17 Red flags to watch out for when assessing management quality

The author is an external contributor. Views are personal and do not reflect the opinion and views of PrimeInvestor.

Investment recommendations come to us with a lot of details. Most of them can be put into two buckets – financial commentary and business commentary.  They lead us into buying shares based on expansive notes about ratios, how the business is booming, how margins will improve, blah blah. 

There is usually no mention of who is the owner or the person who drives the company. What is his background, what is his competence, what other businesses he runs, what conflicts of interest does this company have with any of the promoter entity/personalities etc.  The investment universe seems to be firm in its view that the promoter or management quality is not important enough to be part of research.

“When large enterprises are being managed, both trust and rules are essential. Berkshire emphasizes the former to an unusual – some would say extreme – degree. Disappointments are inevitable. We are understanding about business mistakes; our tolerance for personal misconduct is zero.” Warren Buffett

Promoter is key 

But when I buy a share, in essence, I am becoming a co-owner with the promoter. I have chosen to trust him and his business skills to give me a good return on my investment. My basic premise is that we are equal in all respects, as shareholders.  Despite so much at stake, most of us do not bother about the owner or the manager. It all gets decided based on business perception and some noise about how the earnings will rise.

When I was in CRISIL, one of the key attributes in assigning a rating was “Management Quality”.  Even if all the other attributes were good and there was a problem in Management Quality, it would pull the rating down. It was a subjective view.

It is not possible for each of us to know of the promoter. The person who writes the research report has to be the person who tells me about the promoter / management. Sadly, no equity research report I have seen talks much about this. Yes, I can understand that there would be complications in saying bad things about bad people, since these are qualitative and subjective in nature. And no one wants to lose business for his firm or end up with a lawsuit for defamation.

If we spend some time checking these things out, we can make better decisions. Scepticism is an important attribute for an investor.

First among equals

There are two groups of shareholders.  Promoters and Others. For ‘Others’, the ROE is as printed in the books of account. PAT divided by the shareholder funds. Nothing more or less. We would logically expect that it is the same for the promoter. That is the hypothesis when we invest in shares. 

But this is theory. In practise, we are all familiar with the term “vanishing companies” We also know about companies where the promoters siphoned off so much money that the companies finally became bankrupt and the “other” shareholders got a big zero. In most of these companies, you would have avoided investing if you had paid attention to the quality of promoter or management.  

While it is true that there is a board of directors under whose guidance the company is run, and there are also ‘independent’ directors, the truth is that this is a façade. In reality, in Indian businesses, it is often the promoter who decides everything. The board, the auditors and outsiders will only know what the promoter wants them to know.

I am also afraid of companies that have a fondness for talking to the media to shore up their share price. In fact, this practice of ‘one on one’ meeting institutional investors by companies is also an evil. It creates pockets of privileged information flow. I fail to understand why a company should talk to so many investors. As it is they publish quarterly results, have jazzy powerpoint presentations uploaded on the net.

And of course, which management is going to say- “Sorry, here are the ten places where we messed up- these are the problems we have covered up”? Have you read an annual report which talks about loss of market share, resignations of key employees, labour problems, foul up in the plant? Often, annual reports are written by expert script writers who are paid to ‘sell’ the story.

The red flags when assessing management quality

I agree that not all of us have the skill or resources to find out about the promoter. However, if we are directly investing in equities, we have to spend time and effort to know as much as possible. There are some ‘flags’ or smell tests that warn me to keep away from a company.  Based on my experience, let me list down some of the attributes that keep me away from a stock. Most of them are proxies for ‘Management Quality’. I also take the liberty of putting down some examples. The key ones are in the table and more more are enumerated below it.

