Warren Buffett on AUDIT committee

This is a must read- Each sentence is worthy of reading again and again.

 

6.2 Warren Buffett on the Challenge of the Audit Committee

Often called the “Oracle of Omaha,” Warren Buffett, the largest shareholder and CEO of Berkshire Hathaway, is well known for his adherence to the value investing philosophy, his conservatism when it comes to issues of governance and accounting, and for his personal frugality, despite his immense wealth. On the subject of a board’s audit committee, he writes,Buffett, annual letter to Berkshire Hathaway shareholders (2002).

Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect. Reforms that ignore this reality and that instead focus on the structure and charter of the audit committee will accomplish little.

As we’ve discussed, far too many managers have fudged their company’s numbers in recent years, using both accounting and operational techniques that are typically legal but that nevertheless materially mislead investors. Frequently, auditors knew about these deceptions. Too often, however, they remained silent. The key job of the audit committee is simply to get the auditors to divulge what they know.

To do this job, the committee must make sure that the auditors worry more about misleading its members than about offending management. In recent years, auditors have not felt that way. They have instead generally viewed the CEO, rather than the shareholders or directors, as their client. That has been a natural result of day-to-day working relationships and also of the auditors’ understanding that, no matter what the book says, the CEO and CFO pay their fees and determine whether they are retained for both auditing and other work. The rules that have been recently instituted won’t materially change this reality. What will break this cozy relationship is audit committees unequivocally putting auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.

In my opinion, audit committees can accomplish this goal by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:

  1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.
  2. If the auditor were an investor, would he have received—in plain English—the information essential to his understanding the company’s financial performance during the reporting period?
  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?
  4. Is the auditor aware of any actions—either accounting or operational—that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

If the audit committee asks these questions, its composition—the focus of most reforms—is of minor importance. In addition, the procedure will save time and expense. When auditors are put on the spot, they will do their duty. If they are not put on the spot… well, we have seen the results of that.

(from  https://saylordotorg.github.io/text_corporate-governance/s08-02-warren-buffett-on-the-challeng.html )

What do I do? My Bond Fund NAV has dipped sharply due to DHFL…

 

While we can debate endlessly on credit risk and the role of the mutual funds, let me address a simple issue- What if I am an investor in one of the funds that has knocked off the NAV?

What does it mean for the investor who is still in the scheme? Logically, the write off could have been for 75% of the investment in the defaulted paper. If we exit immediately, we get the lower NAV.

What happens when the bond pays off after a delay of a week or a month or a year? In that case, the fund house would ensure that everyone who redeemed after the write back gets their fair share. That is logical and should happen. Staying on or redeeming should make no difference.

Of course, the lucky ones are those who redeemed their money till two days ago, where they probably got the higher NAV.

If the fund had already sold of the paper at a loss, the NAV would reflect the loss. As an investor, you have probably suffered some loss.

 

Thus, as an investor, wait or exit should not matter.  The only issue will be in case of FMPs, where you would have to stay on till the end, unless there is a provision for early redemption.

Health- Handling Medical Emergencies

(This is a column I wrote in Moneylife in October 2016- This is relevant at all times, I feel)

Medical Emergencies & Your Money

 
This time, I want to talk about being smart with money during medical emergencies. I request the readers’ indulgence and want to share my learning from a medical emergency and how we can be smart with our money. The medical industry is designed to exploit the ‘fear’ and ‘ignorance’ factor and transfer wealth from the average individual to the group of players who dot the medical industry—doctors, hospitals, pharmaceutical companies, etc.
When medical emergencies arise, logic and reason take a back seat. You are ready for exploitation by the healthcare industry. The situation is compounded by the fact that corporate hospitals are sharply focused on their bottom-line and the doctors have to recover the exorbitant cost they have incurred on their medical education. Many of the emergencies would involve either a cardiologist or a neurologist or both. Most of us have not ventured into this space and are, generally, at the mercy of a hospital that is closest, or a hospital that advertises, or some other recall that is based on hearsay. Such emergencies can, often, involve one or more of the following:
  • A large single-ticket expense that will involve a few lakh rupees;
  • Medical intervention or procedures all of which may not be necessary;
  • Medical intervention costs that are exorbitant;
  • Post-operative care and medicines that will burn a big hole in your pockets;
  • Choice of medications that may not be the best for you.
I had a medical emergency a few months ago. It was mid-morning. A kindly neighbour rushed me to the nearest big-name hospital. The doctor advised some checks. The first two checks showed things were fine and no cause for concern. At this stage, I could have been kept under observation. However, the doctor and another accomplice persuaded me to have an angiogram. We had to trust that gentleman in the white coat. After the angiogram, he told us that I had two blocks—one of them was supposedly 90% and the other, 70%. I started getting a severe headache. The doctor said that it was a side-effect of some medication that he had put me on and that he would change it to some other.
The doctor then went into a huddle with my family and suggested that I go through a stenting process; he recommended that I go for the ‘absorbable stents’ that were, supposedly, better. I was told that the two stents would cost around Rs4 lakh. During all this, the hospital had discovered that I was covered for medical insurance up to some five lakh rupees.
By this time, my friends had arrived. They talked to the doctor who said that the surgery was imperative and that there was some specialist who would be coming to that hospital in two days and there were a series of these ‘absorbable stent’ insertions that day. My friends persuaded the doctor that we would source the stents directly. Reluctantly, the doctor agreed. The distributor, who supplied the stents, told us that the doctor was his biggest client and that more than half of the price would be a rebate to the doctor! So we got the stent at less than half the price and the distributor invoiced the stents to the hospital at one rupee. Obviously, the money he collected from us would have been given in part or full to the man in the white coat.
My family doctor was upset at this gentleman in the white coat. He said that if the blockage were so severe, he could have done the stenting at that moment and not have had to open me up again. An angioplasty meant that I had to undergo another intervention which necessitated more medication and extra care. My headaches were continuing. Finally, the stents were inserted and I was shifted out of the ICU (intensive care unit) and told that I could go home the next day.
Now, having completed the surgery, I tried to read some papers or books and found that my vision in one eye was badly impaired. My headaches refused to go. The doctor kept on giving me Crocin and reasoned that the stress must have caused this headache and the vision problem and that it would set itself right.
This gentleman in the white coat then performed his final act of cruelty. Post-stenting, we have a choice of medicines. Some cost Rs5 a tablet and some cost Rs50 a tablet. The company selling the Rs50 tablet ‘promotes’ the product by offering incentives for prescription. Once you are on a particular medication, you have to continue the same thing for one year. So, I was locked in for the Rs50 tablet, twice a day for one year. I did not have the sense to ask the doctor about the choices.
By this time, my faith in the doctor, his team and the hospital had evaporated. I went to an eye-hospital to check the problem with my eye. It was a week after the surgery. During the eye check-ups, the doctor told me that I should go for a brain scan, since he suspected that there could have been a haemorrhage in the brain that could have compressed the nerve supplying blood to the eyes. A brain scan confirmed this. Apparently, the excess dosages of blood thinners (one when I got admitted, one for the angiogram and another for the angioplasty—given in rapid succession) had caused this haemorrhage. Luckily, we knew a good neurologist who helped us out. Now my vision is recovering as the haemorrhage heals.
I do not want to sue this man in the white coat, because he has far more resources than I have, to fight a legal battle. After all, everything he did was ‘opinion’-based. A top-notch cardiologist, who I now consult, went through the history and opined that the blockage seemed far lower and that stenting may not have been necessary at all. So, in this opinion business, I have been at the receiving end. Some lessons for everyone:
  • Keep all medical insurance cards/papers easily accessible and known to ALL members in the family;
  • Do some basic research on doctors and hospitals in your neighbourhood. Find out who the good or reliable ones are in disciplines like cardiology, neurology, orthopaedics, etc. We cannot cover everything, but some primary ones are essential;
  • Find out what your medical policy covers by way of limits on surgery, on stent, on hospital rooms, etc;
  • Have one family doctor who can be consulted during medical emergencies;
  • Identify hospitals closer to home which will not rob you blind;
  • Talk with friends about medical treatments, costs, etc;
  • Once someone is admitted, have some friend or relative who will be entrusted with thinking about money alternatives and is willing to question doctors;
  • If a major surgery is involved, take some time. Ask your family doctor before you go ahead with any medical intervention;
  • While the patient is in the hospital, it would be useful if one family member or friend visits another hospital to find out costs, processes, etc. Shopping for this is important, given the fact that the medical profession treats us like any commercial object;
  • At every step, question the process and the medicines. If the doctors cannot respond to your questions, it is best that you switch doctors;
  • Record critical conversations with doctors on your mobile phone. Before the final discharge, make a list of questions. Ask them clearly and write down the responses.
There are many more issues that you will come across. I know, it is not easy to keep one’s calm and reason things out, during a medical emergency. So, it is best to do our homework well in advance. And, yes, an ounce of prevention is better than a pound of cure. Spend time and money on your diet. It is cheaper than paying hospitals which, today, are corporate entities out to boost their bottom-lines at any cost. Stay healthy. Health is, indeed, wealth.

