When we started investing around a decade back, markets were on a dope. Steel strip suppliers wanted the valuation of telecom tower companies and bold cross-border acquisition plans were fancied by investors. Most of the corporate governance checklists were thrown out of the window to strike a deal.
Then came 2008, and the standing orders were to not close any deal, question everything from promoters salary to his/her personal P&L. Needless to say that either ways were extreme.
Zoom out a decade, the frameworks have become more rational and “test the intent than the action”. Getting answer to two questions is most important during our diligence:
Is the promoter’s wealth creation aligned with mine, or has his wealth creation already happened, or will happen through the leaks in the company?
Is the company’s best days behind it or in the future? If the best days are behind, it creates adverse incentives to stick and defend the legacy.
As secondary investors we cannot influence anything but can pick up breadcrumbs of the promoter’s behavior. This is where the most difficult, subjective and interesting part kicks in. Its a mix of analytics and diligence outside the business.
Will cover both the analytics and subjective part with relevant cases, obviously with no names.
“Less salary is bad news”
Look for Promoter’s salary as a % of overall PAT. While Company’s acts best cap is 10% of PAT, the calculation is more wholistic and subjective. We have come to learn the “less is bad”. A promoter who discloses and takes a flat high remuneration, is far better than the one who draws less and then finds ways to create leakages in the company. Leakages are in the form of movable assets, related party businesses, inducting more than reqd. family members, entering new businesses that match promoter’s lifestyle.
Same applies to the salaries of the Key management. Less is bad. I remember this from an apparel portfolio company. The salary on the books for two business heads was low. We were invited to a new store launch and to my surprise saw them both getting out of their own BMWs. When we asked the promoter in a casual manner, how nice their cars were, the promoter in a sheepish manner, mentioned “They work hard, have given them cars to rest well on the way back!!”. We didn’t know how to respond!! Needless to say, that company and promoter was a big CG fraud!! Everything on the BS was cooked up.
“Speak with the Auditor if you can”
Not a big fan of Big 4 or Big 10 in the Indian context. But questioning something like: how can an auditor audit a 1000 cr + topline company in 7 L of fee, is critical. Sometimes, it just doesn’t add up. This is a huge problem we grapple with Pharma, Building Material and Consumer Durables Companies. Auditor’s salary just doesn’t add up. How can one audit a multi location plant, sales, distribution set up having a 1500 cr plus topline in less than 25 L !! Not saying these company’s are bad, but one needs to find ways to get comfort that they are professionally managed. Same is the problem with some traditional sectors like building materials, consumer durables.
Speaking with auditors or someone in the team is a good to have. We remember speaking with the auditor of a leading bags company. We had called them up to get a meeting with the promoters. To our surprise, the lady on the other side told us, “Why are you wasting your time, they are going be busy in a sales tax fraud” !! The company was imitating complete assembly of bags in a tax free zone. The only assembly step that was however happening in the tax free zone was sticking of handles!! :)
Having a good CA network helps. They know the personal reputation of some of the business groups that we sometimes do not have access to. One company I remember thorough this interaction was a leading home/kitchenware company. The CA whom we were using for leads, insisted that we meet this promoter group as they are very conservative/fair in their business dealings. Not sure how aggressive they were, but were good people to meet. We ended up liking the promoter group for their sharp focused and long term approach to the business. Needless to say, the company is a multi-bagger in last 5 years.
“How distracted is the founder”
We started this as an informal exercise. But soon realized that this is core. What we are digging for is “How distracted is the founder”. Will not delve into specifics as it is a very subjective point. We use this for elimination, than for selection. But can tell you, this helped me knowing that the MD of a leading durables company was contesting for Lok Sabha elections. Or the MD of a leading men apparel brand was more bothered about his sports and snow cars than how he plans to turnaround/grow his business in the next 5 years. Or the MD of a mediocre ceramic tiles company was a close buddy and had similar habits as of one of the promotes mentioned above. It’s important to gather these breadcrumbs to know where Promoter’s attention is.
