On April 16, 2016, I got the opportunity to address a group of investors in an event “Investor Club” organised 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.
The current article is the second 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: firstname.lastname@example.org
You may read the other parts of this series here:
The current article, which is the second part of this series, would highlight some 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 inculcate 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.
Let’s study the tools available to common shareholders by which she can decide about the management quality of a company by using the information available in the public domain:
A) Check Promoters’ Background:
Checking the background of the promoters’ is the first step in the assessment of the management of any company. A background check might mean different things for different investors. Some may stress on educational qualifications while others may focus on the family background, however, I advise investors to focus on the past management decisions of the promoters.
Educational qualifications do not give the investor any idea about the shareholder friendliness of the promoters. Shareholder friendliness is reflected in the character and integrity of the promoters/management. Therefore, the investor should focus on promoters’ past decisions and try to assess whether those decisions were taken while keeping the interest of minority shareholders’ in mind.
Let’s see an example of a good business and try to assess its promoter’s background and find out whether the background check helps the investor in decision making:
Brooks Laboratories Limited
Brooks Laboratories Limited, established in 2002, is a small cap company with market cap of about ₹110 cr. It is active in contract manufacturing space and boasted of big names like Zydus Cadilla, Alembic, Wockhardt, FDC, Alkem etc. in its clientele.
Brooks Laboratories Limited came into my investment radar in 2013 due to its very good financial position:
Brooks Laboratories Limited’s financials presented a picture perfect scenario of any good business:
- Sales were growing at 23%
- Profits were growing at an even higher rate of 36%
- Brooks Laboratories Limited was using its profits to repay debt and was essentially debt free at the end of FY2013 and
- As the company was acting like a cash machine, it was able to generate surplus cash after meeting debt repayments and was accumulating cash reserves year on year.
Finding a company with such performance is a dream for any investor and I was very happy to have chanced upon Brooks Laboratories Limited.
However, as mentioned above, I suggest that every investor should do the background check of promoters’ before making an investment decision. The steps to do background check is very simple:
“Just Google It”
It is essential to search for the name of the company with certain keywords like “Fraud, Issues, SEBI, Dispute, Court etc.” One such search attempt should give an investor about any critical information that might be present in the public domain.
Readers would notice that one of the results about Brooks Laboratories Limited is from Moneylife. In current times, Moneylife is very active in writing about corporate frauds and it is highly likely that if any listed company has been involved in any issue, then Moneylife would have covered it on its website. Therefore, investors may use the keyword “Moneylife” as well to search for the issues related to any company.
The check of promoters’ background for Brooks Laboratories Limited reflected that they were involved in defrauding public investor in their IPO and have siphoned off the investor’s money from the company. As per the below article in Businessline, SEBI found them guilty and imposed penalties on them.
After learning about the frauds conducted by the promoters, I decided against invested in Brooks Laboratories Limited.
Thus, investors would notice that a simple Google search could be very useful tool in assessing management quality of any company. Therefore, one of the essential tools for any investor is to do a background check of company’s promoters at Google, to assess whether they are shareholder friendly.
Over time, investors would notice that such background search results bring out key information about promoters. Let’s see an example where the results point out to positive things about the promoter:
Manappuram Finance Limited
(Disclosure: I am invested in Manappuram Finance Limited)
Manappuram Finance Limited faced heat from the regulator Reserve Bank of India (RBI) in 2012 when RBI asked it to stop using its branches to collect deposits from public on behalf of Manappuram Agro Farms Limited (MAGRO). MAGRO is an entity owned by the promoter of Manappuram Finance Limited, Mr V.P. Nandakumar. Let’s see the way event unfolded over the next few days:
- February 7, 2012: RBI bans MFL and MAGRO from accepting deposits
- February 10, 2012: Manappuram replies after the board meeting
The investor would notice that the company took the notice from RBI seriously and within a few days clarified its stance about RBI’s instructions.
