model is to acquire small software companies under one umbrella while giving them autonomy without fiddling from HQ.”
25iq in 2018: “With an initial $25-million investment from OMERS and his old associates at Ventures West Capital in 1995, Mark Leonard has built Constellation into a world-leading consolidator of vertical market software (VMS) companies—firms that create products to help run businesses in specific industries. Over the years, Constellation has made scores of acquisitions and, through its six operating groups, now provides software to over 60 industries, from health care to law to public transit…. Typically, Constellation’s acquisitions are small—in the $2-million to $4-million range—but add them all up, slip in a dose of Constellation’s financial and operational discipline, and you have [a company with a market cap of $18 billion….In this age of zero privacy, Mark Leonard has managed to maintain a practically unthinkable level of anonymity for just about any individual—let alone an IT executive who runs one of Canada’s most dynamic, fastest-growing and most acquisitive software companies, and who has been compared favourably with Warren Buffett and Prem Watsa.”
Eagle Point Capital in 2021: “Mark Leonard and the small headquarters team are the foundation for capital allocation at Constellation, but most of the work is carried out in the subsidiaries. Leonard is clearly a very skilled capital allocator and investor. He thinks like Buffett and has a repeatable framework when thinking about acquisition candidates, purchase prices, risk, and forward rates of return. Constellation’s stated goal is to be a “great perpetual owners of VMS (vertical market software) businesses”. They look for what they deem both “exceptional” and “good” VMS businesses. Exceptional businesses feature an outstanding manager, consistent profitability, and above average growth. Leonard classifies good businesses as first or second-ranked players in their verticals that may still be working to establish a solid track record of growth and profitability. Constellation has carved out a sweet spot by acquiring lower organic growth (GDP-like growers) albeit very high-quality software companies. They’ve been able to maintain valuation discipline by staying away from high-growth software businesses where valuation multiples are far higher.”
Russ Roberts: “What gets measured gets managed. But I’m saying something stronger here. If we are not careful, what gets measured is all we manage. We don’t just pay more attention to what is in the light. We forget what is in the shadows. We forget about the rest of the things that do not get captured in measures we become accustomed to studying and using.” More: “A life well-lived, as I argue in my book, Wild Problems, is not a calculus equation to be solved.”
Nathan Baschez: “A lot of times, instead of thinking big, we actually need to think small. Instead of getting hyped about broad narratives that explain our predicament, we need to just buckle down and ask ourselves how we can do what we’re already doing—but much, much better. We need to focus on execution, not strategy. So why don’t we? The main reason, at least in my experience, is we don’t realize just how much better we could be executing, and just how much the metrics could improve if we did. We assume we’re performing most of our key activities roughly 80% of the way to perfection, and pushing harder to get the remaining 20% wouldn’t move the needle that much. In my experience this is usually false. We may not be able to imagine how, but 10x or even 100x improvements are possible more often than we think. And the ultimate effect of making that kind of change on every activity has compounding, multiplying effects.”
Read: Lost Man of Bombay, by Vaseem Khan. A thriller set in 1950 Bombay.
In his book, William Thorndike discusses 7 other case studies besides Teledyne and compares them with Jack Welch’s performance at GE (who is not among “The Outsiders”). The table below from Strategy for Executives summarises the performance of the Super 8 capital allocators:
Period as CEO
Stock’s Compound Annual Growth Rate (CAGR)
Factor by which the stock outperformed the S&P 500
The Washington Post
Over 100 Times
This chart from the book (via Kyle Eschenroeder) shows what the 8 Outsider CEOs had in common:
Towards the end of the book, Thorndike has a capital allocator’s checklist. Here’s a summary:
The allocation process should be CEO led, not delegated to finance or business development personnel.
Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).
Calculate returns for all internal and external investment alternatives, and rank them by return and risk
Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.
Focus on after-tax returns, and run all transactions by tax counsel.
Determine acceptable, conservative cash and debt levels, and run the company to stay within them.
Consider a decentralized organizational model.
Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.
If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.
Shankar Acharya: “Anyone suffering from complacency about India’ s macroeconomic resilience should note that the latest June quarter estimate (from CMIE’s rolling surveys) shows India’s employment rate (total employment divided by working age population) languishing at a very low 36.6 per cent, by far the lowest among “all large economies”. It means that less than two-fifths of the working age population in India today is actually able to find any work!”
Hayek: “A limited democracy might indeed be the best protector of individual liberty and be better than any other form of limited government, but an unlimited democracy is probably worse than any other form of limited government, because its government loses the power even to do what it thinks right if any group on which its majority depends thinks otherwise.” [via CafeHayek]
Shane Parish: “A huge obstacle to success is a fear of appearing foolish. When we learn to walk, we fall over and over again until we can do it. We look foolish until the minute we don’t. That is how we learn. As adults we often tell ourselves that failing in front of other people is bad, so we don’t try things that might make us look foolish. During boom times, people who aggressively went all in appear to be prospering and make a more financially stable approach seem foolish. Only those who were properly positioned, however, can take advantage when the boom ends. So much advantage in life comes from being willing to look foolish in the short term.”