Debt Funds, Promoter Loans and other evil

(Today’s column in Deccan Chronicle http://epaper.deccanchronicle.com/articledetailpage.aspx?id=12512434

Ignore the badly inserted headlines- Basic conclusion is that Investing in Fixed Income through Mutual Funds is a poor choice and highly risky. Liquid Funds- If they guarantee that they will stick to maximum 90 days duration, only P1+/A1+ of CRISIL / ICRA and Central Govt Securities- T Bills are fine. The Mutual Funds rip the investors off by taking away more than twenty percent of the potential income)

DEBT IS A FOUR-LETTER WORD

Debt paper issued by ‘investment’ companies form a significant part of the portfolio of many institutional investors.  In a way, these investments are banking more on faith than on cash flows. Many of the investment companies are in the nature of holding companies which have no cash flows other than dividends received.

Repayment is possible only if :

  1. The investment company sells some shares in order to repay the debt; or
  2. It keeps replacing one debt with another.

In the real world, the first is a rare happening. And when it is forced upon by the lenders, it leaves behind a wave of destruction of value.

The first time it happens in a big way and selling started, there have been questionable deals by mutual fund companies and the promoters.  Whether it is Zee or ADAG, it has become not only a problem for the mutual funds but also for the shareholders. ADAG went to court against the selling of shares by Edelweiss and caused legal costs and pain to Edelweiss.  And once this level of selling happens in a concentrated dose, the traders get wind and the stock price simply collapses, leading to compounding of misery.

The other thing is that promoters may escape disclosing these as ‘pledged’ shares. Often the agreements could be private lending arrangements like in some intercorporate loans.

When a loan is created by pledging of the shares, repayment rarely happens unless the promoter sells off some asset or the other. If so, why not sell off that asset in the first place? A promoter may say that he is waiting for a better price. If so, why cannot his need also wait?

It would be best if Mutual Funds are prohibited from investing in to paper issued by “Investment Companies” . In general, these borrowers are unlisted and have limited access to capital markets. And there is no control or transparency in end-use. They are used for various ‘corporate’ purposes through a maze of onward lending. Of course, someone will say that there are ‘good’ promoters and not so good promoters. However, mutual funds start increasing their risk while chasing higher yields.

