Evaluating Management

Talk to any investment expert, growth or value or the ones that use blended approach, all would recommend that investors should look at the quality of the management. But how should one check the quality of management?

There are multiple ways of evaluating company management. Be it quantitatively or qualitative judgement. Experts tend to use a combination of these criteria to form their opinion on company management.

Qualitative aspect

Ravi Gopalakrishnan, Head Equities, Canara Robeco Mutual Fund looks at how well the capital was used by the management. He says, “The ability of the management to deploy capital efficiently based on past track record needs to be evaluated. For example periodic raising of capital from the market or unrelated capital expenditure for new ventures should raise red flags.” He doesn’t stop here, other variables he looks at are the quality of board, background of key management personnel, transparency and communication.

“Management quality is about evaluating intension of management. One way to check is whether management is overpromising and under delivering,” says Vinay Khattar, Head of Research at Edelweiss.

Parag Parikh, Director of Parag Parikh Financial Advisory Services (PPFAS) says, “We can observe a few things that can help gauge the quality of the management like the treatment of minority shareholders. If management also owns controlling stake in the company it is vital to see how the management is using the shareholder’s funds.” He also advises to check how the management has dealt with acquisitions in the past & try to understand the rationale behind them. 

“We can monitor management during lean times when the industry is under performing. That’s a good time to separate smart managements from the rest who will take advantage of the lean times to invest in new capacity for the expected upturn,” says Parikh.

So there is no one standard on the quality side either. But a number of items that investors should look at based on availability of information.

Quantitative aspect

“Consistent dividend track record of the company helps us evaluate the ability of the management to reward shareholders,” points Gopalakrishnan. Among the financial parameters which can be used to evaluate management quality are growth rates of the company and its margin compared to industry average across various business cycles. “Further, consistency of returns ratios such as ROE, ROA, and ROCE compared to Industry average across different business cycles also helps us in understanding the efficiency of use of capital by the management”, he says.

Meanwhile, Parikh adds to it by mentioning, that he also looks at working capital related metrics over a period of time, as it shows how the management constantly endeavours to avoid cash drain through good working capital management. He further adds that ratios that measure credit risk over a period of time tells, how comfortable the management is about borrowing money to fund growth. “All these metrics tracked over a period of time along with understanding the business operations can give us a fair idea about the management’s ability to run their business well,” he says.

Vivek Mahajan, Head fundamental Research, Aditya Birla Money believes that one can easily get the historical record of all the key parameters of the company performance (both financial and operational) during good as well as bad times. On top of that if the management is willing to share fair view on the company as well as industry and most important, is sharing key operational parameters of the company with investors then it is acceptable. “In case management is not able to disclose some data points, in view of competition, it is acceptable,” says Mahajan. 

Differentiating the management intention.

One of the most difficult part is to figure out when the management has unintentionally made a mistake, and when they were involved in poor decision making or they are making decisions with malicious intent. Since, the ability of management to identify the needs of the business in terms of capital requirements for new business opportunities or for expansion of existing capacity is an important criteria for evaluation.

Gopalkrishnan says, “If the intent of the management is to create a long term profitable organisation, management is likely to be more conservative / realistic in setting targets or goals for itself while red flags should be raised when the targeted goals are way beyond the industry norms.”

“Reporting false revenues, excessive related party transactions where the management owned entities benefit the most, issuing increase in salary despite underperforming business, issuing warrants to key management that allows them to purchase shares at below quoted market rate, making unnecessary purchases of trophy objects like helicopters / private jets with the company’s funds, using listed entity’s funds to create assets benefiting unlisted group companies, etc. These are ways that intentionally harm minority shareholders,” says Parikh.

He further adds that there may be instances where the management has taken to risk to back a particular business that did not turn out the way they anticipated for reasons beyond their control. “The distinguishing factor between wrong intent and bad luck is the amount of the business that was at stake,” he says.

Sharing his views, Mahajan adds, “Investors should get cautious, usually, when the top management gives indication of venturing into non-related business from the core business, without proper justification.” Key example can be the case of Satyam Computers. Satyam Computers, which was into the business of software development, was planning to venture into the infrastructure business. He adds, software and infrastructure business are totally unrelated businesses and has pole apart style of doing business. Later on, it was revealed, cash on book with Satyam Computers were fictitious and the company was trying to hide the same, by the way of acquisition of infrastructure company.

Giving another example, Mahajan says, “Crompton too was punished some four years back once they announced intention of acquiring a plane. They subsequently got rid of the same in within a year.”

Another important point to watch out for management intention is the changes in dividend policy, changes in accounting policy, etc. says Khattar of Edelweiss.

Is meeting management important?   

It is not possible for small investors to meet the management, even though many experts always point that one should meet the management to understand their intention. Gopalkrishnan believes that if management is not approachable for small investors, the management evaluation can be done through the process of channels through which they would normally communicate. For e.g. Attending Annual General Meetings would give perspective about the future course of management’s plans or alternatively through Annual Reports where management gives colour on the business environment.

