How to pick a company strong on ethics and corporate governance

By Guest |  02-05-18 | 
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Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

Veteran investment adviser and writer R Balakrishnan shares some interesting pointers in a concise format. This post initially appeared in Bala's blog

Management quality is a function of ethics and governance. Someone asked me how important are these two attributes?

If we go by ‘equity research’ reports, it has absolutely no importance. No report comments on the quality of the management, preferring to be diplomatic or practical, since most sell side firms need some business in banking or equities to come their way. Equity research as a function has never made money on its own. It is like the appendix in the human body.

Of course, it comes in to play when we want to acquire a company or take a significant stake in a company. Then we will all perhaps spend a lot of time figuring out who the owner is and what are his strengths and weaknesses.

Sometimes, I see large institutional investors taking significant stakes in companies where the management quality is known to be suspect. I can only infer that it is perhaps a reflection on the quality of the investor also. Institutional investors are managed by people who get salaries and bonuses and they are not investing their own money. Most of us seem to think that it will not impact the investment.

We think that by the time the bad qualities come to the fore, we would have cashed out our gains. Or we think that with so many other investors, we are not alone. We always seek for this comfort that we are not alone.

Governance and ethics of the highest standards are something that exist only in seminars and books. When it comes to money, there are shades of grey everywhere. The one thing working in favour of the investors is that most often, the businessman is also interested in maintaining a perennially north bound share price and hence our interests are aligned.

In the old days, when salaries of directors were restricted to a few thousands, there we no ESOPs or ‘preferential allotments’ or ‘warrants’, the story was different. Also, the interest rates used to be high and our markets were small. Stocks never got such fancy valuations as what exist today. So, the promoter found it useful to take money away and leave just enough for the shareholders.

Today, with the fancy valuations the stock markets give, the promoter finds that keeping a rupee inside the company adds substantially to his wealth. And the promoter can take his multi-crore salaries, dilute when the price is right, issue warrants to himself when the timing is good etc. There are so many indulgences that have become legal now. Thus, the promoter has less reasons to skim off.  A higher EPS translates in to significant wealth, given the benevolent secondary markets.

Of course, no one is immune to a structured fraud. That can happen to catch the best of investors unaware. Satyam Computers was one. Of course, the investors got lucky there since there was a motivated attempt to rescue the company in order to bail out a select few. However, I do not see the same things happening in a Gitanjali Gems.

However, there are ways to stay safe:

  • Avoid companies with high debt, unusual amounts of cash in hand combined with low dividend payouts, continuous raising of capital, constant mergers and acquisitions, having hundreds of subsidiaries, having too many ‘associate companies’ (associate companies are where there is no disclosure, since there are external persons who are co-owners) etc.
  • Avoid in general companies where ‘revenues’ are based on some funny accounting or on ‘certification’ by management rather than plainly visible ones.
  • Have a look at the schedule of Fixed Assets (nowadays referred to as ‘non-current assets) and look at what is happening there. Is there too much of fictitious assets like Goodwill? Is too much invested in real estate? Too much goodwill? All of these are just warning signs and call for deeper probe rather than just ignoring or accepting. Many edifices are built of papier-mâché. Kicking the tyres by going through the schedules of accounts for a few years will be a good habit to keep.
  • Other thing that has helped me is to have a binary classification for valuation- companies that have brands or consumer products to be valued on basis of revenue. Companies that deal in commodities etc to be valued by Balance Sheet. In essence, I find out what the company can make and how much of assets are needed.
  • Then compare it with the “ENTERPRISE VALUE” (enterprise value is the sum of market capitalization PLUS debt).  That helps me to buy when the industry is doing badly and sell when it is doing well.  Of course, the approach is simplistic, but a great starting point.

Management integrity always pays off handsomely over time. If you are taking chances, taking it knowingly. And be prepared for surprises. There is no early warning signal as to when a fraud will be exposed.

P.S: A good analyst can always smell the cockroaches. No investor has the patience to listen to someone ranting about it.

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Richard Frederick
May 2 2018 12:20 PM
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