- It clarified its intention of fully complying with the regulator’s instructions by dissociating itself from MAGRO
- Mr Nandakumar assured that he would honour all the liabilities towards the depositors of MAGRO
- And most importantly, Manappuram Finance Limited established a committee under the chairmanship of Mr Jagdish Kapoor, former deputy governor fo RBI and chairman of HDFC Bank to improve the governance standards of the company. Moreover, reputed companies like Amarchand Mangaldas and KPMG were appointed to help this committee.
These actions reflected the intention of the company to comply with the regulator’s intentions in letter and spirit in sharp contrast to some other corporates who try all the options under the sun to fight regulators be it in courts or media.
- March 14, 2012: Mr Nandakumar writes to the board of Manappuram Finance Limited about his plan to sell stake in the company to pay outstanding depositors of MAGRO:
- March 15, 2012, Press Release: Marquee PE investors led by Baring India, Sequoia Capital, and Siguler Guff buy 4.75% of Manappuram Finance Limited from Promoter on the stock exchange.
Thus we see that the promoters of Manappuram Finance Limited accepted the directions of RBI, stopped collecting the deposits, took steps to enhance the corporate governance, raised funds by selling personal stake in the company and then deposited the money in an escrow account with a public sector bank as the source from which outstanding deposits would be paid on maturity.
These steps took care of interests of every stakeholder: MAGRO depositors and Manappuram Finance Limited & its shareholders. And all these events happened within a short period of about one month.
Such events establish that the promoter kept in mind the interest of outside stakeholders while taking his decisions, which is one of the essential qualities to look for while investing in any company.
As we notice that bad habits persist in people similarly, we notice that good habits also persist. We would notice that it was not the first time when Mr Nandakumar had kept the interest of public shareholders above his own:
In this interview published on Rediff in November 2011, Mr Nandakumar talks about the event post the IPO of Manappuram Finance Limited in 1995:
Mr Nandakumar had started Manappuram Finance Limited in 1992 with a capital of ₹10 lakh. He used to add his money to the capital every year so that the capital grew. Then NBFCs required a minimum of ₹3 crore paid-up capital to list at the BSE.
In 1995, Manappuram Finance Limited achieve a capital of about ₹1.25 crore. Mr Nandakumar asked for small investments from his family members and friends and could raise another ₹1.75 Cr. to meet the regulatory requirement for the IPO.
However, as mentioned in the interview, soon after the IPO, the share price reduced from ₹10 to ₹8 per share and the investors started asking him to compensate for the losses. Mr Nandakumar bought back the shares that traded in the market for ₹8, at ₹10 from these investors to keep his word.
This is in stark contrast to the case of Brooks Laboratories Limited, which defrauded investors and siphoned off the money from public investors.
Therefore, looking at the contrasting cases of Brooks Laboratories Limited and Manappuram Finance Limited, an investor would appreciate the different kinds of managements that are present in the listed companies’ marketplace. The investor would also appreciate the need for differentiating between these managements and the key role that a background check can play in avoiding bad managements and find out good managements.
Therefore, a background check by way of Google search is the first step for assessing the management of any company, which every investor should mandatorily do.
B) Promoter’s Salary:
The salary taken by the promoter/management of the company is one of the key parameters that can give critical insights into the management intentions.
Salary/remuneration data of promoter/management/directors is provided by the company in annual Report. This data is not available in the public financial sources like screener/moneycontrol etc. Therefore, it is essential for investors to read the annual reports to assess the management on this parameter.
After analysing many companies as part of my stock selection process and for answering queries of readers, I notice that the usual salary range for promoter directors/management is about 2-4% of net profit after tax (PAT). The salary generally contains 2% commission on PAT and a fixed monthly component along with other perquisites.
Let us see the examples of performance of two companies and the salaries being taken by their promoters:
An investor can see the sharp contrast between the salaries being taken by promoters of ESS DEE Aluminium Limited and Ambika Cotton Mills Limited.
