Natarajan Chandrasekaran is the Chairman of the Tata Sons. Tata Sons is the holding company and promoter of more than 100 Tata companies. The following is an imaginary conversation between Chandrasekaran and Warren Buffett. This blog is for entertainment purposes only.

Chandra: Hey Warren!

Warren: Hey Chandra!

Chandra: I have been such a big fan of yours and its such an honor to meet you, finally.

Warren: Thanks Chandra! Actually our jobs are pretty much the same.

Chandra: Really?

Warren: Oh yeah! Our #1 job is capital allocation. To put it simply- we just need to allocate capital where we are likely to get the best returns. I first realized this back in the 60s and 70s. We bought into this lousy textile business which had not much returns. Thereafter, Charlie and I decided to take the earnings out of the textile business and invest it in better business like insurance and newspaper. And we never looked back since.

Chandra: Warren — no one can explain capital allocation in simpler words than you. Please tell me more.

Warren: Chandra — you’ve got 100 businesses to manage. I’ve got about 70 odd. We can classify those businesses into three kinds – the great, the good and the gruesome. The great business generates excellent returns (Return On Equity of about 50–60%) and has excellent competitive advantages. The Good business has an ROE of about 15 to 20% with competitive advantages. And the gruesome business would have ROEs in single digits or sometimes in negative and would have no competitive advantages.

Now, as Charlie would say, “Invert, Invert, Invert”. So instead of trying to figure out the greats and the goods, we first eliminated the gruesome ones from the consideration set. That means, we don’t buy businesses if they are commodity like or lack competitive advantages. Elimination, removes 95% of the businesses from the list.

If all gruesome ones are eliminated, then what is left behind has to be great or good ones. We then try to pick the great ones first, followed by the good. Sometimes we are lucky and at other times I prevail.

I am sure you have the greats, the goods and gruesome ones at Tata as well.

Chandra: Oh yeah, tell me about them! We got out of some gruesome businesses last year like in telecommunications. We sold it to a competitor for almost free, but if we had kept it, it would’ve guzzled capital.

Warren: Excellent! So you wan’t get out of businesses that don’t have a return of at least 15 to 20%. There is an opportunity cost to capital you see. Money stuck in a gruesome business compounds at say 5%. That same money could’ve compounded at 30 or 40% in a great business. Time is the friend of the great business and enemy of the gruesome. Therefore you want to invest as much as you can in businesses that can compound at 30 to 40%.

Chandra: We have Tata Consultancy Services (TCS) and that is a compounding machine at the rate of 35–40%. Unfortunately, it can’t take any more capital and so we have a happy problem on our hands.

Warren: Yeah! That reminds me of See’s Candies. See’s compounds at 60%, but can’t take any more capital. So they send the profits to me and I use that to buy other great or good businesses. What other great business have you got?

Chandra: I’ve got investments in two airlines and I am going to make an investment in a third. Then I am going to merge the third with one of the two and I am going to get out of the other. It’s a great business….

Warren: Do the airlines make any money?

Chandra: No…but you don’t understand Warren. India is the fastest growing airline market in the world and if we don’t get in now, Mukesh might get in and we will miss the bus (or flight) and then we will regret it…I just wont be able to handle it. I have to buy it!

Warren: Chandra, you don’t have to swing at all the pitches. You just need to swing only at the ones in your comfort zone. From what you just told me, I don’t think airlines is in your zone. Then why are you swinging at it?

Chandra: To not regret it in the future.

Warren: Airlines is a tough business. There are more dead players than alive ones. And they guzzle capital like crazy. You need an organization that is super efficient that can sweat expensive assets like airplanes. To me, your interest in airlines sounds like a classic case of fear of missing out. I think you’d be better off if you focused on getting out of gruesome businesses and investing in the great ones.

Take the example of Titan Industries, one of your great businesses. Between 2015 and 2018, it’s added about Rs 700 Cr of fixed assets. These assets have helped it grow it’s net profits by about 314 Cr. Or an incremental return of 45%! I think you and the Tatas, would be much better off investing in your great businesses — Titan, TCS or Tata Elxsi. And gradually getting out of the commodity businesses.

In fact, if you could use Jack Welch’s framework of getting out of businesses where you are not #1 or #2, you’d do great.

Chandra: Thank you Warren! You are a genius! Things are so much clearer to me now.

Warren: You are welcome Chandra! You have an unenviable and a tough role of running 100 companies and most of them were bought or started by your predecessors and therefore you have inherited their legacy. So you are an outsider, just as I was when I took over Berkshire. And you can use that to your advantage by not suffering from sunk cost fallacy and ruthlessly getting out of gruesome businesses that aren’t working for you. That’s going to be your legacy!

Best wishes Chandra!