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Monday, September 12, 2016

How to gauge management quality and integrity in India

There is a lot of articles on this but mostly in the western context. I thought to write a brief note on what I do to evaluate Indian companies
  1. What they say about themselves
    1. MD&A: There will obviously be puffery and exaggeration but do they take a balanced view and try to highlight risks/issues? Or do they just take credit in the good years and blame external factors in the bad years 
    2. AGM Q&A: Do they address all questions including critical questions?
    3. Conference Calls: How is the behaviour and confidence on the con-calls?
    4. Investor Presentations: Is the presentation balanced?
  2. What others say about them
    1. Scuttlebutt What do competitions,employees, channel partners, suppliers and regulators say about them? Are there serious quality or safety concerns? 
    2. Media(Incl interviews): What does the media say? Does this seem paid media/hagiography or an objective look?
  3. Public records
    1. Are they listed as defaulters or have criminal cases been filed? Have they/related entities defaulted on debt to banks, or has case been filed against them in personal capacity(eg murder-this is a real case against the MD of a listed infra co in maharashtra)
  4. How did they behave during adverse times
    1. Did they convert preferential issue warrants at above market prices? Or did they allow it to lapse: Before SEBI made it mandatory for preferential allotment to require a minimum 25% upfront non refundable advance, promoters used the warrants as a free 18month call option! While 25% is low, it is still enough of a deterrent for opportunistic investors. When the regulations were lax, did the promoters allow the warrant to lapse
    2. Did the company cease all non mandatory investor relations activity: Some companies in 'bad times'(when they make losses/stock price collapses) stop updating IR presentations or maintaining the site. If possible, ask a veteran investor in the stock if the company did like this. 
  5. Ownership/Shareholding pattern
    1. How much is purchased vs acquired via mergers into listed company, ESOPs etc: Have the ownership stake increased via merger of unlisted entities into the listed companies at valuations blessed by a pet merchant banker, in the era before this required majority votes from non interested shareholders
    2. How much is insider trading-and is this buy/sell? Do the promoters trade frequently in their sales? How much pledged and do they usually buy or sell>  
  6. How are their incentives aligned with yours
    1. Management compensation linkage with company profit: Do the promoters primarily link remuneration to profit or clearly defined KPIs
    2. Do the management take a pay cut/NIL pay when company starts defaulting/making losses?
    3. Related party transactions- red flags: Is a high extent of expense/sales from related parties? 
    4. Other related entities/business group: If having outside business interests or part of vertically integrated group, how aligned are the interests of the listed and non listed entities
    5. Minority shareholders Squeezeout: Have they squeezed out minority shareholders ever earlier(supposedly this was done by Godrej also one).
  7. Professional Management
    1. How much are the KMPs paid? Are the KMPs paid at the maximum possible limit? How reasonable is the compensation given industry salary levels?
    2. How much is the compensation growth of promoters vs others? Do promoters take a hike when everyone else is flat
    3. Are the 2nd generation promoters catapulted into high levels at remunerations greater than market levels? Is the 'usually foreign educated' son/daughter made a VP/AVP at levels greater than IIM/HBS alumni? This indicates undue favouritism. 

A guide to industry analysis for fundamental investors in India

·          Some points which struck me recently while listening to a friend: 

