Role of management in long term investments

Ashish Kila

Perfect Research

Our Chairman - Mr. R.A. Kila

Perfect Research Team

Is Management’s role important

Motivation to manage earnings

How to smell a rat : Clues

Examples from our own investing history

View’s of value investing gurus on Management

What does Buffett has to say about management ….

“The extraordinary business does not require good management,” Buffett said in the interview, which was conducted in Omaha, Nebraska.

“When a management with a reputation of brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Competence Vs EthicsCompetence Vs Ethics

We humbly think that Buffet’s views are more with regards to the competence of the management, meaning that even a dumb management can make money off an excellent business.

However, our entire focus in this ppt is on management’s intentions, incentives, ethics and willful actions to destroy value

External Pressures Analyst’s forecast Contractual agreements & debt covenants Roaring stock market

Pressures within the company Merger attractiveness Short term focus Personal factors – Compensation, bonus, promotions, job retention

Executive compensations - Bonus, Stock Options etc.

“If we had to name a single father of the bubble, we would hardly need a DNA test to do so. The father is executive compensation made manifest in the fixed price stock option.” – John Bogle

How To Smell a RatHow To Smell a Rat

Dr. Howard M. Schilit • He is founder of the Financial Shenanigans Detection

Group, LLC, and an international leader in forensic accounting and corporate governance.

The seven shenanigans:1. Recording revenue too soon2. Recording bogus revenue3. Boosting income with one-time gains4. Shifting current expenses to a later or earlier period5. Failing to disclose all liabilities6. Shifting current income to a later period7. Shifting future expenses into the current period

How to smell a Rat : Clues

1. Dishonest Management2. Inadequate control environment 3. Changes in auditors, outside legal counsel, or CFO4. Changing in accounting principles or estimates5. Large deficit of CFO relative to net income6. Substantial disparity between sales and receivable growth7. Substantial disparity between sales and inventory growth8. Large increase or decrease in gross margins (GP/sales)9. Recording revenue when risks remain with seller10.Presence of commitments and contingencies

How much the company’s operating profit get converted into cash flow from operation.

Lack of commensurate operating cash flow is a red flag, which one needs to study further in detail

Source: Capitaline

REI Agro

 Rs cr. FY-12 FY-11 FY-10 FY-09 FY-08

EBITDA 835.7 779.1 616.4 450.1 321

CFO 439.7 215.5 -764.1 -293.2 -720.9

Cash Flow Conversion 0.53 0.28 -1.24 -0.65 -2.25

Rising receivables vis-à-vis sales growth

E.g.:- REI Agro

Increasing working capital requirement as % of sales

Mar-12 Mar-11 Mar-10 Mar-09 Mar-08 Jun-07 Jun-06Working capital 1847 1928 4542 3202 2481 1465 828Net Sales 4225 3724 3693 2448 1735 1085 959Working capital/Net sales 44% 52% 123% 131% 143% 135% 86%

Working capital/Net salesRs cr.

High contingent liab’s against PAT is a threat signal.

One needs to go in detail and understand the reason, magnitude and probability of materialisation of such liabilities . E.g.

Where to find updates on issues related to corporate governance:

www.watchoutinvestors.com Initiated by SEBI

www.ingovern.com Founded by Shriram Subramanian.

He has over 17 years of banking and capital markets consulting experience.

Previously served as a Practice Lead for wealth and asset management at Infosys Consulting, managing a team of globally located consultants.

www.iias.in Founded by Anil Tandon and Amit Singhvi Anil Singhvi has over 30 years of experience, out of which 22 years

in Ambuja Cement including as its managing director   CEO. Amit was the managing director of Fitch Ratings (till June 2011),

before that Amit was senior vice president and head of corporate banking at ICICI Securities.

www.sesgovernance.com Founded by Mr. J N Gupta and two

other young professionals

Mr. J N Gupta has over 35 years of diversified professional experience in public and private sector including two terms with securities market regulator (SEBI) in India.

Mr. J N Gupta, Ex. SEBI Executive Director

Owning your cake and eating it too.

Sun TV Network chairman and managing director Kalanithi Maran and joint managing director Kavery Kalanithi receiving an annual compensation of Rs 57 Crs. Individually which is 16.41% of Net Profit of the Company for the FY 2011-2012.

No Independent Remuneration committee:

The Chairman and MD of BGR Energy Systems Mr. B. G. Raghupathy (Left) take salary of 25.92 crore that rose up by 180 percent during 2010-2011and which is 8% of Net Profit of the company.