Its also important to speak with industry experts or competitor top managements to know what they like about the promoters. We were evaluating an upcoming wellness company and spoke with a competitor. The competitor highlighted the headwinds in the sector and how they were diversifying. When we asked the same question to the company we were evaluating, we got arrogant answers around market share and half baked answers of selling their products through mobile app. As if mobile apps were a magic wand that could sell anything!! Needless to say, the company we were evaluating, could not make the shift. Its at the same market cap as it as 5 years back.
“Look for events of shareholder wealth creation”
This is a litmus test that is above all. Prior behavior of founders to distribute cash reserves, not dilute minority shareholders, high dividend payout, not participate in buybacks, and no event of a pref allotment are all very strong indicators of a good governance. Another event to measure the same is the terms of merger of a group entity. Have never liked promoters who merge/de-merge group entities too often. If done too often, its usually good only for founders.
Also, a promoter who pledges his stake for equity infusion in another business is a big no. Usually such companies, are not left with much juice and your wealth creation (already a low prob) is not aligned with that of the Promoters. No matter how good their business is, this is an absolute no.
Have been in some promoter meeting where after the usual Business Q&A is over, promoters ask so what do you find interesting to invest in public markets. That’s a slippery slope, I love this question as a bait. Needless to say, Promoters who find some other stock more interesting than theirs, need a double check.
Another bait is to ask, if you were to raise [YY] cr of primary capital, what would you wanna do with it. Good ones, do not need me or my money, whereas the bad ones have interesting answers: own more stores, get a brand ambassador (most usual), go online (easy right !!). Best companies (even including banks) are non-dilutive. They don’t need us or our money. Promoters who are not keen in our money or chivalry, are good.
“Look for volatile changes in the Current assets and liabilities in the balance sheet”
Most of the current account are sticky and don’t have huge swings. If you these accounts changing too often quarterly or half-yearly, dig deeper. Ask the management on the reason. Have seen good managements change their accounting policy during bad times. Best to assume anything transferred from short term to long term is lost. Again, a leading B2B company had a great execution track record. But when projects started getting delayed, the receivables and loans/advances started moving from current account to long term account. While the cosmetics of it looked good, on the overall basis, the accounts were swelling and so were losses.
Also, ask simple questions such as, how do you write off your inventory. Or if you have sent 10 types of suits, how many do you expect will sell and what do you do with the balance. For some consumer companies (mainly apparel) PAT and EBITDA are an outcome of how they value their inventory, so is completely subjective.
“Try to get as close to the answer to why is he doing this?”
Have been surprised, that the root cause has been often a very simple urge. Sometimes it is linked to social status with peers, sometimes it is a better lifestyle and sometimes just the urge to be the decision maker than being an employee.
The answers are not that difficult to justify for a first-generation founders. Things become complex for second and third gen founders (something u find a lot in public companies). A good reason sometimes is that the next gen cannot run the business the same way as his pop has run. Hence, he changes the shape/form of the company to make it more modern. We have also seen, some well educated promoters taking time to assess whether he/she is interested in taking the baton.
What we think is a clear red flag here is lack of education, or mediocre education, and a sense of entitlement. Next gen Promoters are often advised well to not commit silly mistakes, what they however need time for is to know how they want to express themselves. Groups such as Eicher Motors, Blue Star, Birla have done a phenomenal job of grooming their next level of leaders.
As per us, its ok that a promoter is not articulate or sure about the answer to this, as long as he has the humility to explain his own thoughts and is at it, it works well in the longer term.
“Is a company’s best days behind it or in the future?”
While the answer to this question is party summed up above, it always helps to know from a founder, what led to the success in last 3–5 years. Replicability is a function of inputs not externalities. Good managements attribute success to both internal inputs and external factors which are non-replicable. So they discuss the future with a word of caution or just focus on the inputs. Success is often a function of both inputs and tailwinds in the sector. Only schmucks can predict or pretend to predict the next tailwind. We are wary of founders who define future in terms of valuation, sales growth or market share.