  1. Preferential shares and warrants to promoters. This is tantamount to denying equal rights to other shareholders. A promoter should not be simply diluting equity when needed and then issue warrants to himself. The government is party to this wrong-doing because they changed the laws to permit this shady practice
  2. Royalties to family companies or parent companies are not always kosher. Unless there is value which is tangible, royalty is not justified. Usually, a brand is built by the company that owns the brand and spends on promoting it. In reality, royalties should be paid by ‘franchisees’ of brands like McDonalds, KFC etc.  In some cases, it is possible that the parent company’s strength enables easy access to capital markets and banks. However, this is more than compensated by the valuation premium that the capital markets give for the lineage
  3. Frequent access to capital markets is a red flag. A good business will generate enough cash to take care of future growth and not launch equity offers in every bull market.
  4. A high rate of ‘acquisitions’ is also something I worry about. In one case, an overseas acquisition turned out to be of a company that belonged to  family members of the promoter. After a couple of years, the company was wound up, no questions asked. There was another company which acquired almost a dozen companies in five years.  It raised continuous capital and debt. It soon joined the list of ‘defunct’ companies without a single asset to its name
  5. Increasing debt even as the company crows about rising earnings and sales. A good company should be able to keep reducing its debt and become debt free. Rising debt is a danger sign and calls for detailed investigation
  6. Frequent change of auditors/ resignation of independent directors are indicators that things are not as they appear to be. 
  7. If you like to read the accounts, study the accounting policies over time. Frequent changes to  methods are a bad sign. I just saw one company (EKI Energy) auditor being ‘sacked’. If there is a genuine difference in views, the management can put out a public response to the auditor’s note or the qualification. By simply removing the auditor, it raises a flag
  8. I also worry when I see a high ‘salary’ to a promoter. When the director salaries form a significant percentage of the total salary bill, I take a pause. The promoter already has a large equity stake in the company and gets rewarded by the increase in share price and dividends. When the promoter pays himself a salary that is several times the ‘market’ salary for a CEO, I do not like it, no matter how much money the company makes.
  9. Too many subsidiaries, associates and related companies make me uncomfortable. I also do not like when there are some associates/subsidiaries where the family owners have stakes in their personal capacities. 
  10. Related party transactions are always a minefield. Once, a company declared itself ‘insolvent’, got restructured after the banks wrote off the loans etc. This was the seventies. The promoter had transferred assets to his relative and went for the insolvency after five years. After a few years, the promoter set up a five star hotel. The land was sold by his relative to the new entity at a fancy price and then the company got listed. After a lot of bank loans and more such properties, the company wound up in NCLT and the promoter family has no time to count their wealth. Study the schedule of ‘related party’ transactions. 
  11. When a company keeps buying land and keeps adding to its ‘vehicles’ it is also a route to have personal assets at shareholder costs. One listed company owner had a passion for ‘antique’ cars. They were bought by the listed company. Over time, they were depreciated and then sold at ‘book’ value to a relative. This company went bust and banks and shareholders lost
  12. A company from a very ‘reputed’ group sold company owned flats (apartments) at ‘book value’ (they were acquired in the 1960s and 1970s) to some key executives. It is a well-liked and well owned company and the promoter has a good reputation
  13. A company once issued shares with differential voting rights to its promoters. Nothing wrong, I guess. Only thing was that these shares carried about two votes each! This chicanery is used by a lot of American companies, that preach to us about governance and ethics! 
  14. There are cases where in order to repay debt at the holding company level, there is a continuous flow of cash from subsidiaries that have a public shareholding. There was a recent attempt to push a foreign company into Hindustan Zinc Ltd, perhaps so that the holding company  could find some cash. The GOI, which still holds 26 percent in the company, is reported to have been against the move and the deal had to be dropped
  15. There have been cases of promoters who deliberately show a poor financial picture to crash the share prices to below asset prices, then do a de-listing. In due course of time, they reappear in the market with a new  ‘IPO’ at fancy prices. This is perfectly legal too. 
  16. Capital allocation. I am particularly wary of promoters who ‘diworsify’ into unrelated businesses. They are using shareholder money to satisfy personal whims. The legal framework allows them to do what they want. Prior approval from ‘other’ shareholders is not required. They won’t even know what price was paid. In many companies, businesses are ‘split’ to accommodate family succession! These are not board-room decisions but dining table decisions!
  17. I also do not like where the promoter ‘pledges’ shares. My simple and naïve belief is that he needs to buy something. How will he repay the loan? Will he dip his hands into the till? Why not simply sell the shares? I also do not like to buy companies where promoter stake is below thirty percent. No reason, but a preference based on my personal bias. 

In bull markets like the current one, investors don’t look too much into management quality. They are happy to stick to promoters so long as the share price holds up. Even if a promoter makes headlines for poor governance, it does not bother anyone, least of all institutional investors. So, maybe I am like the dog barking at the moon. Each one thinks that the promoter is also interested in his share price and that interests are aligned. What is right and what is wrong is decided by the share price.

So, in the real world, it boils down to a collective call. Yes, if there is destruction of the business, the share price will be worth nothing. There are enough recent examples (Kingfisher, PC Jewellers and hundreds of vanished companies). However, when the governance issues at a company like Zee came up, no one made a rush to the door. 

As an investor, with my OWN money, I am afraid. I keep away. A missed opportunity is better than loss of principal.

I must also share with you a final example.  Remember Satyam? When the scandal was exposed, the share price collapsed to a virtual single digit number! There was a viable business that was probably worth more. There was no debt. It was an opportunity to take a calculated risk. At that point, no one knows how it would end.  The basic call was that the business value was more than the panic share price. This was a rare case. Today, what comes to the NCLT, I see that the shareholder has no hope because there is so much debt!

Ultimately, the management quality reflects in the cash left in the company. High debt is ALWAYS a worry. I find the movement in total debt as a good proxy for my call on the promoter.

At PrimeInvestor, management quality is one of the key aspects that we look into when making stock recommendations, which you can find at Prime Stocks.

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