The chairman and MD of JSPL, Mr. Naveen Jindal (Right) o Receiving salary package of Rs 73.42 Cr. (1.83% of Net Profit)o Company does not have a separate remuneration committee, so

effectively MD is deciding his own salary.

Vis-a Vis Mr. Arun Jain :-

The Chairman & Managing Director of Polaris Financial Technologies Limited did not draw remuneration from the Company, (salary & bonus) except certain essential perquisites not more than Rs. 20 lacs.

Acting like shareholder of the company by taking dividend only.

Insider Trading allegations Jaiprakash Associates Limited. (JAL)

SEBI has imposed penalty totaling Rs 70 lakh on three senior executives of JAL, including Executive Chairman Manoj Gaur, and their relatives for involvement in insider trading.

They were found to have bought shares of the company during the period from October 11, to October 21, 2008 when trading window was closed while they were in possession of the unpublished price sensitive information.

Orchid Chemicals

V K Kaul, as a director on Ranbaxy’s board, was an insider to the subsidiaries decision to purchase Orchid shares starting 31st March, 2008.

Four days before 31st March, Bala Kaul (Wife) purchased 50,000 shares of Orchid chemicals and sold them two weeks later for a Rs 43 lakh profit (Profit of more than 30%).

45% price rise in just 7 days

Subsidiary Juggleries : Number of unaudited subsidiary

Skumars Nationwide

Red Flag:- Twelve subsidiaries with total assets of 988cr (20% of total consolidated asset) remain unaudited according to auditor’s report from annual report FY11.

Aftek Ltd. In 2007, with around 400 Crs of cash on books, net of

cash, co was trading a multiple of <3.  Red Flags - In FY-06 company fully acquired “Arexera

GmbH” by paying Rs.54.82 Cr. for 50.77% stake.(Previously held 49.23% at Rs. 46 Cr.) So total valuation comes around Rs.100 Cr.

Management didn’t disclosed that this acquisition is from (promoters), as we can see from FY’6 AR excerpts:

Revenue of the subsidiary was not more than Rs. 1 Lac. Hence acquisition was effectively at P/E of 100.

In the FY-09, company decided to close this wholly owned subsidiary with 29 Cr. Of loan receivables. And in total Rs.129 Cr. Of loss marked in the P&L as exceptional item in the year.

Undisclosed interest of Directors in company transactions.

Vikas WSP

• Revenue above 1000 Cr., available at the P/E multiple of 2 & a negligible P/S ratio.

• Red Flag:• Company has made transactions with the firm namely, Vikas

Chemi Gums (India) for the purchase of goods (Gaur Splits- Raw Materials).

• These directors did not disclose their interest in the company with whom the transactions were made and hence faced trial in the year 2000.

(Source: Watchout Investor)

Once Buffet Said- Problems in a company are like

cockroaches in the kitchen. You will never find just one

Non Payment of Dividend

It has been complained by the shareholders that the company declared an interim dividend at the rate of 50% in April, 2001 but the same was not paid to the shareholders within a stipulated period of 30 days thereby violating the provisions of Section 207 of the Companies Act,1956.

Curious accounting policy with regard to goodwill

Opto circuits

In FY12, goodwill has reduced from Rs 627 Cr to 449.7 Cr , with no entry in the P&L account.

This impairment has directly adjusted against reserves. No sign of impairment loss in the Profit and loss account.

Capital AllocationCheviot Company Ltd.

The company has been consistently profitable and has good free cash flows. Company has Net Cash of Rs. 142 Cr. and current Mkt. Cap is Rs 145 Cr. So effectively stock with Rs. 295 Cr. Of revenue is available at Rs. 3 Cr only.

Red Flag: Making continuous loss in direct investments. Which is not the core

business of the company.

During mid 2012, Company was available in the market at cash bargain price of Rs.70 per Share. But we didn’t invest as management didn’t seem to be deploying surplus cash, neither in expansion or acquisition nor distributing to shareholders through healthy dividend or buyback.

Historically company has utilised surplus cash through buyback options. In April 2008 company announced a buyback followed by series of buy back offer in November 2010 and in April-2012 (31% of Public Float.).

Nucleus Software

Sasken Communication Technologies Ltd.

Curious revenue & Expense recognition policy

Jyothy Laboratories Ltd.

• Story: In the month of May 11, Jyothy Laboratories announced the acquisition of Henkel’s stake in its Indian subsidiary Henkel India, gaining a foothold in the detergent market. Jyothy has borrowed money of Rs. 460 Cr. on its balance sheet and lent that money to Henkel to manage debt on its books.

