May 29, 2016

Steps to Assess Management Quality before Buying Stocks (B) (Moneylife Session Part-3)

On April 16, 2016, I got the opportunity to address a group of investors in an event “Investor Club” organized by MoneyLife Smart Savers, courtesy Mrs. Sucheta Dalal, Managing Editor of Moneylife and Mr. Debashis Basu, Editor of Moneylife. The session focused on the assessment of management quality while buying stocks.


I was touched by faith reposed by the audience in me, who had come to Mumbai to attend the session from the locations like Vishakhapatnam, Trivandrum, Kochi, Surat, Pune etc. The feedback of the session from the audience was very good and it was felt that the content was useful to investors while making investment decisions.

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited

The current article is the third part of a series of articles that I plan to write to cover the learnings shared in this session with the audience. However, it is not a transcript of the session. For the original video links of the session, you may contact Moneylife: support@moneylife.in

You may read other parts of this article series here:

The second part discussed some of the key tools that an investor has at her disposal to assess the management quality of companies. You may read the second part of this series of articles here:


In the second part we discussed the following tools for management assessment:
  1. Promoters’ background check
  2. Promoters’ salary
  3. Related party transaction

The current article, which is the third part of this series, is a continuation of the discussion of the key steps/tools that investors should use to find out a good management and avoid bad management. An investor should read these carefully and use them in her stock analysis process so that she may avoid falling into the trap of unscrupulous managements that try to benefit at the cost of minority shareholders:

4. Warrants:


Warrants are like options which are issued to select shareholders by the company that gives these shareholders a right to convert these warrants in to shares of the company at a predetermined price. Like options, warrants come with an expiry date i.e. the period in which the warrants can be converted.

Over the years, promoters/majority shareholder have been treating warrants as a means to give special treatment to themselves. The special treatment might be related to pocketing risk free gains and to gain/increase stake through backdoor channels.


i) Risk Free Gains: Converting a situation of potential increase in costs to potential gains


This usually happens in cases where the warrants are issued and become convertible right from the date of issuance. In cases where such immediately convertible warrants are issued at a discount to the market price of the stocks of the company, then it amount to handing over free money to promoters/majority shareholders as promoters do not need to anything else other than convert the warrants into shares the same day and sell these shares into the market to pocket the amount of discount as a risk free gain.

Even though the allotment price of warrants is guided by statutory regulations by SEBI and the price of allotment would be in compliance with the regulations, however, the point to note here is that if the promoters would have tried to buy shares from the market, then they would not have got it at the prevailing price. Instead, the news of an attempt by promoters to buy shares from the market would have led to significant increase in share price and in turn leading to an increase in the cost of acquisition of shares to the promoter.

However, by way of warrants, this effect of an increase in share price of the company is reversed. The increase in share price which would ideally lead to a higher cost of acquisition of shares (if promoters would have bought shares from the market). However, through warrants, by freezing the cost price of shares at a pre-determined price, the promoters convert the impact of the increase in share price to their advantage by getting a call option payoff. 

Many companies have resorted to such issuance of warrants. Let’s see the example of one such company:

Rexnord Electronics & Controls Limited

Rexnord Electronics & Controls Limited made the following disclosure in its annual report for FY2015:

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited



As per the disclosure, at September 23, 2014, Rexnord Electronics & Controls Limited had allotted 3,478,800 warrants to its promoters at a price of ₹13.40. Each of these warrants was convertible into one equity share of the company. The promoters could convert these warrants into equity shares at any time within 18 months from the date of allotment (September 23, 2014).

The eligibility to immediately convert the warrants is the key here because the closing market price of shares of Rexnord Electronics & Controls Limited at September 23, 2014, is ₹23.34. This effectively means that the promoters can convert the warrants allotted to them on September 23, 2014, the very same day at ₹13.40 and sell the resultant equity shares received into the market at ₹23.34 and pocket the difference of ₹9.94 per share as a risk-free gain, which ideally would have been their cost of acquisition of shares, if they would have tried to buy shares from secondary market as the market would have immediately increased the share price. (Promoters got rights to 3,478,800 shares through warrants, whereas the average daily trading volume for Rexnord on the stock exchange is only a few thousand shares).