To me it is a big caution and warning to mutual fund investors. In an equity fund, if there is loss of three to ten percent of the NAV, it is not a shock to an investor. Market moves and stock selection can cause this and the equity investor is ‘prepared’ or not shocked by such falls. Most people at the personal level, approach Income Funds as an alternative to Fixed Deposits with Banks or Companies. Some also think that the Income funds will give higher returns. So far, we have not seen any bad debt crisis in Income Funds. Suddenly, there is a bunch of mishaps that are hitting the mutual fund investors- IL&FS, DHFL, ADAG, Zee Group etc..  When there is a permanent loss of capital in a fixed income fund, it hurts. There is generally no upside. Apart from paying very high costs for investors, the least that a fixed income fund investor expects is that Credit Risk is eliminated (or minimized) by sticking to high quality debt instruments of creditworthy entities. Lending to a promoter is like Loan Against Shares to an individual. A promoter wraps his shareholding in an Investment Company, giving it the façade of a Corporate Debt Paper.

From the Investor perspective, these kind of risks are a deterrent to investing in Fixed Income Funds. If I check out the returns for the last three years- the TOP 10 medium to long term funds have given returns between 6.7 to 8.1 percent per annum. Hardly any better than Bank Fixed Deposits. And if there is some bad debt that takes away even five percent of the corpus, the return will be below the savings bank rates. Is it worth taking this risk? I would keep away from all fixed income funds except the Liquid Funds, which invest only in prime short term paper.

Even in short term paper, I would like to see a cap of ten percent on finance segment. Today, the portfolios are packed with debt paper and structured instruments from investment companies. And another important thing I would like to see is the fund manager paying attention to the quality of the Rating Agency. Laying the blame on ‘ratings’ in general is highly irresponsible. Every player in the industry knows about credit rating agencies. Not all of them are equally trustworthy. A simple ‘recognition’ from SEBI means nothing.

As an investor, I do not mind equity mutual funds- where my first preference is for an ETF on the index. As regards Fixed Income Funds, I think I am happy with Bank Deposits, Company Deposits. Of course, I will go by my judgement of credit rather than depend on credit rating agencies. If I cannot find anything good, I am happy with bank deposits.

 

 

 

 

 

 

 

Paying a price- Expectations matter

(An old piece  from Moneylife … Markets are markets- Amazon just ripped through the price barriers, while Eicher seems to have cooled off. I still maintain my views, but price prediction is not my cup of tea. Only thing I want to be sure about is that if I buy something, the upside potential in price has to exist. And some cushion for a downside too. )