• Next quarter Jyothy booked other income of 14.82 crores. Nearly about 12 crores of it is interest paid by Henkel India to the parent for the money that Jyothy has lent to it.

• (Source:Ninad Kunder’s Blog)

But, there is no corresponding interest expense booked in Jyothy’s account against the income that they are booking. On the concall the management said that since it

is a zero coupon debenture which is being redeemed at a premium, the company is allowed to write off the redemption premium ( which is essentially interest) from the reserve and surplus.

So magically they are booking interest income in the profit and loss account and expensing it out in the balance sheet.

Vijay Mallya Vs Kumar Birla

- With whom you would like to park your money

Sincerity, Simplicity, Integrity

However attributes above no way guarantees success.

Escorts Limited (EL)

Escorts Construction Equipment

Limited (ECEL)

Escotrac Finance and Investments

Private Limited (ESCOTRAC)

Escorts Finance Investments and Leasing

Private Limited (EFILL)

100% subsidiary

JV- 49.81%

J V- 49.81%

Holds 49.81% in each other

12.83%

6.5%

Escorts Finance Limited.

(EFL)

9.49% 31.68%

26.70%

(Source: Ingovern.com)

“EFILL and ESCOTRAC are classified as joint ventures even though Escorts holds 99.62% in each either directly or indirectly.

Hence, they should be classified as subsidiaries. EFILL and Escotrac hold a total of 19.33% in Escorts, which tantamount to violation of Section 42 of the Companies Act 1956.

Besides, as at 31st March,2012 promoter held 27.67% of shares. But actually they holds only 8.34% and rest 19.33% is indirectly held by Company on its own through its two Joint Ventures.

After the proposed merger of its WOS and two joint venture company and through a convoluted structure and cross-holdings and unclear valuation, the promoter group holding is

increasing from 27.67% to 37.68% due to the above amalgamation of the two joint ventures and wholly owned Company. But actually company increases its own holding in its own company by 19.33 % to 30.49% indirectly by creating Trust.

The above transaction leads to a 13.84% dilution for existing non-promoter shareholders because of Company increase its own holding in its own company.

Akzo Nobel proposed to absorb three unlisted group companies at a higher valuation, a premium of approx 30% to akzo India.

As a consequence of the amalgamation, promoters will increase their stake from 56% to 66%.

The proposal was then withdrawn among heavy investor criticism

(Source: www.ingovern.com)

Diluting minority stake through preferential equity:

Falcon Tyres As per the annual reports, company receives interest free

loan from undisclosed body corporate of Rs. 132 Cr.

Further, this loan seems to be distributed to three different unrelated parties.

(Source: Neeraj Marathe)

Falcon Tyres : Public stake dilution

These 'unrelated parties' are being allotted equity shares pursuant to conversion of the unsecured loans into equity shares, at a price calculated as per SEBI guidelines. This will lead to massive dilution.

Three words need to be pondred upon :-

‘interest free loan’ – Really, why? 'outside parties' – Who are they? “Three outside parties” – Why? Not hard to

figure out

Promoters pledge their shares as collateral to raise working capital or short term loans, to increase

their holding or to fund an acquisition. Historically pledging of shares by promoters resulted into

huge loss for minority shareholders.

(A) Plethico Pharmaceuticals Ltd. Plethico’s founder has pledged 82% of the company’s

paid-up share capital to borrow funds used to help grow the company’s business.

Later two lenders had taken control of the stock. Stock declined around 50% over four days of trading

occurred amid fears the lenders would sell the stock.

(B) Glodyne Technoserve• As on June 30, the promoters of Glodyne have pledged 81% of their shares as collateral to

raise working capital or short term loans. Stock price fell 20% for two successive days in late July.

• In a regulatory filing early AUG, the company said lenders had taken control of some of its pledged shares.

Halonix Ltd. Halonix is globally 4th largest player in Halogen

headlamps and domestically a market leader with 70% market share. 

During March-2011, Halonix was available at Rs. 100 almost 40% discount to Actis's cost of acquisition of Rs.170, trailing PE of <10 and at Rs.300 Cr. Mkt. cap.

With selling of loss making general lighting subsidiary, company was moving towards debt free status and along with expansion plans, it was overall a rosy story.

Red Flag: Actis owns 66% of Halonix Ltd. The association

announced hiving off a loss-making CFL business to an associate of Actis during august 2010.