The total risk free gain pertaining to the issued 3,478,800 warrants amount to ₹3.36 cr., which is the free money handed over to the promoters by the company.

This amounts to a loss of minority shareholders as the company has sold its ₹23.34 worth of asset at a price of ₹13.40. Therefore, investors should always compare the allotment price of warrants with the market price of the shares of the company.

An investor may read a live example of another promoter-management of a company using warrants for personal benefit in the following article:

Read: Analysis: Indo Count Industries Limited


ii) Gaining/increasing stake through backdoor channels:


Let’s see what further benefit the warrants bestow upon the promoters/majority shareholders.

In FY2015, the promoters of Rexnord Electronics & Controls Limited increased their shareholding from 46.47% at March 31, 2014, to 51.46% at March 31, 2015, by increasing their shareholding by 888,300 shares. This move is very significant from the perspective of promoters as it gives them a majority in the shareholding of the company.

However, when an investor analyses deeper, then she comes to know that the entire increase of 888,300 shares in the holding of promoters had happened by way of conversion of warrants at December 13, 2014, when the promoters had converted 1,098,300 warrants into equity shares of Rexnord Electronics & Controls Limited.


The issue to be focused here is that promoters have acquired these additional shares on December 13, 2014, at the warrant conversion price of ₹13.40 instead of the market price of ₹22.85 for the shares of Rexnord Electronics & Controls Limited on that day.

Investors who have spent some time in equity markets would realize that when the promoters start to buy shares in their company, the market sees it as a very positive sign and it increases the market price immediately. However, in the case of Rexnord Electronics & Controls Limited, the promoters instead of paying a premium to market price to increase their stake in the company, got these shares at a deep discount to the market price.

Therefore, effectively the non-promoter shareholders, including retail shareholders, of Rexnord Electronics & Controls Limited had subsidized the purchase of shares by the promoters. And this was made possible by an ingenious instrument: Warrants!

Therefore, whenever an investor is analysing a company and she comes across issuance of warrants to promoters/majority shareholders, then she should analyse the issuance and exercise of these warrants to assess whether the management/promoter/majority shareholders is benefitting at the cost of minority/retail shareholders.

5. Management Focused on Share Price:


Running a business as well as investment in equities demands long term vision. A promoter/manager is expected to create wealth for the shareholders and take decisions that are beneficial for the business over the long term and not be primarily concerned about short term implications. Similarly, a long term value investor should consider holding her investments over many years and not get worried about periods of share price declines in the interim period.

However, many times we see that the promoters/managers are constantly worried about the share price of the company, which is heavily influenced by daily level changes in the operating environment. Such kind of management is hardly willing to take the strong decisions that might be needed for long term benefit of the business and in turn for shareholders.

Therefore, an investor should always analyse past decisions of the promoters/managers to assess whether their decisions have been motivated by long term vision or the short term share price fluctuations.

Let’s see a recent incident, which presented a pertinent example to this issue.

DCB Bank

DCB Bank has its origins in the merger of many co-operative banks in the 1930s. It was granted the scheduled bank license by the Reserve Bank of India in 1995. Renowned Tata group bought 4.6% in DCB Bank in 2007.


Potential 100bagger:


DCB Bank is covered by many big brokerages and has been a favourite among many of them to the extent that Motilal Oswal Securities in its 19th Annual Wealth Creation Study (2009-14), released in December 2014, selected DCB Bank as a stock with a potential of giving 100 times return to the shareholder on their investment.

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited

DCB Bank had a market cap of ₹2,900 cr. then and effectively the analyst at Motilal Oswal assessed that the Bank has the potential of becoming a ₹290,000 cr. market cap company (A few of the comparative companies to this market cap today, May 28, 2016, are: HDFC Bank ₹300,000 cr., ITC ₹290,000 cr. and Infosys ₹286,000 cr.)

The analyst pointed out that in the evaluation of a common stock, the management is 90%, industry is 9% and other factors are 1%. I completely agree with this belief and therefore assume that the analyst which assessed DCB Bank for the report, would have dedicated at least 90% of the research time in assessing the management of DCB Bank.