Further, an analysis of the annual report might give some aspects of the management quality in terms of capital allocation, debt position, related party disclosures, etc.

Parikh further adds that, “If an investor cannot meet the management at all & yet wants to understand the business & the management quality then he/she should interact with customers of that business, suppliers to that business, dealers / distributors, competitors, etc. This can give a good idea about how the management treats these entities. It’s not fool-proof but adds another layer to our understanding about the management.” 

Arpinder Singh, Partner and National Leader, Fraud Investigation & Dispute Services, EY says, "Being sceptical is very important. For example if the accounts receivables is equal to a full year’s sales then it’s a clear red flag. Or growth has been nearly 100% in the last one year whereas for the last 10 years the company has been reporting only 15%. So the management will give a rosy picture so I would actually advice that go meet the customers and vendors."

This can further be supplemented by management interviews and quarterly conference call transcripts. By doing this an investor can a have good sense on the quality of the management, vision and the way management plans to execute.

It is not an easy work to assess the management of the company but nonetheless there are ways to assess them.

ELEMENT - 1

Quick guide: Qualitative Evaluation Management

1. Capital Efficiency –The ability of the management to deploy capital efficiently based on past track record needs to be evaluated.

1. Quality of Board – The composition of the board of directors in terms of independence, quality and experience of persons in the board determines the broad outlook for the company. 

1. Background of key management personnel – Further, the experience and track record of key management personnel in running the business also is a key determinant of management quality.

1. Ability to move up the value chain  - It is important to determine if the company has invested in backward and forward integration and thereby improved its operating efficiencies over time.

1. Ability to de-risk the business at all levels– The ability of the management to de-risk the business is also an important criteria. It is important to evaluate whether the company has been able to perform consistently compared to peers & industry during both, upturn as well as during the down turn in business cycles. Ability of the management to protect the business from uncertainties and global events also needs to be evaluated.

1. Transparency and communication – Finally, the extent of how transparent the company is in terms of sharing / communicating the information with the investors as well as to the public at large also helps in evaluating management quality.

1. Treatment of minority shareholders & upholding their rights:  – Check out the related party transactions within the promoter group. They inform which promoter group entity has benefited from transactions with the company.

ELEMENT - 2

Arpinder Singh, Partner and National Leader, Fraud Investigation & Dispute Services, EY, shares his views on what investors should look at in a private company. The same principles can also be employed in a public listed company.

Round tripping is where you create fictitious customers and vendors. To take an example, there is a company which shows 1,000 crore of sales to customers and also shows that supplies came from vendors which is also an exact amount of 1,000 crore. So the company management will show it was a no-profit and no-loss situation but it’s the red flag. In this the money just flows between customers and vendors who are all related parties and the balance sheet is inflated. If you look at most of the financial statement fraud that are reported in the newspaper is around this. So what we suggest is that rather than talking to management investors should always go and meet the top five customers and vendors.

Background check is very important. While investors have been doing it in India pre-investment, I believe investors should also do a background check post-investment in a company. By background check I mean see if the promoter has other businesses as well, not listed or having any connections with the current business? If there has been tax raid on this business or any other business? Is there any police case against him? Is the promoter black listed in the CIBIL or globally on something called world check?

I think post investment investors should also track the cash flow and not limit it to P/L and financial statement. How much money was put in and how is it being used every month. Usually many investors just invest and then they do not bother much for a year, till the next financial statement.

Being sceptical is very important. For example if the accounts receivables is equal to a full year’s sales then it’s a clear red flag. Or growth has been nearly 100% in the last one year whereas for the last 10 years the company has been reporting only 15%. So the management will give a rosy picture so I would actually advice that go meet the customers and vendors.

Also another important factor that investors should always ask, though the new companies act gives direction on whistle blowing policy, but investors should always also check this aspect of a company. The employees always get to know when something is wrong and they will also report it and making sure the mechanism is such that you as investor also gets to know about it.

One of the trends that we witness is that while major investors are hiring us for assessing the financial statement, they also request someone from the forensic team to look into key risk area to avoid major embarrassment in the future. For example in terms of excessive cash - are the bank statement correct or forged? Are the sales what the company is telling us? Is there any money being syphoned out to related parties?

With foreign investors we are noticing an interesting point, perhaps because of the UK Bribery Act of the Foreign Corrupt Practices Act, they are all checking if the company has been paying bribes to get the business, etc. They are making sure they do the bribery and corruption due diligence before investing. So they want to know if you have the right policies, are they heavily dependent on government businesses?

This is the submission draft. The actual story had appeared in August issue of Money Today. You can read the final version. Click here or copy paste the given below link - http://businesstoday.intoday.in/story/return-value-yearly-systematic-investment-plans-sip/1/209784.html