Investors welcomed this news and share price rose by 100% from Rs. 80 to Rs. 160 in 6 months following a restructuring proclamation in Feb 2010.

Halonix board then dumped the restructuring without proper explanation months later. Recently on 11th Sep, 2012, a board meeting was called to take decision on this restructuring but again deferred.

Company making losses again and again and management wanted to increase their remuneration.

Mr. Ashish Kila (Perfect Research) and ‘Unifi capital’ - shareholders of Halonix Limited raised their voice against these resolutions being passed during the company AGM and cast their vote against it.

Excerpts from the minutes of Halonix AGM :

Now further, Unifi capital has taken the matter to SEBI and Enforcement Directorate.

Indo Asian Fusegear Limited. (Now Eon Electronics Limited)

The Company sold its Switch Gear Business and received Rs. 305.7 Per Share Cash, but they declared only 3% special dividend payout. The Stock fall over 42% in 2 Month.

Royalty payment to promoter:

The Wadias disclosed the plan to charge royalty to group companies - Bombay Burmah Trading, Bombay Dyeing, Britannia Industries and GoAir - of 0.1 per cent from the current fiscal year, which will be increased to 0.25 per cent of their profits for employing the family brand and benefiting from the shared services of the group.

Decision was not put up for voting from shareholders

HUL pays 1.31% royalty to their promoter as royalty but for technology & brand value to gain benefit in their sectors.

Deccan Chronicles Holdings Ltd.

Laden with debt, its owners facing fraud and forgery charges, its stock in free fall and its survival uncertain.

the current problem of Deccan Chronicle is due to unrelated diversification and the management’s loss of focus.

DCHL defaulted on redemption of Rs 250 crore worth of unsecured redeemable non- convertible debentures.

Total exposure of banks to DCHL stands at around Rs.5,000 crore,

Share Conversion issue

Triveni Engineering

The company had in a 2003 scheme told shareholders that their shares would be converted to preference shares unless they opted for non-conversion.

Of the 70,000-odd shareholders at that time, only less than 400 opted for non-conversion.

The promoters, bound by their agreements with lenders, did not participate in the scheme and consequently, their holding in the company increased.

Company received 404 complaints relating to the scheme. Some shareholders said they had not received the intimation of the scheme, and as such they could not opt for non-conversion.

“Silence is not acceptance”

Some complaints said, "the promoters had taken undue advantage of the small shareholders of the company by not participating in the scheme“.

Notorious PromoterPicadily Agro

Mr. siddhartha Vasistha, popularly known as Manu Sharma is son of Chairman of the company.

Manu sharma shot a waitress for refusal to serve him a drink.

Would you like to partner with such a management

Unrelated acquisition at high valuationSatyam Computers

Ramalinga Raju, chairman and founder of Satyam, tried to pass a RPT worth US$1.6 billion as a deal with ‘Maytas Infra’ in the year 2008.

Ramalinga Raju’s immediate family owned more than 35 percent of Maytas Properties.

Red Flags in the deal: Unrelated business Board approved the deal without shareholder approval. Company did not even release the name of the adviser

to the deal.

It was later found that the deal, estimated to be worth only US$225 million. The acquisition attempt was seen as an attempt by the

Raju family to exploit Satyam's cash resources, as the transaction would have left Satyam in a debt of around $400m.

After protests from the institutional shareholders, the deal was abandoned.

Raju stated that the aborted Maytas deal was actually a last attempt to "fill the fictitious assets with real ones“.

After all of this boards independence been questioned. And finally financial irregularities in company’s account

came into light.

Replacing Auditors:

IFB Industries- Is history repeating itself ?

In 1997 Bhadra & Bhadra has made several qualifications in the company's annual report for the 18-month accounting period to December 31, 1997. Later auditor replaced by Deloitte.

Now again IFB has replaced deloitte with BSR & Co. as Deloitte have expressed their unwillingness to continue.

No reason cited by auditors or companies for change in auditors. Is it a regulatory pitfall?

MCX India and ITD Cementation are other examples.

Foreign parent company- Focus on unlisted Indian subsidiary

Saint Gobain

Saint-Gobain Sekurit India Ltd.-Listed Parent company has hardly invested 90 Cr. Of capital

and does a business of around 100 Cr. With marginal profit.

Saint Gobain Glass India- Unlisted Invested Rs. 978 Cr. Of capital, having Rs 1210 Cr. Of

sales and Rs 208 Cr. Of profit.

