Let me emphasise that the quality of management matters. Since you are investing for a long term, you would not trust a management that is unscrupulous, non-transparent, incompetent or short-sighted. The basic feature of corporate structure is separation of ownership and management. As a shareholder, you are a part owner of the company. You trust your money to the management who must use it in judicious manner and create wealth for you. If the management is unscrupulous, it may destroy your wealth. If the management is not trustworthy, the quarterly and annual results lose their credibility. All the analytical tools that you are taught to use in this book would lose their reliability if the management has no credibility.
Bad managements are known to compensate themselves disproportionately, even to the detriment of shareholders. Indian shareholders have suffered greatly in the hands of bad managements, and the scams have recurred every few years. Harshad Mehta in the 1990’s connived with greedy managements, and banks and jacked up the share price of target companies. When the bubble burst, the banks had lost Rs 4,000 crore, and the investors also lost crores of rupees. 10 years later, Ketan Parekh would collaborate with corrupt managements and do circular tradings to pump up the share prices. A decade later, Ramalinga Raju would cook the books of accounts of Satyam causing a loss of 15,000 crores to shareholders. The unbroken record of cheating has continued in present times, with companies like Gitanjali Gems fudging accounts. These are extreme examples; hundreds of managements would resort to questionable practices almost regularly.
Warren Buffett laid great importance to the quality of management. He understood the importance of a trusted management for passive investors like him. He once said, “Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.” At another time, he went on to say, “It’s hard to overemphasise the importance of who is CEO of a company.” When asked about his key criteria in identifying good companies, e would say, “Charlie and I look for companies that have able and trustworthy management.” So much emphasis on quality of management by the greatest investor in the world. He understood that in the first place the business model had to be good, and the company should have some kind of ‘economic moat’ to keep competition at bay. This advantage would be lost if the quality of management was questionable. He put it so aptly, “You need two things—a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle.” Buffett knew it all too well that economic moat needs to be guarded by the king in the castle, and he was a weak king the moat would not hold the enemies. In fact, a strong management itself is a moat.
A big question is how can a small investor assess the quality of management? In the olden days when information was difficult to access, investors like Philip Fisher would travel and spend time in and around the company and try to get as much information as they could gather. Fortunately for us, we are living in a world where information is available at the click of a mouse. Every step that every human being and every corporation takes gets recorded. Information like never before is available to someone keen to get it. The cost of gathering information has also come down to near zero. This has proved to be a great leveller, an informed investor with a capital of just Rs 1 lakhs has the access to the same information that a large institutional investor has.
A good starting point is always the annual reports of the companies. Warren Buffett is known to read every page of annual reports of companies he is invested in. I always imagine Warren Buffett sitting on his desk, under a table lamp with a heap of annual reports and cans of Cherry Cokes.
Following are the factors to look at for determining the quality of management.
Are acquisitions by management value creators or value destroyers? Are the acquisitions in the area where the company has core competence, or is just done for the sake of spreading the empire by an overambitious management with excess liquidity? Will the new acquisition create synergy, or destroy it? Is it growth for growth’s sake or real value creation?
Are acquisitions moat widening or moat destroying? Is the company able to strengthen its position because of the acquisitions, thereby creating wealth for shareholders? Or did the acquisitions make holes in the moat?
Does the company pay fair price for the acquisitions? A value investor looks for a management which is also value investor. In other words, it looks for acquisitions with a margin of safety. In recessionary phase of every trade cycles, many companies get injured, and are available at attractive pricing; a shrewd management looks for such opportunities.
Is the management willing to take long term decisions, which may cause hardship in the short run, but are great value creators for shareholders over a long period of time, or is more interested in pleasing the market, and analysts quarter on quarter?
Is the management transparent and straightforward? Does it call a spade a spade, or does it show a rosy picture always? It is not uncommon for some managements to give a guidance that because of poor macros, or for whatever reasons, the profits of the next quarter or year would be impacted. Conversely, it is not uncommon for many managements to continue to post a great picture, until the doomsday. Needless to say, harsh words of the former are appreciated more than the pleasant expressions of the latter.
Does the company have history of project cost or time overrun? Does the company stick to the implementation schedule (usually announced in annual report)? Is delay or is discipline the norm?
Does the company have appropriate amount of debt looking into nature of its business and capital adequacy? What is the average cost of debt? (Bad managements are forced to borrow at high rate of interest, great managements have access to cheap funds)Does the management use short term funds for long term funding requirements?(This may cause liquidity problems when the funds are recalled) What is the credit rating of the company in the debt market?