Remuneration of Mr Sudip Dutta, the promoter of ESS DEE Aluminium Limited has increased from ₹3 Cr. in FY2010 to ₹9.5 Cr. in FY2014 whereas the net profit of the company has decreased from ₹182 cr. to ₹76 cr. over the same period. The salary as a percentage of net profits has increased from 2% in FY2010 to 12% in FY2014.
An investor might question the basis of the increase in remuneration of the promoter even in the scenario of declining profits. Such kind of remuneration practices that are not linked to the performance of the company effectively serve as a means for the promoters to benefit at the cost of company shareholders.
On the contrary, if an investor analyses the remuneration pattern of Mr P. V. Chandran, the promoter of Ambika Cotton Mills Limited, then she notices that the salary of Mr Chandran:
- is in the range of 2%-4% of net profits, which is the average range for most of the listed entities,
- has increased only in the years when the profits have witnessed an increase. In the years, when the profits did not increase, the salary remained constant.
- the salary increased beyond ₹0.8 cr. in FY2014 when the profits of the company increased to ₹48 cr. which was more than the previous high watermark of ₹41 cr. achieved in FY2011.
ESS DEE Aluminium Limited came into my investment radar in 2013, however, after analysing it I decided against investing in its shares. The high salary of the promoter which was continuously increasing without a proportionate increase in company’s performance was one of the primary reasons for avoiding investment in ESS DEE Aluminium Limited.
Recently, when I revisited the company, then I noticed that the company is reeling under debt of about ₹500 cr. and has been making losses since last 2 quarters (September and December 2015) and its share price has declined from about ₹750 in February 2014 to about ₹90 in May 2016.
Ambika Cotton Mills Limited came into my investment horizon in September 2014. I liked many aspects of the company. You may read my analysis of Ambika Cotton Mills Limited in the following article:
Out of multiple factors that I liked about Ambika Cotton Mills Limited, the reasonable salary being drawn by Mr Chandra along with the moderate level of salaries being paid by the company to potential successors (daughters of Mr Chandran), was an important parameter that helped me take the final investment decision about the company.
(Disclosure: I am still invested in shares of Ambika Cotton Mills Limited)
As I have mentioned in the article above that bad habits persist, similarly, good habits also persist in people.
We saw another example of this in December 2015 when Ambika Cotton Mills Limited filed the following notification in stock exchanges:
The notification mentioned that Mr P. V. Chandran has decided against accepting the commission part of his remuneration, which was calculated at 2% of the net profits of Ambika Cotton Mills Limited. This notice meant that Mr Chandran would be taking only the fixed component of his salary, which is about ₹2 lac per month.
On seeing this notice, one of the celebrated investors in Ambika Cotton Mills Limited, Prof. Sanjay Bakshi, wrote a thank you note to Mr Chandran appreciating his kind gesture towards minority shareholders. This is what Mr Chandran wrote back to Prof. Bakshi:
Mr Chandran highlighted that he is satisfied with the dividend that he receives from Ambika Cotton Mills Limited, just like minority shareholders and that he does not want to receive any special treatment different from other shareholders. Mr Chandran stresses upon living up to the faith reposed by minority shareholders in him.
I calculated that that the promoters of Ambika Cotton Mills Limited would receive about ₹4.28 cr. in the dividend in FY2016 for their 48.63% stake in the company. ₹4.28 cr. per annum seems sufficient for living a good lifestyle in India unless one plans to live very lavish life associated with private jets and parties at private islands.
I respect such managements, who respect the minority shareholders (Ambika Cotton Mills Limited) and don’t mind taking a financial hit to keep their words (Manappuram Finance Limited). I like to invest in the companies run by such managements and stay invested as their partner in the growth of the business over long periods.
C) Related Party Transactions
Related party transactions section is one of the essential parts of the annual report that every investor should analyse in detail for every company that she plans to study. This section discloses a summary of all the transaction/balances at year end for the dealings that the company made with promoters and their personal entities, joint ventures etc. during the year.
