Companies with good goverance are for safe investment

Management quality is a function of ethics and governance. Someone asked me how important are these two attributes? If we go by ‘ equity research’ reports, it has absolutely no importance. No report comments on the quality of the management, preferring to be diplomatic or practical, since most sell side firms need some business in banking or equities to come their way. Equity research as a function has never made money on its own. It is like the appendix in the human body.

Of course, it comes in to play when we want to acquire a company or take a significant stake in a company. Then we will all perhaps spend a lot of time figuring out who the owner is and what are his strengths and weaknesses. Sometimes, I see large institutional investors taking significant stakes in companies where the management quality is known to be suspect. I can only infer that it is perhaps a reflection on the quality of the investor also. Institutional investors are managed by people who get salaries and bonuses and they are not investing their own money. Most of us seem to think that it will not impact the investment.

The one thing working in favour of the investors is that most often, the businessman is also interested in maintaining a perennially north- bound share price and hence our interests are aligned. In the old days, when salaries of directors were restricted to a few thousands, there we no ESOPs or ‘ preferential allotments’ or ‘ warrants’, the story was different. Also, the interest rates used to be high and our markets were small. Stocks never got such fancy valuations as what exist today. So, the promoter found it useful to take money away and leave just enough for the shareholders.

Of course, no one is immune to a structured fraud. That can happen to catch the best of investors unaware. Satyam Computers was one. Of course, the investors got lucky there since there was a motivated attempt to rescue the company in order to bail out a select few. However, I do not see the same things happening in a Gitanjali Gems.

However, one way to keep ourselves safe is to avoid companies with high debt, unusual amounts of cash in hand combined with low dividend payouts, continuous raising of capital, constant mergers and acquisitions, having hundreds of subsidiaries, having too many associate companies, etc. Avoid in general companies where ‘ revenues’ are based on some funny accounting or on ‘ certification’ by management rather than plainly visible ones.

Have a look at the schedule of fixed assets ( nowadays referred to as ‘ noncurrent assets) and look at what is happening there. Is there too much of fictitious assets like goodwill? Is too much invested in real estate? Too much goodwill? All of these are just warning signs and call for deeper probe rather than just ignoring or accepting.

Other thing that has helped me is to have a binary classification for valuation companies that have brands or consumer products to be valued on basis of revenue. Companies that deal in commodities etc to be valued by Balance Sheet. In essence, I find out what the company can make and how much of assets are needed. Then compare it with the “enterprise value” ( enterprise value is the sum of market capitalisation plus debt). That helps me to buy when the industry is doing badly and sell when it is doing well. Of course, the approach is simplistic, but a great start point. The writer is a veteran investment advisor. He can be reached at balakrishnanr@ gmail. com