December 28, 2014

How to do Management Analysis of a Company

“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. Until now, we have learned about:


We learned in Part 4 that detailed analysis of any company & its stock involves: Financial Analysis, Valuation Analysis, Business & Industry Analysis and Management Analysis. We have already covered financial, valuation and business & industry analysis in previous articles in this series. The current article deals with management analysis of any company & its stock.

MANAGEMENT ANALYSIS


Management is the most important parameter and I give it more weightage than any other parameter. I want to invest in companies, which are run by honest people whom I can trust with my personal money. A crooked manager will always find more than one way to cheat shareholders. I avoid companies where I see even the slightest sign of compromise of integrity.

Addendum (June 06, 2016):The current article on Management Analysis was written in December 2014. Recently, I have written a detailed series of articles focusing on assessment of management quality before buying stocks, which cover management analysis in much more depth. It is highly recommended that you read these articles before making final opinion about management of any target company. You may read these articles here:
Management analysis of a stock is similar to the analysis that one does when any acquaintance asks monetary help. A good person would do her best to repay it on time. She would take care of your money and use it for productive purposes. Moreover, when you need it, she would give your money back even by borrowing from someone else or even by selling assets. However, if money is lent to corrupt person, recovery can be next to impossible. There is no dearth of excuses then can be provided by anyone who does not want to keep her word. In such cases, prevention is the best cure available. One should try her best not to lend to dishonest people else, she would be at devil’s mercy. Similarly, while choosing stocks for investment, avoiding investment in companies, which are run by dishonest management, is the best chance to safeguard one’s money.

Steps/Tools for Management Analysis:


Management analysis is mainly a subjective exercise. However; it contains some objective parameters as well.

A) Subjective Parameters:


1. Background Check:

 

a. Promoters:


We should read profile of promoters, search about their credentials, any issues, penalties, regulatory actions etc. about them from public sources (e.g. Google). Many a times, a simple web search is enough to find out the misdeeds that promoters have done. Let’s take example for a similar case: Brooks Laboratories Ltd (BLL):

BLL has been showing good growth rate of its sales & profits in past few years and has been clearing my initial stock screening filters consistently. Its low debt levels prompted me to explore it further:

INR Cr.(10 million)
2007
2008
2009
2010
2011
2012
2013
2014
7 Yr. CAGR
Sales
23
28
45
45
53
56
80
85
20%
Net Profit
1
4
3
5
7
9
7
7
31%
Debt
8
12
16
12
9
0
1
0


We can see that BLL posted sales CAGR of 20% and profit CAGR of 31% over 2007-2014 and this growth led to reduction of debt to almost ‘0’ levels. On the face of it, these numbers present a very attractive investment opportunity. However a simple web search about the company would bring out the details of IPO fraud, the company and its promoters were involved in:


“...it is clear that through fictitious transactions of round tripping of funds, the said noticees ie Konark, Blue Print, Sunshine and Shardaraj along with the promoters of Brooks, had siphoned off the funds to the tune of Rs. 8 crores from the IPO proceeds,” SEBI said.
Moreover, SEBI noticed that one of the entity, Suryamukhi Projects, had received Rs. 15.30 crores in advance “without the infrastructure being developed at the project site, which ultimately is siphoning off the funds from Brooks”. Suryamukhi has been fined with Rs. 30.60 crore by the market regulator for such act.

Let us also see an example of a company, where promoters had taken steps to ensure the best interests of depositors & shareholders. Manappuram Finance Ltd (MFL) is one such company, which was stuck in a regulatory issue in February 2012 when Reserve Bank of India (RBI) asked it to stop using its branches to accept deposits from public in name of a promoter owned entity, Manappuram Agro Farms (MAGRO)


February 11, 2012: MFL clarifies that its board has asked MFL to dissociate itself from MAGRO & all other promoter owned entities. Promoter, V.P. Nandakumar, promises to undertake all steps to honour all his commitments. Below is a section of the stock exchange filing by MFL:



March 14, 2012: Mr. Nandakumar intimates MFL that he wishes to sell 4% out of his stake in MFL to honour his commitments. Below is a section of the stock exchange filing by MFL:



March 15, 2012: Mr. Nandakumar sells 4.75% in MFL to deposit money in an escrow account to cover all liabilities for MAGRO depositors. Below is a section of the stock exchange filing by MFL:



This reaction of Mr. Nandakumar is in stark contrast to many other promoters who fight tooth & nail to avoid paying lenders & depositors. Kingfisher Airlines is one such example.