Related party transaction section is a goldmine of the information for assessment of any management. By studying each transaction in this section, an investor can conclude whether the promoters are benefiting from the company at the cost of minority shareholders.
Let’s analyse the related party transactions of a company:
Rexnord Electronics & Controls Limited
Rexnord Electronics & Controls Limited founded in 1988, is a Mumbai-based small-cap company with a market cap of about ₹45 cr. The company is a manufacturer of fans: AC Axial Fans, DC brushless fans, condenser cooling, evaporator, no frost, water cooler and gear motors.
I came to know about Rexnord Electronics & Controls Limited, when one of the readers of the website, Susheel Kapoor, asked me a query about his analysis of the company. You may read about Susheel’s analysis of Rexnord Electronics & Controls Limited and my inputs to his analysis in the following article:
While reading the annual report of Rexnord Electronics & Controls Limited for FY2015, an investor notices that the company has sought shareholder’s approval for an agreement, which the company has already entered into with M/s Excelum Enterprises. The agreement is for sale & purchase, payment of commission on sales including overseas sales and reimbursement of expenses to Excelum Enterprises.
Excelum Enterprises is owned by Mr Kunal Tanna, who is the husband of Ms Nanny Tanna. Ms Nanny Tanna is the daughter of founder promoter & chairman of Rexnord Electronics & Controls Limited, Mr Kishore Chand Talwar. Therefore, we notice that Rexnord Electronics & Controls Limited is entering into a transaction with the son-in-law of the founder promoter of the company.
When an investor analyses the annual report further, then she notices that until last year (FY2014), Mr Kunal Tanna was working at Rexnord Electronics & Controls Limited, as the Vice President – International Business. To an outside observer, the current arrangement of payment of commission on sales to Excelum Enterprises by Rexnord Electronics & Controls Limited seems like paying to Excelum for the skill that its proprietor (Mr Kunal Tanna) has learnt by working at Rexnord itself.
Moreover, a look at the salary structure of the promoter family for FY2014 highlights that Mr Kunal Tanna was being paid the highest remuneration in the company even higher than the salary of founder promoter & Chairman Mr Kishore Chand Talwar.
I believe that it is good if relatives of the promoter join the company as employees/directors and contribute to the growth of the business and take a commensurate salary for their contribution. Family members at key positions ensure continuity of the business as well as relatively stable loyalties when compared to professionals who keep on shifting their loyalties by giving 90 day notice periods.
However, the investor should become circumspect when she sees the promoter family members entering into contractual agreements with the company. This is because, as in case of Rexnord Electronics & Controls Limited, when two members of the family, a father-in-law, and a son-in-law sit across the table to decide what percentage of commission would be paid to the company of son-in-law, then the minority shareholder can only pray that they would have her best interest in their mind.
The cases of Gujarat Automotive Gears Limited, Cairn India Limited and Maruti Suzuki India Limited, which have been discussed in the first part of this series of articles on assessing management quality, should serve as a caution for investors before investing in companies that have a lot of related party transactions. You may read the first part of this series here:
Read: Why Management Assessment is the Most Critical Factor in Stock Investing? (Moneylife Session Part-1)
With this, we have come to end of second part of this series of articles, where I would stress the importance and steps of management assessment while making stock investments. The current article has highlighted some of the important tools for assessment of management quality:
- Promoters’ background check
- Promoters’ salary
- Related party transaction
In future articles, I would discuss remaining critical tools which an investor should use to differentiate a good management from a bad management. Therefore, stay tuned…
Also 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.
- 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.
- I have used the data provided by screener.in, annual reports of the companies mentioned above and various stock exchange filings done by these companies on Bombay Stock Exchange (BSE) for this article.
Registration Status with SEBI:
I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013, since May 25, 2016.
Details of Financial Interest in the Subject Companies:
Out of the companies discussed in the above article, I own shares of Manappuram Finance Limited and Ambika Cotton Mills Limited 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.