The margin trap: Why innovation matters more than short-term profits

One of the clear takeaways when speaking with senior people working with Apple is their disappointment at the lack of willingness among India Inc to step up and make the investments needed to bring the Apple ecosystem into India. While China is putting up obstacles, the profit focus of Indian entrepreneurs is also a stumbling block. Whether it is putting up the component supply chain or making large capital investments for display units, there is a lack of interest on the part of large Indian groups to commit capital.

 

They cite the low margins on offer and the intense scrutiny that Apple demands on quality and scale. In effect, it would take years of sustained effort to earn a reasonable return on capital — if at all. Is it worth it? Many believe they would be derated by their shareholders, who would not accept the initial losses and question the ultimate return on capital. With a drop in margins will come pressure on valuations and market capitalisation — this is the common belief among Indian industrialists.

 

Indian markets are hyper-focussed on profitability and return on capital, producing numerous multi-year compounders as a consequence. India has among the best long-term equity market return profiles in the world, and the focus on capital discipline has been a strength. One reason India has delivered much stronger returns than China (over the past 25 years, China delivered 4 per cent real returns compared to India’s 6.9 per cent) is this sharp focus on profitability and capital allocation. Global investors appreciate that Indian entrepreneurs understand the cost of capital.

 

However, could this intense focus on profitability and market capitalisation be turning into a long-term weakness? Have Indian investors become so focused on short-term profitability that they are not giving our companies the space to make the long-term investments needed to succeed and become global leaders? After all, whenever you are trying to break into a new business and acquire global scale or capability, it will require upfront investment and losses. Innovation is also inherently risky.

 

How is it that Apple has had no difficulty finding suppliers in China? Chinese suppliers have been willing to accept lower margins for the chance to learn the technology and acquire scale. This has made them a manufacturing powerhouse, accounting for 32 per cent of global manufacturing.

 

Or is it that, unwilling to put in the hard grind needed to break into and compete in a global supply chain — or to take the risks inherent in innovation — Indian promoters are conveniently blaming investors? Maybe the high valuations are lulling everyone into complacency. If you can get a multi-billion-dollar valuation just by being a participant in the India growth story, why do anything different?

 

Take the case of the Indian IT services players. Despite earning margins of over 30 per cent in their heyday, they never spent meaningfully on research and development (R&D) — not even a few percentage points of revenue. When asked about this, they would always blame their investor base, saying they could not let profitability drop, even temporarily, as investors would punish them in the market.

 

While China may be a poor template — with a corporate sector heavily subsidised by the government, lacking discipline in capital allocation, and intensely focused on size and scale at all costs — the US is a model worth emulating. On Wall Street, it is normal for technology/healthcare and consumer companies to spend over 10 per cent of sales on research or branding, and they get penalised if they spend less. As an example, Alphabet alone spends $50 billion on R&D, equivalent to over 1 per cent of Indian gross domestic product! It is common to see companies take their current profitability and cash flows to build new businesses, in order to extend their growth horizon.

 

Microsoft, for instance, took six years to build its Azure Cloud business, losing over $10 billion in the process. Yet investors remained patient, and the company had the clarity to keep investing, regardless of the short-term impact on margins. They are now doing the same while building out their artificial intelligence (AI) business. You have examples of Netflix and Amazon, world-leading innovative business models, which investors were willing to back in the public markets despite taking years to turn profitable.

 

How is it that public markets in the US —  the most short-term oriented and intensely capitalist in the world — were willing to back and value loss-making businesses like these, while we seem unwilling to do the same in India? Is it that US companies can take these incubated businesses global and create disproportionate value? The successful businesses create such value that it is worth funding the initial losses? Amazon, for example, has compounded its market capitalisation at 32 per cent annual rate since listing in 1997. High valuations in the US markets seem to be a structural advantage in encouraging innovation and risk-taking as the payoff profile for success is worth the risk.

 

To be fair, this willingness to value innovation and new business optionality is unique to the American financial markets. The US has a model of government funding for basic research, strong academic partnerships with industry, and venture capital and other investors supporting companies at every stage of their lifecycle. In India, we need to strengthen the academic–industry–government partnership. We also need venture capital that is willing to look at deep tech and areas beyond consumer-focused apps. And we need public market investors who are prepared to look beyond short-term margins and back companies that are trying to scale new businesses. 

 

India Inc spends less than 1 per cent of sales on R&D. Despite lower labour costs and minimal R&D, its margins are no higher than those of global peers. We generate fundamentally lower gross margins, linked to lower value addition. India has the possibility of creating an environment similar to that of the US, where investors are willing to look through initial losses as companies build new businesses. The payoffs in India for building a new business or acquiring global scale are enormous. Markets reward success disproportionately.

 

Given its robust private and public market ecosystem, India has a chance to be the only other market besides the US that is willing to value loss-making businesses and take a longer-term view in evaluating success. We can convert our high valuations into an environment where risk-taking is encouraged. We are probably the only large market that can realistically hope to emulate the US, as we have a similar payoff profile where markets reward success disproportionately.

 

In my view, India’s top entrepreneurs — those with credibility and a proven track record — will find support from public market investors and will be given the space to invest and build new businesses. The public markets are not as short-term focused as they are often perceived to be. Companies may find it better to raise growth capital from public markets rather than from private equity, which typically demands a minimum return and has only a five-to-six-year horizon.

 

India needs to get on the innovation cycle — and everyone has a part to play. The government must provide basic funding and strengthen linkages between industry and academia. Private markets must support genuine innovation and public market investors must not obsess about short-term margins. We can create a risk-taking culture that no country other than the US has managed. We must aspire to this — and work towards it.

 

 

The author is with Amansa Capital