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It’s the Base Rate, Stupid!

Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.

In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.

~ Warren Buffett, in his 1995 letter to shareholders

Buffett called retailing as “have-to-be-smart-every-day business”, and retailers after retailers have proved that over the years, in India and abroad.

Anyways, twelve years after Buffett wrote the above lines to his shareholders, a retailer was born in India, whose “About Us” page reads today like this…

…went live in 2007 with the objective of making books easily available to anyone who had internet access. Today, we’re present across various categories including movies, music, games, mobiles, cameras, computers, healthcare and personal products, home appliances and electronics, stationery, perfumes, toys, apparels, shoes – and still counting!

Be it our path-breaking services like Cash on Delivery, a 30-day replacement policy, EMI options, free shipping – and of course the great prices that we offer, everything we do revolves around our obsession with providing our customers a memorable online shopping experience.

If you haven’t guessed it till now, this is how India’s leading online retailer Flipkart defines itself. So it says..

  • We started with books, but now sell everything under the sun (see, we do run a “have-to-be-smart-every-day” business)
  • Buy now and pay us cash later, sometimes in easy instalments (easy for you, not so for us)
  • We also don’t charge for some costs we bear for you, like shipping
  • We offer great prices (because, you see, we have no pricing power)

If you have been fed on the diet of the idea that businesses are meant to make money, and not burn them, Flipkart and many others like it are there to prove you wrong.

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And then, when the founder says ‘Profitability is not a focus area’, you feel you have done yourself a great injustice all these years believing Buffett, Munger, and Graham…who have laid profits (and cash) as primary drivers of value creation.

Make no mistake, I like Flipkart as a consumer for their service though not anymore for their prices (a very credible source – my wife – says many other sites offer better prices on products), and I believe they have really shaken the Indian e-commerce market with their offerings, the fact that it will remain a cash burning train is something that worries me – simply for the wrong message it is sending out to so many new entrepreneurs in India.

At 30-50% discounts on a regular basis, it’s difficult to make any margins and you can’t keep losing money forever. Then, a “war chest” of US$ 300 million+ only makes you crazier.

You increase discounts, kill thousands of small mom-and-pop stores who don’t have even a box of cash (forget a war chest), still make losses, create fancier presentations to promote the “India opportunity”, justify stupid valuations, and raise even more money to extend the craziness till eternity.

That fits Buffett’s “gruesome business” definition to the tee.

Now, double the gruesomeness when you know that Flipkart’s co-founders took home a salary of Rs 10.25 crore each (US$ 1.7 million at then forex rates) in the six months ended March 2012, which was same as the annual salary of Jeff Bezos, the founder of Amazon, a company light years ahead of Flipkart in terms of sales, profits, customers, assets, service, and vision.

On his salary, the Flipkart CEO is reported to have said, “It’s proof that entrepreneurship in India, if done right, can be extremely rewarding.”

Rewarding for whom? Well, that’s the question.

Avoid “Have-to-be-Smart-Every-Day” Businesses
Will Flipkart fail? When will Flipkart fail?

I don’t have answers to any of these questions, and I care less.

I believe there is a great probability that Flipkart will someday list itself on the Indian stock markets – when the money is available and the IPO market is hot – and investors will lap up its shares thinking it’s the next great thing for the Indian business.

But it’s important for investors to understand that whether it’s retail (online or offline), or aviation, or any sector where companies have to be smart every day to just stay in their place (like a treadmill), staying away is a great decision.

As Charlie Munger says, “You don’t have to pee on an electric fence to learn not to do it.”

As I see it, the Indian online retail market looks strikingly similar to the low-cost aviation market a few years ago. Airline operators were then making similar noise of how India’s huge consumer population and poor alternate mediums (like trains and buses) made low-cost airline such a highly profitable model in the long run.

We know what happened then. The reputation of the business – a commodity that bleeds its owners tonnes of cash – has survived, but the operators have all disappeared. The Indian online retail market seems to be taking a similar route.

So will be the story of so many other companies from others sectors that…

  • Are expanding aggressively on borrowed capital
  • Are burning cash at rapid pace
  • Are cutting prices to gain market share at the cost of profits
  • Have promoters consistently diluting stake
  • Have promoters that are overpaying themselves
  • Have just the “future growth opportunity” to show for their vision and valuation

Remember the Base Rates
Prof. Sanjay Bakshi recently shared a brilliant article he wrote on the various types of Indian promoters.

He categorized them as OO1, OO2 and OO2, where OO stands for ‘Owner-Operator’.

While I suggest you read the full article here, here is how he has described the OO3 promoters…

Owner-Operator 3 (OO3): An owner-operator who is passionate about the business but primarily runs it for his own benefit. He does not take minority shareholder interests into consideration. He is quite likely to be very aggressive when it comes to expansion is likely to make large gambles. When these gambles go right, he is likely to be treated as a hero, but it will only take one big mistake to destroy his career. He is quite open to using political clout to further his interests.

He is also open to recklessly use huge amounts of borrowed money to expand his empire. His focus is more on expire expansion, instead of low-risk expansion of per-share intrinsic business value. It is this type of owed-manager who is to be avoided at all costs. Becoming partners with such a person is risky.

Investors, however, often ignore this risk and get carried away by an OO3’s charisma, grand vision, and the crowds (investment as well as media) which follow him.

Online retailers like Flipkart fit the above description to the tee (except the part on using political clout). Given the economics of their business, things are not likely to change in the future.

As for you, avoid such promoters and their businesses at all costs.

There are a lot of rash and fast growers in “sunrise” industries that look as if they could not fail. But the base rate of success for such companies is extremely low.

Here is what Prof. Bakshi said on base rates in his interview with Safal Niveshak

One of the great lessons from studying history is to do with “base rates”. “Base rate” is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money.

But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run? If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks!

That’s the case, not just in India, but in every market, in different time periods. What you don’t see can really kill you! And people don’t see the base rates.

When you evaluate whether smoking is good for you or not, if you look at the average experience of 1,000 smokers and compare them with a 1,000 non-smokers, you’ll see what happens.

People don’t do that. They get influenced by individual stories like a smoker who lived till he was 95. Such a smoker will force many people to ignore base rates, and to focus on his story, to fool themselves into believing that smoking can’t be all that bad for them.

As an investor, here is what you must always remember – When the evidence of long-term success in a business is weak (like in retailing, airlines, and textiles – the “have-to-be-smart-every-day” businesses), you should stick with the base rates.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.


  1. Reni George says:

    Good Evening to you Vishal

    Deja-Vu,I was expecting a post from you on flipkart,I was also preparing one.I was going to put forward that on the eve of the IPO listing of Flipkart,and I was expecting the same from you,but you came out little bit early…

    I do not know,what prompted you do this fast,may be the news that some idiots somewhere were valuing this business at more than 9000 Crore (Yaa its true,if you see the current round of capital Infusion),that would be more than the market cap of P&G,which has not reached at 9000 crores after so many years. and also more than the market cap of many companies which generate positive cash flow.

    I am a businessman,Let me put forward what a businessman or anyone likes,that is what is the bottom line…[PROFIT],for any business to grow,profit is needed and let me tell you as businessman,Iam ready to invest more capital in my business,if it is going to give me incremental profit.[Nothing Else],if not then I am not at all interested.I will not be interested in even growing that business,if it is just going to burn my hard earned cash.Frankly speaking i have closed down two of my ventures,when it started burning cash,as simple as that.

    Now let us see,if the founders of Flipkart were to receive a salary of Rs.1 and were promised ten times their annual salary,if they could generate positive operating cash flow.Then I doubt they would be so passionate about their business and would have given some worthwhile answers.

    Now we investors should understand that,a business with just 100 rs.Capital and a owner profit of 10Rs. is far more worthy than a business with 1000 crore of capital and 0 profit.The problem with all the companies is that,taking the huge divergent middle class population of india,every damn promoter is making some absurd claims,as if each and every individual is going to buy from them.

    Let me put forward,some wordings of a promoter of a jewellery company.This was his reply to a question of generating profits.
    “Believe me, 50% of Indians are below the age of 25 years and most of them are yet to get married. So, each marriage if you take into account a minimum Rs 20 lakh worth of jewellery spend, it is close to a trillion dollar jewellery consumption in 10 years,”
    Now this words look something like the story of how to become a billionaire from a single chick,this words are of Mehul Choksi of Gitanjali Gems.

    What’s a use of a Billion Dollar business,when it can’t generate even One rupee in profit,for its owners.

    Remember,sooner or later this company is going to come out with an IPO,because the owners or founders of this company might have agreed with the guys who have put forward huge sums of money,that they will surely find bigger fools in the market,on whose head,they can throw the shares of this company.

    As an investor,you should always say what Cuba Gooding Jr said in the film Jerry Macquire, “show me the money,dear show me the money”

    So dear everyone,miss every business,which does not show you the money,simple,i would always desist from being an owner of such type of business,which does not “SHOW ME THE MONEY”

    Again an Excellent post,you are more behaving like a great wine,aging and getting better.

    Thanks and Regards,
    Happy and Safe Investing

    Reni George

    • “….behaving like a great wine, aging and getting better.” ROFL, Reni!

      I thought I was getting younger, and you killed my hopes 🙂

      Great as always to hear you thoughts. I wrote this post after my wife asked as to why are these e-commerce sites offering such unbelievable yet stupid deals! I told her that’s simply due to the stupid and cheap money that has flown to them. And then I though of putting all this in a post, for it’s relevant to so many other businesses that are burning cash at a rapid pace, at the cost of gaining volumes and some survival time.

      “Show me the money” will just invite you stares from such promoters.


      • Reni George says:

        Hi Vishal,

        Good morning to you!

        A couple of days back, Prof. Aswath Damodaran came up with a similar writing, which can be read here.

        This will also throw more light on the absurd valuations given to online retail and ad generating stores.

  2. We should have some articles or discussions on IPOs in general to make people aware of its pros and cons. Further we should discuss new IPOs so that SN readers don’t fall in to the next IPO trap. We have seen IPOs of jewelers, retail shopping cos, ecommerce or online cos, innerwear cos, etc …. All hyped up for a few months or a year. But their results are not in mind with their prices. Brokers, investment researchers, analysts, etc always follow and recommend these stories making life worse for investors.

  3. Excellent post. The Munger quote was just there!

  4. Shamil Abdul Kader says:

    Completely agree with you. Whatever is good for customers need not be good for the business – remember Buffett’s analogy while shutting down the textile business instead of burning more cash.

    I enjoy the convenience and good deals offered by online retailers. Your wife is right – Flipkart no longer offers good deals. Their service has deteriorated (as per complaints online) once they moved to marketplace model. I will always remember Flipkart for giving me confidence to shop online and for great deals. At the same time, I will be careful about my System 1 biases while dealing with Flipkart as an investor (Association Bias is strong for me in the case of Flipkart).

    I have moved to Amazon/ Snap Deal. Amazon is very good and I have been buying a lot of goods from them (mostly books). It’s too early to pass a verdict on Snapdeal – a courier is supposed to be delivered today.

    • Shamil, my wife has been browsing “shopclues” off late. 🙂

      They seem to be offering “deals beyond imagination”…and as I guessed right, after a funding very recently.

      This seems a fight till the end!

  5. Swaminathan Kumaran says:

    Thanks Vishal for this article. I am happy as I am thinking like you a bit on flipkart. As a customer I use it to pick deals but surely not going to be the owners of such business. One is giving up margin, initially they were selling below the cost price.

    Only one thing which is not clear is, originally they used to stock items to sell, lately they started partnering with dealers like Amazon, in this model it is just commission which they earn right? What is those investors expecting, like google search engine revenue?

    • Thanks for writing in, Mr. Kumaran! Flipkart is shifting its model to that of becoming a “marketplace” where other sellers will sell their wares, and Flipkart will earn a commission for each sale made. That is what even Amazon is doing. The question is – what are the entry barriers that Flipkart can create with such a model? If they think it is “technology”, they may be wronged as technology has never been a barrier for companies to stop competitors…simply because technology can be bought. It won’t take much time for someone else with deeper pockets to set up a Flipkart like model.

  6. Vishal,

    I agree with you on Flipkart.But looking at the American economy, there have been several brick and click retailers who have been very successful for their customers , employees and shareholders ( eg: Walmart,Amazon,Costco,Kroger,Target,Macy’s,Nordstrom) are just a few in a long list of examples.So the base rate of retailers in the US would be far higher for now than in India.But maybe a few years down the line, we can see some retailers in India who put profitability ahead of growth.


  7. vishal sir ,
    thanks for the thing that came to my mind reading the post & the comments, how would the Courier companies like BLUE DART be linked with online shopping b’cz dwn the line even india like usa would end up buying online & there would be courier companies making money out of it.
    would love to listen to everybody’s thoughts on that.


  8. Chetan Chhabria says:

    Hello Vishal,

    What are the sources of the company burning cash? In my opinion it is the employee cost,technology and other overhead expenses(advertising). Please throw light on any other source. Most of the companies in this space follow the marketplace model, Isn’t the seller of the products losing out on margins selling at such lower prices, how is flipkart’s profitability effected from this source (selling at lower prices).

  9. Lifeperspective says:

    Agree mostly, though their preferred listing route will not be in the Indian markets but abroad, where the “India Story” is easier to sell (a la Makemytrip).

  10. Wonderful write up Vishal. Once again thorough analysis and unbiased view was a treat to read. The hype of online retail is buzzing up in market and IPOs will come up when hype is on its peak. The irrational behaviour of crowd will be another testimony of greed. Thanks for the wonderful article.

    Vikas Kukreja

  11. It is a great article. As u said, Base rate tell us companies dont succeed easily so chose your investment wisely and patiently. Probability of getting failed is much more.

  12. Rajaram S says:

    Thanks, Vishal, for continuing to share your wise thoughts. The excess liquidity in the global system has probably given rise to many such Flipkart phenomena. Just look at the “clean tech industry”, it also resembles the “dot com” bubble. I don’t think investors get into these ventures just to make money. There is also the “kick”. I would not label these investors as “fools”. I think these are people who understand the monetary system well, and have made enormous wealth. And now they want fame, adulation, intellectual stimulation, adventure etc. So they invest into these “sexy” ventures. Even if these burn money, still it gives the investor/VC a great kick, and also plenty of fame.

    For a “value investor” mind-set, it’s about “do not loose money in the long term” and “conserve cash/energy”. This is not “sexy” at all, it is a boring process of consistently making the small but correct moves over a long period of time, it is like life itself. I guess value investing applies to the majority of us, who do not have the means or the wherewithal to earn “excess” cash for “sexy” indulgences and endeavours. The majority has to learn to need to focus more on preservation, conservation, and other principles that will allow us to keep going in the long term (until we have to just let everything go and bid farewell, like it or not).

    As I have learnt, the stupidest thing is when a person needs to live a value investor’s life, but thinks he/she should be “sexy”. This is the guy who burns cash that he has, or borrows cash that he does not have. This is the real FOOL (maybe each one of us has to look within carefully and see whatever is showing up even if it is not flattering)!

    Value investing is not for the intellectual geniuses among us. The intellect can often be a problem, as it tends to seek thrill and needless differentiation. Value investing is for the ordinary among us, who are willing to open up and see things for what they are, and what they are likely to be….

  13. Excellent and very informative post Vishal.

    I’m looking forward to your Pune visit!!


  14. Great post. Buffett is very clear from his experience about the difficulties of retailing. However, I think Amazon has the same challenges as Flipkart. Despite the head start, Amazon has yet to be profitable (see this NYT article).

    If we use Graham and Buffett’s screens of margin of safety and owner earnings/FCF, Amazon doesn’t pass the test right now. It also appears there is little focus given they are trying to do many things at once (and by implication competing with a number of different companies at once–Netflix, Apple, Barnes and Noble, etc.).

    Further, Walmart has been studying Amazon and looks like they are about to take advantage of their fixed costs and incredible distribution system (already paid for) to take on Amazon (see this NYT article).


  1. […] of successful acquisitions can be substantial, but it’s also important for you to consider the base rate of success of acquisitions, which is very low…simply for the reason that most acquisitions […]

  2. […] have already written about the subject of base rate earlier, so I won’t take your time to explain it again […]

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