Price to Expectations

 
Be mindful of your expectations when you buy really expensive shares
Old stamps, antiques, old watches, paintings, etc, are called ‘priceless’ for a reason. They do not follow any rules, or principles, of valuation. Their value could be from zero to infinity, depending on the eye of the beholder. And, unlike government securities or stocks, they do not generate any income. Still, there are experts for everything who can fix a value for things in their domain. Such valuation expertise defies rules applied to popular income-generating assets.
Of late, we are seeing most global markets flush with so much money that every asset class is getting an upward revision in valuation. Nothing is considered expensive. A promise, or a potential, is deemed far more valuable than actual profits. Someone aptly put up a forward on WhatsApp that read as under:
The company is Amazon, the online e-tailer. Yet to record profits; but hope springs eternal and, therefore, command sky-high valuation. We have companies in our country too that are as precious as antiques or stamps, even though they are profit-making. Only a collector can justify the valuations prevalent:
Market-capitalisation is the value attributed to a company with these financials. If we were to put the amount for its market-cap in a bank fixed deposit (FD), carrying interest at 8%pa, it would earn around Rs4,800 crore every year. This company is earning around Rs700 crore today. And will the earnings double every year? Even if they do, it will earn Rs1,400 crore in one year, Rs2,800 crore in two and Rs5,600 crore in three years. The company looks like it is grossly undervalued. What if the company were to grow only at 30%? Then, it would take nearly eight years for the profits to reach that level. In the meanwhile, the bank would have paid Rs4,800 crore in the first year itself, with every year, compounded. I would like to think that the market believes that the company will nearly double its earnings every year; in other words, a growth of 100%pa, or close to it.
What if the company stumbles? What if the company’s profits stagnate or fall? Or am I being stupid in even considering such a possibility? The company is Eicher Motors which has had a spectacular run. I do not know many people who bought its shares a few years ago, but there is a lot of talk about the stock now. Going by numbers, I see ‘great’ expectations riding behind the price. One small slip and the price will come crashing. If the market-cap rises at the same pace as the turnover, the stock is surely priced like a Kohinoor diamond. Definitely, not valued like a financial asset.
There are many such stocks. The problem with the markets is that they can be irrational—on both sides. What would I have done, if I had bought the share when the company’s market-cap was, say, Rs500 crore? Frankly, I would have started offloading my position long before the market-cap hit 30-40 times its rising profits. That itself would have been a spectacular return. Yes, I would always look back with ‘regret’; but that is my style. I do agree that, in the early stages, companies can keep doubling the revenue and the bottom-line every year. Where will it halt? It is a call that is hard to take; but I would take the call at some time. Eicher has doubled its top/bottom-line every two years. That is a near 40% (compound annual growth rate—CAGR). Even at this rate, it will take nearly five years or more for the profits to reach the level of the return on a bank fixed deposit on today’s principal.
Irrational: I do not understand these kinds of valuations that border on irrationality. I am happy to keep away from something that I cannot believe in—until I am comfortable with the price. A company may be great, its products great and prospects great. But price has to have a relation to the profits it makes. After all, money has alternate uses. We cannot impute a price simply because it is a price at which the last person bought.
One way to address this issue is to follow what Charlie Munger, partner of Warren Buffett, says: “Invert, always invert.” In this case, you might like to ask yourself, whether you would be willing to pay Rs60,000 crore to buy out the entire company that delivers profits of around Rs700 crore. The company’s highest (current) return on equity (RoE) is around 50%. HUL and Colgate deliver near, or more than, 100% RoE. Of course, I could be totally wrong. Maybe Eicher will sell two million motor cycles in a few years and earn Rs3,000 crore as profits. If you think it is going to happen, you should buy the share.
In all markets, we will always have prices that do not conform to normal valuation rules. They don’t trade on ‘Price to Earnings’ (P/E) basis but ‘Price to Expectations’ ratio. Of the two examples I discussed above, neither seems to fit in my buy list—at the current prices. I must say, that I like the company, Eicher, and have used it as an example to discuss and debate stock-market behaviour. It is just that I would like to own it, but at a considerably lower price.
The bigger game is in spotting such companies very early, if we have to make super returns from stocks. Page Industries is another great example of how companies can reward the investor, if spotted early. Here is where some deep thinking and knowledge of the product, the markets and the company helps. So we have to keep aside some of our investible money for such potential winners. We may choose three or four and, even if one pays off, it is worth the risk.
Potential Winner: For a potential winner, we must be sure when we are able to visualise the company a few years down the road. This would mean fulfilling the following conditions:
•  It has a product that is easily understood and enjoys strong demand.
• There is some advantage over existing players that can give an edge.
• It has enough resources to keep growing, without coming to the capital markets.
• The company has very low debt or no debt.
• The product enjoys high profit margins.
• The product has a long life cycle and will survive for decades.
• The company can focus on building the product/brand and does not have to invest in logistics, distribution channels, etc.
• Company’s product/s has/have a mass market or cater to a growing and/or ‘aspiring’ population.
• The promoter owns at least 51% of the business.
It is important that one can understand what drives profits in the business without going into complicated Excel-sheet numbers. The simpler it is, the higher the chances of success. Also, look for global comparisons, wherever possible. Page Industries was harder for many to spot because its parent, Jockey International, is not a listed company. Information was not easy to access; one had to go on the premise that it was one of the top two or three brands in the world in ‘innerwear’ and that the Indian promoter is a trusted franchisee with the background, etc. The first-year numbers, the quarter-on-quarter numbers were all showing the way.