o    Industry Specific: Wherever there are specific statutes or regulators for an industry, understanding this is essential as also the dynamics. Some regulators are even handed(eg telecom, natural gas) while others leave much to be desired. Is there any possibility that your industry will be on the wrong side of these rulings Foreign regulation also matters as in FDA inspection of factories
o    Competition Law: Some industries like cement, tyres, shipping etc are perceived to be cartelistic, and therefore at risk of penalties from the Competition Commission.
o    Export/Import related-There have been export bans and/or pricing floors imposed on various commodities such as basmati rice, onions, sugar, iron ore.  Similarly, import tariffs have been raised on commodities supposedly dumped from China such as tiles, steel. Having an idea of the trade policy and the lobbying power of the industries(suppliers vs importers)
·          Banking/Finance regulations:
o    Foreign investment: Wherever there are foreign investments limits on shareholding and sectors and these are eased, the demand pool goes up therefore helping the stock price. Examples are industries where FDI limit raised from 49% to 75% or even to 100%-the stock prices goes up anticipating higher demand from FIIs/FPIs
o    Prudential Norm/Banking Regulation: When it becomes difficult for certain industries to raise more funds(say real estate, gems) from banks, they need to tap the bond market or expensive sources, and hence the stock price might fall. Same holds for regulations affecting troubled loan resolution(eg CDR, SARFAESI).
·          Taxation          
o    Indirect- some industries face ‘sin taxes’ such as tobacco, alcohol. This is a real risk for those companies
o    Direct-some benefit from tax holidays or weighted deductions on research, while some are tax free(eg SEZs, agriculture).
·          Customers
o    Pull vs Push: Is there a lockin of revenues or orders as evident via customer contracts and cash/carry, or is it a push driven credit dependent business
o    B2B or B2C: Is the company largely in B2B or B2C? If B2B, expect the margins to be lower unless it is a hidden champion. Just ask insurers who suffer from losses in group health insurance but who still continue it for revenues
o    ‘Sophistication’: Are the customers aware or do they think they are aware of the business? People may not understand paints or hardware (one reason why hardware shops mint money), but they ‘get’ FMCG and hence may not continue brands.
o    Value Migration: Is there a demographic migration from basic to luxury? Or do people migrate from products(eg scooters to bikes)? Implications
·          Competition/Industry
o    Market share of top few players: If the HHI index is below 50 or if the top few players do not exceed 50%, there is a sign of unorganized sector
o    Profit pool of industry and trends: Is the industry overall profitable or loss making(like airlines, ecommerce)? How has this trend changed in the last few periods?
o    Ecommerce/Online Impact: Is ecommerce favourable(say +ve for logistics, packaging, impulse purchases, advertising but –ve for brick and mortar)? Is there any industry where competitive advantage is negated via ecommerce distribution network access(eg ability to launch smartphones without dealer network, this has hit Samsung/Nokia/Apple)
o    Growth and import competition:  Is there a China threat? Are they getting bulk of the incremental demand(eg replacement tyres growth eaten up by China market)
o    Demand supply gap-presently and 5yrs: Do you have visibility on new capacities? Can  there be a scenario where the industry becomes surplus in capacity domestically or globally due to undergoing investments?
·          Suppliers:
o    Where the key suppliers are organized or have pricing power, expect your profits to be squeezed. Ask any customer of petrochemical firms in India
o    Statutory regulation on terms of trade-Whether it be quantity allocation(like natural gas priority allocation to power and fertilizers), price controls(coal, railway) or any statutory restriction on terms of trade, this has an impact.

Why you should not be glued to the market/watch ticker all the time

Day trading is not for everyone. An article I read recently explains it in great depth below(reproducing the whole article as it is simply too good!). For those with the FOMO(Fear of missing out) yet considering trading as a 2nd day job, they can get heart from this article.

  • Restraining oneself from watching the market until decision making time can help reduce anxiety and indecision issues. Having the discipline to stay relaxed until the necessary decision time (i.e. when the bar on your chart is about to be completed and that a new bar is about to be formed) is great but not everyone can do that.
  •  Once you glue yourself to the screen monitoring every tick, you mind cannot control itself in response to the changes in the chart. It is especially true when you have a position on. Your mind is working hard to make sense out of the information every second. You are practically setting yourself up to burn your brain out.
  •  Not everyone can analyze a fluid situation dynamically like the chess grandmasters do. Reduce the decision making process to very specific conditions and shut out the rest. After all, you are not playing chess. You are not required to compete in trading from start to finish. You can pick the battle you know you have better chance to win. Do not even look at the markets when the prescribed conditions are not showing. That will limit your mind from random thoughts messing up your decision making process.
  •  Some people are capable of highly concentrated real-time processing. But such talent has its limitations. Even if you are physically fit, using mental strength in highly concentrated ways every day will burn the brain out very quickly. This is what happen to many day traders working for trading firms as they are pushed to perform. It is not a good idea if you are planning to make day trading your career.
The solution is to utilize the talent by trading within a very short time window every day (e.g. just the first 10 minutes from stock market open). This allows the trader to fully focus within that short period of time making analysis and decisions on every tick. The rest of the day the trader can do other productive things. Most important of all, the trader is giving the brain time to recover so that long term performance is not jeopardized.