On October 13, 2015, DCB Bank came up with its future business strategy and informed the public through stock exchange filings:


DCB Bank stated that:
  • it plans to increase the branch expansion speed from earlier 25-30 branches per year to about 150 branches within next one year along with various other technology initiatives
  • It had done detailed planning for this business strategy and expects that the cost ratios and in turn profits would be negatively impacted in the short term horizon of about 2-3 years but these decisions would create long term wealth for the shareholders from FY2019 onwards.

The Bank has done in depth planning by assessing various parameters like probable break even, payback, return on equity, return on assets etc. and the management seemed to be in the know of the steps that they are taking. The management seemed an ideal one, which prioritizes long term interests of the business over the short term incentives. I find that such bold managements are in rarity now a days and appreciate such managements.

However, the markets were spooked by this announcement. The share price of DCB Bank tumbled 30% in a span of two days from ₹133.45 at October 13, 2015, to ₹92.35 at October 15, 2015.

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


Reaction of stock market started with the report of Kotak Securities, which downgraded DCB Bank to “Sell”:

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


Kotak labelled the management strategy as “very dangerous…..disappointing shift in their strategy”

In quick succession, Edelweiss downgraded DCB Bank to sell.

However, the real shocker was next to come when Motilal Oswal Securities, which has cherished DCB Bank as a potential 100bagger, downgraded it to a “Sell”.

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


Any long term investor would be surprised to read the opinion of Motilal Oswal Securities in its “Sell” recommendation. It stated that despite acknowledging that the business strategy of DCB Bank is beneficial to business in the long term, we are recommending a “Sell”.

So much for the long term vision of the market analysts!

It takes 20.5 years for an investment to grow to 100 bagger if the share price grows at 25% each year.  20.5 years is a very long period, which is sufficient enough for every bit of external and internal environment of any company to undergo a change. The changed business strategy of DCB Bank within one year of the study led the stock analysts to downgrade a potential 100bagger to “Sell”. I fail to understand whether the stock analysts expected the management and business environment to remain unchanged for 20.5 years

DCB Bank responds:


The story is not yet over.

Soon thereafter, DCB Bank filed another announcement to stock exchanges on October 15, 2015:


This announcement meant that the business plan, which seemed to have been devised well after a detailed background work, proper research with possible challenges in execution and their responses in place, was changed based on feedback from analysts. To stress, this was the feedback from investors and analysts who might not have worked in a bank branch and would have hardly done the research and hard work that DCB Bank staff might have done to devise the business strategy.

This was a complete “U” turn from the earlier strength and boldness expressed by the management. This demanded a deeper assessment.

One possible answer seemed to lie in the annual report for FY2015 on the page detailing the employee stock options outstanding for the Bank.

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


It showed that at the end of FY2015, DCB Bank employees had about 1.1 cr. (11 million) options outstanding, which were exercisable at a weighted price of ₹47.29.

On October 13, 2015, when DCB Bank’s share price was ₹133, these options (ESOPs) had a value of about ₹95 cr. to their holders. And as per the prevalent corporate culture, a huge majority of these ESOPs are expected to be in the hand of top very few senior management employees.

On October 15, 2015, when the DCB Bank’s share price fell to ₹92, the value of these 1.1 cr. options had declined to ₹50 cr. That is a decline in value of a whopping ₹45 cr. and that too primarily from the hands of top very few senior management employees.

A decline of ₹45 cr. in wealth (whether real or notional) is very significant for any salaried employee. This significant decline in value of ESOPs presents one probable explanation to the almost U-turn that the DCB Bank management did on its business strategy based on apparent “Analyst” feedback.

So much for the long term vision of the management! Neither the analysts nor the management is willing to bear the short term pain for long term gains.

Let’s see how the market responded to the volte face done by DCB Bank management:

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


(*the stock price chart represents the data until March 31, 2016, prepared for the presentation at Moneylife. At May 28, 2016, the stock price of DCB Bank at BSE is ₹93.60)

The stock price, which is continuously hovering around ₹70-80 potentially reflects the shaken faith of the markets in the management of DCB Bank.

Therefore, it is always advised that whenever any investor analyses any company, then it becomes imperative for her to assess whether the past decisions of the promoters/managers have been motivated by long term business vision or short term share price fluctuations. Reading annual reports, the presence of significant amount of ESOPs and going through stock exchange filings can help her reach a decision about such behavior of promoters/managers.

