May 29, 2016

Steps to Assess Management Quality before Buying Stocks (C) (Moneylife Session Part-4 Final)

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, and 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, Satyam Computer & Services Limited, Golden Peacock Awards, Corporate Governance, Accounting Juggleries

The current article is the fourth and the final 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 the other parts of this article series here:

The second and the third parts 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


You may read the third part of this series of articles here:


In the third part we discussed the following tools for management assessment:

4) Warrants and their misuses
5) Management focused on the share price
6) Dividends funded by debt


The current article, which is the fourth and the final 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:

7. Accounting Juggleries:


Many times, instead of working hard to grow the business managements resort to the shortcuts and manipulate the publically reported financial results to create a false image that the company has been doing very well. However, sooner than later, invariably such accounting manipulations are caught and the market heavily punishes the stocks of such companies.

In such cases, it is the minority shareholder who loses her entire investment in the company without any of her faults. Therefore, identifying accounting juggleries/shenanigans becomes a very important aspect of stock analysis.

I have written a separate article highlighting key tools available to investors for identifying key features of the financials, which have a high probability of containing manipulations. You may read this article here: 7 Signs to tell whether a Company is cooking its Books

These key tools are:
  1. Cumulative Cash From Operations (cCFO) falling short of cumulative Profit After Tax (cPAT) in the past
  2. Increasing Receivables Days/Days of sales outstanding (DSO)
  3. Fast buildup of inventory/decreasing inventory turnover
  4. Free Cash Flow
  5. Frequent Acquisitions
  6. Abnormal/supernormal performance
  7. Frequent changes in accounting policies/disclosures

After going through the above-mentioned article and reading the book mentioned therein “Financial Shenanigans: How to Detect Accounting Gimmicks & Frauds in Financial Reports”, an investor would realize that there are certainly red flags, which most of the manufactured balance sheets contain. If an investor is able to detect these red flags and avoids investing in such companies, then she would be able to steer clear of most of the accounting frauds. 

These red flags are:

i) Rising Sales, Rising Receivables, and Rising Debt:


This situation primarily appears in companies, which book sales aggressively, sometimes even fictitiously. Such sales do not result in receipt of cash and therefore, lead to increasing account receivables/debtors/trade receivables. However, as the company has to incur operational costs like employee costs, utility costs etc., it typically relies on debt to meet its expenses.
Therefore, unless an investor personally knows that the promoters/majority shareholder in such companies is a person with integrity and that the buyers are facing a genuine financial crunch, which is leading to delayed payments, she should be better off avoiding such companies.

ii) High cash with high debt:


Such a situation is usually avoided by companies as raising funds by debt and keep them as cash without deployment is a losing scenario as it has a financial cost attached to it. Debt invariably has a higher cost than the bank FDs or liquid investments in which cash is usually held by the companies. Therefore, an investor should do extra due diligence whenever she is faced with such a situation in her target company.


The company might have many explanations to keep high cash alongside high debt on its books. Most common answer is that the company is looking for a strategic acquisition and therefore keeping the cash chest ready in case any opportunity arises. However, most of the times companies do not find good acquisition targets soon and therefore the continued presence of high cash with high debt raises concerns for shareholders.

In cases of accounting frauds, it has been seen that the debt shown is a true figure whereas the cash shown in the balance sheet turns out to be fictitious. Most of the times such cash has already been siphoned off from the company by the promoters/majority shareholders/management.

Therefore, it companies with high cash balances along with high debt should always be subjected to deeper scrutiny by the investors.

iii) Serial Acquisitions:


Acquisitions are usually done by companies to get bargain deals in times of stress in the industry. Acquisitions are done by overseas companies in new markets/geographies to get access to the approvals, patents that the target company would have in order to shorten the time to enter a new market. However, acquisitions always pose a challenge to investors as the merging of accounts of two companies using multiple assumptions, mark to markets, revaluation of assets etc. completely mixes up the accounts.

Therefore, it becomes utmost difficult to assess the real financial position by analysing the accounts of the merged entity. No wonder, many accounting frauds remain hidden in the books of serial acquirers and companies find acquisitions as the most convenient method of fooling the analyst community about their real financial position.

Still it’s ok if a company acquires a target company once in a while for business reasons and assimilates & nurtures the target company as a part of its own entity. However, things start to become suspicious if the acquirer acts like a hedge fund and frequently buys & disposes of companies.