What is the dividend policy of the company? Does the management reward the shareholders adequately, but at the same time making sure that enough money is retained in the business for the ongoing growth?
What is the management compensation policy? What kind of remuneration the management pays to itself? Is it commensurate with the size of business and profits? Is the compensation linked to performance? Will the management be willing to cut its compensation in the event of lower profits of the company. Does the management allocate the compensation judiciously to all stakeholders, or just cares for its own compensation? Buffett puts this very aptly in one of his letters to the shareholders, “It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many ‘alignment’ plans flunk this basic test, being artful forms of ‘heads I win, tails you lose.'”
How are the minority shareholders treated? Are the investors grievances resolved to their satisfaction? (A simple test of this is to raise a grievance-if you are already a shareholder, and see how does management resolve it?)
Is the management proactive to changing business and technological environment? Does it adopt new cutting edge technologies to keep itself abreast of the competition? If a new technology suddenly disrupts the business model, what is the preparedness of the company to handle it?
What is the background of the promoters? Have they been hauled up by the regulatory authorities in the past for any offence or violation?
What kind of transactions the company carries out with companies belonging to directors or their relatives? Related party transactions is a very important area to look into to detect unscrupulous managements. Funds are often siphoned off using companies and firms belonging to relatives. Law makes a disclosure of such transactions mandatory. You may recall the recent case of Videocon Industries. A loan of Rs 3250 crores was extended by ICICI Bank (and consortium) to Videocon Industries. It was alleged that after obtainin the loan Videocon Chairman Venugopal Dhoot invested Rs 64 crore in NuPower Renewables, a firm owned by Deepak Kochhar, husband of Chanda Kochar MD and CEO of ICICI Bank. Later Dhoot’s company, Supreme Energy took over NuPower, which was transferred to Dhoot’s associate Mahesh Chandra Pugalia. Pugalia took over the company, and later transferred his entire stake to Deepak Kochar’s company Pinnacle Energy for only Rs 9 lakhs. The ultimate effect of this series of transactions was to transfer Rs 64 crores to Kochar. Unscrupulous managements are known to create a chain of transactions in a way to hide the trail.
Is the management overtly concerned with share prices? Some managements are more interested in share prices rather than actual operations of business. Any management that involves itself in day to day price management of its own scrip must be looked at with scepticism. The job of the management is to manage the business, not the share prices. Good share prices follow good management practices. A strong stock market performance in the short run does not mean a good quality management; nor does a weak performance mean a bad management. It is expected that in the long run the stock market will pay the right premium for the management quality; however keep in mind that stock prices comprise of countless variables. More often than not, the price is likely to be off-balance. The job of the management is to manage the company and not the stock market.
What is the management’s stake in the equity? There are enough empirical evidences to prove that the management which has no stake in the equity of a company tends to be reckless and often irresponsible. That is the reason intelligent investors shy away from companies where the promoters stake is low. It is not unusual for promoters to sell off their entire stake, and still sit on the board of the company, directing the affairs of the business as owners. This is potentially dangerous situation. To paraphrase Nassim Talib, unless you have the skin in the game, you are not to be trusted. The recent case of Singh brothers running Religare and Fortis long after selling off their stake is an example of ‘no skin in the game’
To cut it short, the investor should look at managements that have a long term track record of growth and profitability and go about doing their job with a great degree of honesty and integrity. There is absolutely no compromise on that. You will trust your money with them for years.
Let’s hear more from the Oracle of Omaha, Warren Buffett on this: “Our experience has been that the manager of an already high- cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.” Buffett seems to be emphasising on quality of management in every letter to the shareholders and rightly so, as he realises that it is the most important input in investment decision making. In 1991 letter to the shareholders he says, “With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”
He advises investors to thoroughly understand how the management treats the shareholders. “You want to figure out how well that they treat their owners,” he says. “Read the proxy statements, see what they think of — see how they treat themselves versus how they treat the shareholders. The poor managers also turn out to be the ones that really don’t think that much about the shareholders, too. The two often go hand in hand.”
A strong management is the backbone of a successful company. It is like the captain of the ship, assigned with the task of sailing the ship through all weather conditions. The management represents the shareholders, and must at in the best interest of the shareholders. The primary task of management is to create wealth for the shareholders, it is quite obvious that unless the management is adequately compensated for doing what they are supposed to do, they will have no incentive to produce wealth for shareholders. That is to say, unless the interest of the management is aligned with that of the shareholders, not much value creation is likely to happen.
©Dr. Tejinder Singh Rawal
M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD
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This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated