(This appears in yesterday/today edition/s of Deccan Chronicle)
WHO MANAGES THE COMPANY?
The recent ‘discoveries’ of frauds by businessmen on our banking system seems to be yet another reminder of the fact that most investors do not seem to care about what I refer to as ‘management quality’. When buying shares, people tend to rely more on tips, research reports and broker recommendations. They do not do any homework or take any effort to dig a bit more. Ultimately, the biggest success factor for any investment over a long term will be the Quality of Management. All the other factors are a subset of this.
Just see all the research reports by the brokerage houses. None of them talk about the promoter or the management. They all give you some fancy write-ups and some numbers. And project some price based on some formula that is invented afresh for every company share price. If nothing, they will say that another company in the same space trades at X times sales and thus, this can be value like that. Nowhere will they give you a cohesive logic to support a price.
So, how does one take a call on “Management Quality”? I cannot give any precise quantitative measures, but here are some pointers. Tick as many boxes as you can. Where there are doubts or negative issues, you take your call.
Management competencies can be judged fairly well by a handful of ratios that can be used to ‘kick the tyres’ in any investment ideas. For starters, the ROCE is a good starting point. The ROCE has to be over the cost of debt if a business has to be viable. Not in just a single year, but over long periods. You will notice that ‘successful’ companies will have ROCEs that is upwards of twenty five percent. The other thing is that any management should be able to grow the business faster than the GDP plus inflation. In every business, you will have two or three leaders and dozens of ‘me-too’ companies. The leaders will give you long term wealth and the ‘me-too’ companies are speculative. They keep stuttering and making money out of them is a matter of timing and luck. Sometimes, in economies like ours, there are some ‘sectors’ that become ‘hot’. It does not mean that the managers are all great. The retail space is a good example. We have companies making consistent profits, some turning around and many still not making money. Not all of them will live for long.
Accounting quality (how fair are the accounting disclosures) is an excellent indicator of management integrity. The auditor can only be as good as the management/s want them to be. While a high level of accounting competence is needed to critically examine this, there are some tools available online. There is something called the “M” Score that denotes the probability of manipulation of accounts. Valueresearch (www.valueresearchstocks.com), for instance uses a modified ‘C’ score that is useful to give us a first alert on the ‘probability’ of manipulations in accounting. It is not a judgement, but a flag alerting us. Today, the temptation to manipulate accounts is extremely high and not enough efforts are being made to study this. Accounting frauds will keep stock prices going for some time, till the fraud collapses on its own and the shares become worthless. Thus, one good thing to always see is if a company is consistently profitable, does it pay full taxes, does it give enough dividends, does it reduce its borrowings? Cash flow analysis is a leading indicator. Does the company resort to frequent visits to the capital markets? Does it regularly announce ‘corporate’ acquisitions, re-structuring, has too many subsidiaries etc?
The more complex a business and its annual report, the higher the possibilities of goings-on that are buried between the lines. Do not invest in something that you cannot understand. The markets have over two thousand companies and you do not have to invest in every one.
One section in an annual report that is good to read is “transactions with related parties”. Also, check the compensation being taken out by the promoter directors/management. If that is a large part of the total wage bill, it is not a nice thing.
There is also a website named www.watchoutinvestors.com that lists out registered offences or allegations on companies and directors. It is good to spend that time to find out a bit more about the management.
PSUs by nature have a problem that structurally gives them a poor score on ‘management quality’. No reflection on the talent, but the owner’s appointment of management, their short tenures, lack of a credible business strategy, non-business motivations for a lot of actions etc result in uncertainties. Failure to meet goals has no implications on the promoter/management in this case. So, this is a risk that over rides everything else.
Of all the risks that we have in any investment, the risk of ‘management quality’ is least understood. Long term investing success hinges on this factor.