6. Dividends:


One of the key features of stock investment that attract investors is the dividend payment by companies. Stock investors hold regularly dividend paying companies in high regards and believe that the managements that consistently pay dividends are shareholder friendly.

However, before an investor firms up such a belief about any management, it is crucial to assess that the company is paying these dividends out of the free cash available.

Free cash flow (FCF) can be calculated by deducting capital expenditure (Capex) done by the company from its cash flow from operations (CFO):

FCF = CFO - Capex

Read more about free cash flow analysis in the article: 3 Simple Ways of Assessing "Margin of Safety" of a Stock

It is highly likely that if a company does not have free cash flow available after meeting capex requirements from its operating cash flows, then it is meeting the requirements of funds to pay dividends to shareholders by raising debt from lenders.

And investors would agree that if a company keeps on paying dividend consistently by raising debt, then sooner or later the debt will reach such levels that lenders would find it difficult to keep giving loans to it and the dividend payments would not remain sustainable.

Similarly, if the company does not have positive free cash flow and uses debt to pay dividends, then hypothetically there is no limit on the amount of dividend it can pay to shareholders. The dividend amount is only limited by the debt that the company can raise, be it a dividend of ₹1 per share or ₹100 per share the only thing that the management needs to do it to find a lender who can give it a loan and it would give the money to shareholders. The operating efficiency of the company does not remain the key parameter for such managements to pay dividends to shareholders.

Therefore, it is advised that investors should not take any comfort from the amount or consistency of dividend payments by a company that uses debt to pay dividends. Moreover, many times such debt funded dividend payments are to benefit the promoter/majority shareholder at the cost of the company and in turn at the cost of minority shareholders.

Let us see an example of a company, which is paying dividends out of debt proceeds:

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited

The cash flow from operations (CFO) of Tata Steel for 10 years (FY2006-15) stood at ₹105,565 cr. whereas it did capital expenditure (Capex) of about ₹126,073 cr. over the same period, which included massive ₹49,713 cr. in FY2008 primarily to acquire the European steel giant “Corus”.

The net result was that over the 10 years (FY2006-15), Tata Steel had a negative free cash flow (FCF) of ₹20,508 cr. (FCF = CFO – Capex), whereas it kept on paying dividends consistently every year and paid out about ₹9,547 cr. of dividends in 10 years (FY2006-15).

As the company did not have free cash flow to pay dividends to its shareholders, it was not surprising that the dividend payments primarily came from debt, which increased from ₹3,377 cr. in FY2006 to whopping ₹80,701 cr. in FY2015.


There is always a limit to which a company can take debt as with increasing debt levels, the lenders would become increasingly worried about the health of the company and in turn, would stop giving further debt to the company. Therefore, such debt funded dividends are not sustainable in the long term and investors should not derive any comfort from them.

With this, we have come to end of the third part of this series of articles, where I stress the importance and steps of management assessment while making stock investments. Until now in this series, we have covered some of the important tools for assessment of management quality:
  1. Promoters’ background check
  2. Promoters’ salary
  3. Related party transaction
  4. Warrants
  5. Management focused on share price
  6. Dividend payments
Read previous articles in this series:



In future articles, I would discuss the remaining critical tools which an investor should use to differentiate a good management from a bad management. Therefore, stay tuned…

An example how drvijaymalik.com is helping investors:

Steps tools of management assessment analysis in stock analysis and equity investments value investing india warrants, Rexnord Electronics & Controls Limited, DCB Bank, Motilal Oswal Wealth Creation Study, Tata Steel, Kotak Securities Limited


It feels fulfilling to notice that drvijaymalik.com is able to help investors to make opinions and in turn take investment decisions that are good for the long term.

Please share whether you consider management analysis as a relevant parameter in stock analysis and your experience of management decision in the investment experience until date. You may share your inputs in the comments section below.

DISCLAIMER


The views and opinions expressed or implied herein are my own and do not reflect those of my employer, who shall not be liable for any action that may result as a consequence of my views and opinions.

Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.

Details of Financial Interest in the Subject Companies:



Out of the companies discussed in the above article, I do not own shares of any of the companies in my portfolio. I have disclosed stocks in my portfolio on a dedicated page (My Portfolio). I request you to see the list of stocks I own because it is assumed that my views can be biased when I opine about any stock which I own and therefore, have a financial interest.