Sudden unexplained increase in expenses

Honeywell Automation Corporate overhead allocation expenses increased dramatically

by Rs. 38.5 Cr. in one year which is 36.5% of Net Profit of FY2010.

Excerpts from Honeywell Automation Annual report -2010

Figures in Rs. (‘000)

Curious Case of Delisting:Compact Disc Limited

The promoter of company announce delisting of its company shares at Rs.75 at that time the CMP was

Rs.48 only. Promoter holding was only 24.7% and approx 60% was

Retail Public Shareholders.

Promoter showing eager interest to delist and in between HSBC one of the lender of the company file a suit against the promoter for stay on delisting.

After that promoter defer the delisting and now the stock trades at Rs.24 only.

Promoter Holding Level

Low promoter holding is not a sign of confidence Eg:- Temptation Foods. (Only 10.47% stake held by

promoters)

High promoter holding should be considered good because it ensures minority shareholder’s interest aligned with the promoter.

Eg:- IFB Industries Ltd.

Venky’s India Venky’s India- Largest player in Indian poultry industry. Currently

stock is trading at the P/E multiple of 10, P/S of 0.17, dividend yield of >5.

Red Flag: The total revenue of Venkateshwara Hatcheries (Venky’s unlisted

subsidiary) is almost twice as that of Venky’s. Also, barring FY10 the

company’s revenue growth

rate is even higher than

that of Venky’s.

Rs. (Cr) Rs. (Cr)

Rs. (Cr) Rs. (Cr)

View’s of value investing gurus on Management

Buy back of shares where the buy back is in the

company’s interests, for example, buying back share at less than intrinsic value using surplus cash

Capability in allocation of capital Managers who stick to doing what the company does best; ‘the best

business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.’

Ability and readiness to tackle tough problems as they arise The use of retained profits to increase company profitability at

beyond market rates A conservative approach to debt and liquidity Demonstrated ability to consistently grow company earnings and

rates of return.

Managers who pursue company acquisitions for reasons other than the good of the company – ego trips, the ‘institutional imperative’ of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, ‘[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads’.

Managers who pursue growth for growth’s sake, irrespective of the value of that growth to the company

Managers who expend too much of the company’s worth by issuing valuable shares to buy overvalued assets or who use debt to do so.

Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements

(Source: www.buffettsecrets.com)

o Has management allocated capital properly?

o Investing in the business vs. returning capital to shareholders.

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited.

Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur.

Does the company usually find its CEO from inside the firm? (Outside hires should be watched carefully).

Does the company have a management of unquestionable integrity?

Does the management team exhibit have original ideas and employ an entrepreneurial approach to the business.

I don't even want to know what the company is doing.

I don't even want to know who the manager is?

I want to go by the numbers. And i want to diversify a lot.

Check past target accomplishment of management.

Its better off not meeting management. Because they are great sales people that’s why they got to that position. They got the knowledge & quality to mesmerize anyone.

CEO’s are not deceitful people, they are high integrity people but their in-depth knowledge about their company influence the peoples.

If one wish to meet the management make sure they don’t get mesmerized by charisma of management.

Good management will not always guarantee a good investment but bad management will always end in disaster.

Focus on management’s honesty than quality. The point is to avoid dishonest bosses.

Akre evaluates management from two different perspectives: skill and integrity. 

skill without integrity and integrity without skill are equal roads to ruin. 

According to Akre a manager’s skill and intelligence are easier to identify than a manager’s character and integrity.

Ascertaining management integrity is “the tough question and the answer which often takes us years to discover.” One short cut Akre uses is to favor “owner operators,” which refers to managements that own a lot of company stock. The thinking is that if management’s financial interests are aligned with shareholders, they will do right by shareholders regardless of integrity. 

Management have the capital allocation skills necessary to invest corporate money in projects that earn a return above the cost of capital.

Akre makes sure that management’s compensation is not excessive.

Akre looks for management that is in the hands of the founding entrepreneur, because he finds entrepreneurs to be people with passion and pride in having creating a business, rather than just a business suit collecting a paycheck. 

Is management putting the money back into the business through R&D, marketing, cost reduction, distribution, etc.

If management making acquisitions, the acquisitions should be synergistic and the manager should not pay too high a price for them.  

Is management paying down debt or letting it accumulate.

Is management paying a dividend.

For any unanswered questionsYou can reach me on :

ASHISHKILA @GMAIL.COM +91-9999751327

Perfect ResearchT-24A Green Park Extn.New Delhi – 16Blog: http://perfectresearch.blogspot.in Twitter: @ashishkila