Therefore, background check of any company & its promoters, which an investor is actively considering, is necessary. It would save her unnecessary troubles later and keep her hard-earned money safe.

b. Independent Directors:


We should do similar checks about independent directors as well. Many times we see that independent directors constitute ex-bureaucrats, industry professionals etc. We should form our opinion about whether the business requires ex-bureaucrats on the board. Though ex-bureaucrats bring a lot of administrative & management experience to the table, however, such positions might have been offered as a reward for favour done while on job or as a liaising officer for government approvals & contracts. Such arrangements can be indicative of crony capitalism. However, an investor needs to make her own call about such matters.

Once the investor is convinced that there is nothing to question the character & integrity of promoters & directors, she should move ahead with further analysis.

2. Management Succession Plans:


As an investor should stay invested in stocks of a company for decades, management succession plans become a vital factor. As in India, most businesses run in families, we should see whether the key promoter has introduced her next generation into business. We should read about the next generation. We should find out their education credentials and the amount of experience they have already had working under the guidance of their parents. 

Salary being paid to Potential Successors:



In most of the companies, children of promoters who are potential successors, join board positions as whole time directors, however, in reality they are simply getting the ‘on job training’. I believe that a good organization would pay them just as it would pay a trainee. Spending largesse on promoter’s children by way of high salaries, even when they are novices, is wastage of shareholder’s money. It can also provide a glimpse about the kind of values current promoter is instilling in her future generation.

I was amazed to find a company, which made about INR. 50 crore (0.50 billion) in profits but the promoter paid only INR 10,000/- per month to her daughter who had joined the board of directors. Today, I am heavily invested in the stocks of that company. For any clarity, we should always call the company secretary or investor’s relations officer of the company before we commit our hard-earned money to any stock.

B) Objective Parameters:


Many objective parameters can provide indications about investor friendliness of the promoters & management:

1) Salary of Promoters vs. Net Profits:


A comparative analysis of salary drawn by promoters and the profits of a company is a good parameter. The promoter should not have a history of seeking increase in remuneration when the profits of the company declined in past. 

Let us see example of a company where promoter has drawn consistent high remuneration despite decreasing profitability of the company. Ess Dee Aluminium Ltd is one such company.


INR Cr. (10 million)
2010
2011
2012
2013
2014
Sales
541
649
634
688
673
Net Profit
182
108
60
76
50
Remuneration of promoter: Sudip Dutta
3.04
3.11
3.36
9.45
5.77
 
We can see that promoter-Chairman of Ess Dee, Mr. Sudip Dutta, increased his remuneration despite falling profitability of the company during 2010-2013. He has kept his remuneration at consistent high levels despite profits of the company declining by about 73% during 2010-2014.

As an investor, I do not appreciate such behavior of promoters. I believe that in such instances, promoters do not take complete ownership of company’s performance. Promoters might believe that the credit of upside in business theirs and they seek higher remuneration, whereas they assign downside to external factors and expect shareholders to bear that cost. This is not a desirable trait of the person, whom I would want to run the company for shareholders. For an investor to show consistent faith in a company, its management should act as a stakeholder in both upside & downside and not enjoy the fruits of only upside.

2) Project Execution Skills:


Successful execution of increase in production capacity especially by green-field/brown-field plants is a good indicator of competent management. It is very good if the capacity addition has been done without facing any delays. 

We saw in Part 7, that Vinati Organics had consistently increased its production capacity to about 9 times during 2005-2014:


2005
2014
CAGR 2005-14
Production capacity (tonnes per annum)
7,000
63,500
28%
Quantity sold (tonnes) (A)
6,167
54,737
27%

Such project execution skills are a very good trait of competent management.

3) Consistent Increase in Dividend Payments:


A company that has consistently increased its dividends with increase in profits in past, usually has a good management. Let us see how dividends have increased in case of Vinati Organics over 2005-2014. 

INR Cr.
(10 million)
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
CAGR
Net Profit
3
2
4
15
25
40
52
55
69
86
44%
Dividend Paid
1
1
1
2
2
4
5
8
10
12
41%

We can see that Vinati net profits of Vinati increased at a growth rate of 44% during 2005-2014 and the company rewarded its shareholders by increasing its dividends at almost similar growth rate of 41%. This is the sign of a shareholders friendly management.

There can be many situations where a growing company might not declare dividends at increasing rate or it might not declare dividends at all. Requirement of funds to invest in expansion projects is the most common reason for nonpayment of dividends.

Therefore, nonpayment of dividends might not indicate a bad management. However, a company, which is increasing dividends along with increasing profits, definitely has a good management.