Ideally, an investor should avoid companies that are in a habit of growing only through acquisitions. She would do great good to her hard earned money as invariably serial acquirers are known to give negative surprises to shareholders.

8. Competence:


Assessing the competence of promoters/management is a key aspect of stock analysis. However, the competence must not be confused with the educational qualifications of the promoter/management. Time and again evidence have proved that educational qualifications tell little about managerial competence and integrity with which a person would treat its business & shareholders.

Instead, an investor should focus on assessing the project execution skills of the promoter/management. She should analyse the business expansion done by organic growth and ignore the capacity additions through acquisitions while she assesses the competence of the management.

The investor can take help of multiple public sources of information to assess the project execution skills of promoters like annual reports, credit rating reports, milestones on the company website etc. She should focus on organic additions to business capacities and take note of the various warning signs.



Warning signs in promoter/management competence would present in the form of:
  • Company abandoned or cancelled its projects in the past
  • Company was expelled from projects
  • Frequent project execution delays and cost overruns

The investor should prefer buying shares of companies that are run by managements, which have displayed timely completion of the projects within promised timelines.

9. Promoters’ Faith in the Business:


Promoters’/majority shareholders’ faith in the business gets reflected by two parameters:

i) Shareholding level and the trend of its change:


Ideally, the promoters should have a majority shareholding in the company i.e. more than 50%. However, more than the absolute level of shareholding I believe that the trend of change in promoters’ shareholding carries more significance.

A trend of increasing shareholding by promoters/majority shareholders over recent quarters/years should be seen as positive and vice versa.

Many times, it is noticed that promoters dilute their stake a lot in initial years to fund the business expansion of the company. Promoters then try to make up for the lost stake earlier by buying shares from the dividends, which they get once the company starts generating cash flow for its shareholders.

Therefore, unless the promoters’ stake is very low i.e. less than 25%, an increasing trend of shareholding over the years shows promoters’ faith in the business. On the contrary, the companies where promoters have been reducing their stake should be subject to deeper analysis despite such promoters holding more than 50% stake in the company.

ii) Management Succession Plans:


Equity investing is a long-term concept where an investor is expected to hold on to the good companies for years, sometimes even for decades. In such a long-term association with the company, the assessment of management succession becomes paramount. Therefore, an investor should always study the succession plans in depth before investing her hard earned money in stocks of any company.

Companies usually follow either/mix of two approaches for management succession: bringing in promoters’ children/young family members or professionals in the company.

There is no ideal succession plan as both have their pros and cons.

Companies with lot of family members in the senior management run the risk of related party transactions at the cost of interests of minority shareholders as discussed in the second article in this series:


Whereas the companies with all the professionals at senior management positions run the risk of business decisions with short-term focus on share price as mentioned in the third article of the series:


Companies with predominantly professionals’ presence suffer from lack of loyalty as professionals keep on shifting their loyalties by handing over notice periods of 90 days (i.e. resignations and job changes).

Therefore, I prefer companies, which have a promoter in charge of the company and who has delegated day to day functioning of the company to professionals hired from the market who bring in fresh perspectives, market intelligence and competitors’ knowledgebase to the company.

With this, we have come to the end of this series of articles, where I stressed the importance and steps of management assessment while making stock investments. 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
  7. Accounting juggleries
  8. Competence
  9. Promoters’ faith in the business

These are the critical tools which an investor should use to differentiate a good management from a bad management. I believe that if an investor assesses the management of her target company on these parameters and finds that the promoter/management is scoring well on all these parameters, then she has found a company which is being run by a competent and shareholder friendly management.

In such a case, if the company meets all the other parameters like financial, business, valuation and operating performance/efficiency parameters, then she should buy shares of the company and look forward to a long association with the promoters.





An investor should always keep in mind that:


Investment in a great business might be futile if its management is not shareholder friendly

At the end of this series of articles focusing on assessment of management quality of companies, I would like to give one last advice to investors:

“Never Rely on the Awards”

Steps tools of management assessment analysis in stock analysis and equity investments value investing India, Satyam Computer & Services Limited, Golden Peacock Awards, Corporate Governance, Accounting Juggleries


The Golden Peacock Award for corporate governance in 2002 was won by Satyam Computer Services Limited, which later on turned out to be the biggest corporate frauds in India.

Therefore, invariably, an investor should do her own research while investing her hard earned money.

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.