However, before making her final opinion about the management based on consitent record of dividend payments, the investor must ascertain whether the dividends are being paid out of the free cash flow generated by the company.

There have been instances where the companies do not make free cash flow and therefore, the managements have been paying out dividends by raising debt. An investor should not take any comfort from the history of dividend payments or the dividend yield in such cases. You may read the following articles for further details:

Read: Steps to Assess Management Quality before Buying Stocks (B) (See point no. 6: Dividends)

Read: Analysis: Indiabulls Ventures Limited (erstwhile Indiabulls Securities Limited)

4) Promoter Shareholding:


An investor should prefer companies, which have high promoter holding. This would ensure that interest of promoters and shareholders are aligned to each other.

In India, the regulator has put a cap of 75% on promoter’s shareholding in listed companies. In any case, the promoter’s shareholding should not be below 51%, which would ensure that promoters would have management control with themselves. An investor should be wary of investing in companies where promoter’s holding is less than 50%.

5) Promoter Buying the Shares:


Purchase of shares of a company by its promoters is the sign of a good promoter. It shows that promoters believe that shares of the company represent good investment opportunity at current prices. An investor would appreciate that, no one knows about a company better than its promoters do. Therefore, when promoters buy shares, you should buy too.

However, selling of shares by promoters is not necessarily a negative sign. Company’s shares are usually promoter’s biggest asset and they sell it whenever any cash requirement arises in personal life. As per Peter Lynch, in an average company, for every insider buyer there are about three insider sellers.

6) Foreign Institutional Investors (FII) Holding:


Popular belief is that higher FII holding is better as such companies are extensively tracked by market analysts. Information and opinions about such companies is easily available in public sources.

However, I prefer companies, which have very low/nil FII holding. There are many reasons for preferring companies with low FII stake:

There is no surety that FIIs are always right with their investment decisions. Decision makers at FII investment committee are also human being and they too make mistakes and lose money in markets. I prefer to do my own research about companies and not get swayed by existing investment by any FII. FII investment is not a great comfort. There are many reasons for FIIs to buy a stock. Not all these reasons are related to quality of the company. Sometimes FIIs are sold monkeys by target driven investment bankers/merchant bankers. An investor may also fall in the same trap if she gets influenced by FII holdings.

The investment value of companies with high FII stake has already been recognized by the market & investors. Stocks of such companies already trade at high valuations (P/E multiple). Therefore, the returns from expansion of P/E multiple is excluded for an investor in such companies.

Finding good companies is like a treasure hunt and I like to find companies before other market participants recognize the value of a good company. I usually search for investment opportunities in small market capitalization companies and try to invest in good companies in this space before they grow further, become big and get noticed by other large investors like FIIs.

CONCLUSION


In the current article, we learnt about management analysis of a company before investing in its stock. We learned that management analysis is the most important parameter and an investor should stay away from the company where she gets the slightest hint of lack of integrity.

We learned various parameter, using which an investor can distinguish a good management from an avoidable management. These contain subjective as well as objective parameters.

Here is a summary of these parameters, which every investor should test the management of companies shortlisted for investment:

Subjective Parameters:
  1. Background check of promoters & directors: There is no alternative of a web search about promoters and directors. This would provide very vital information about the company. 
  2. Management succession plans: A good workable succession plan is necessary for keeping the company alive for decades to come. Salary being paid to potential successors would provide indications of the values being instilled by current promoters in the next generation.
Objective Parameters:
  1. Salary of promoters vs net profits: The promoter should not have a history of seeking increase in remuneration when the profits of the company declined in past
  2. Project execution skills: company should have shown good project execution skills with cost and time overruns.
  3. Consistent increase in dividend payments: Dividends should be increasing with increase in profits of the company.
  4. Promoter shareholding: higher the better. Should be at least 51%
  5. Promoter buying the shares: if promoter of a company buys its shares, investors should buy too.
  6. FII shareholding: the lower the better.

This concludes the major part of this series “Top Stocks to Buy”. In this series, we have learned about various aspects of stocks selections ranging from characteristics of an investor and the in depth tools of analysis of a company. In the next article, I would conclude the series by providing a summary of the steps required to be followed by an investor while taking final decision about investing in the stocks of any company.

I would like to have your feedback on this series of articles. It would be very helpful if you can tell the readers about your experiences and the parameters you use for analysis of companies & their stocks.

P.S. I have used the financial data various stocks provided by www.screener.in, yahoo.com, bseindia.com and annual reports of various companies for this post.