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Monday, July 23, 2018

Lies,damned lies…

In the aftermath of the Satyam episode (Satyam Computer’s chairman and promoter B Ramalinga Raju admitted to having cooked the books and shown inflated earnings for years)...

Written by Sanjay Kr Singh | Published: January 19, 2009 12:53:06 am

In the aftermath of the Satyam episode (Satyam Computer’s chairman and promoter B Ramalinga Raju admitted to having cooked the books and shown inflated earnings for years),a lot of doubt has arisen about the numbers put out by Indian corporates. The man on the street today feels that while one Raju is in the dragnet,many others are still at large. And if auditors and regulators failed to check irregularities at one of India’s top IT companies,how much faith can one have in the numbers put out by smaller companies?

Moreover,if the numbers put out by corporates are suspect,then the entire enterprise of stock investing — predicting earnings growth and investing in companies whose earnings are expected to beat the market average — rests on very shaky ground.

As the dust settles on this episode,no doubt accounting norms are likely to be tightened,and oversight of auditors is likely to increase. Meanwhile,what lessons does the Satyam episode hold for lay investors? How can they avoid getting their fingers burnt due to investments in stocks of crooked companies?

Have no truck with cheats. One of Warren Buffett’s basic criteria for investment is that he does not invest in companies whose promoters and managers’ integrity is not entirely above doubt. To quote Buffett: “We do not wish to join with managers who lack admirable qualities no matter how attractive the prospects of their business. We have never succeeded in making a good deal with a bad person.” Make this your guiding principle as well.

As the Satyam episode demonstrates,when the wrongdoings of unethical promoters and managers come to light,investors dump their shares. If you don’t want the value of your investments to evaporate overnight,steer clear of companies about which there is even a whiff of suspicion.

Do the numbers keep changing? In a recent study,Clear Capital,a subsidiary of Noble group (a global equities research firm),found significant deviations between the unaudited quarterly numbers and the audited annual figures of as many as one-fifth of companies in the BSE 500. If such deviations and restatement of accounts happen frequently in the case of a company in which you have invested,head for the exit.

How candid is the annual report? To begin with,read Berkshire Hathaway’s annual reports and the chairman’s letters to shareholders. These are legendary for their level of candour. Instead of talking only about his successes,Buffett also talks forthrightly about his failures and missteps. With these letters as your benchmark,read the annual reports of the companies you wish to invest in. You will soon have an idea of the level of forthrightness you can expect from the management. The more reports you read,the better you will get at evaluating management quality. Says Pune-based financial planner Veer Sardesai: “We don’t want annual reports that are full of jargon and are meant to confuse investors. They should present a picture of what is happening in a clear and simple manner. If the language in the annual report is such that you cannot understand it,or the company has hundreds of subsidiaries so that you are not able to understand where the money is coming from and where it is going,stay away from such companies.”

Level and quality of communication. The level and quality of communication of management at a time of crisis or difficulty also tells a lot. Bad management is forthcoming when the going is good,but barricades itself behind a wall of PR and corporate communication staff when things are not going well. Good-quality management,on the other hand,has a transparent attitude in such times.

Take the example of Wipro Technologies. After the World Bank announced it was banning Wipro from its projects,the company’s top management made itself available for interviews with the media,answered tough questions,and explained its side of the story. The chairman,too,wrote a letter to the staff. Judging by how they faced the crisis,it is doubtful if charges of malfeasance against the company will stick.

Are you adequately clued in? Closely track the actions of management and try to understand their ramifications. When Ramalinga Raju announced a completely unrelated acquisition of companies that were into real estate and infrastructure and owned by his family members (a move that was in sharp contrast to rival HCL’s more focused acquisition of Axon),professional investors sensed that something was amiss and offloaded its stock. If you were properly clued in and were able to understand the implications of the move,you too would have jumped ship in time. If you did not,it says something about your monitoring abilities,or rather the lack of it. Perhaps you ought to leave the task of investing to professionals,or just go with index funds.

Remain in touch with the ecosystem. If the numbers lie,you could adopt an alternative approach,which is to do more rigorous qualitative research into the companies you invest in. The premise behind such research is that if a management cheats its shareholders,similar behaviour will spill over into its conduct with other stakeholders,such as employees,customers,suppliers,and competitors. Feedback from the ecosystem could provide you with an early warning.

Aspects you should look into

Labour relations. Are labour relations healthy or does the company face frequent strikes? Do employees feel they are treated with dignity? How fair is the company in the matter of wage revisions? Or does the management use the first sign of a downturn to lay off employees?

Relationship with executives. Speak to a few middle-rung and young executives. Do they feel that promotions are based on merit or on factionalism? If there is a sense of hopelessness and a feeling that hard work and talent go unrewarded,steer clear.

Suppliers. Is the company interested in promoting long-term ties with its vendors,or is it just interested in driving a hard bargain and squeezing them for all they are worth?

According to Sardesai,“Enquiring into these aspects is very important. It is unlikely that a company that treats its employees badly will be fair to its shareholders. Being in touch with suppliers will enable you to know whether suppliers are competitively selected or on their willingness to pay kickbacks to promoters.”

Attitude towards customers. Does the company react with alacrity to solve customer complaints? Or does it delay and harass?

Competition. What better source to know about a rival company’s shortcomings? At the same time,treat words of praise from a competitor as worth its weight in gold.

Uma Shashikant,managing director,Centre for Investment Education and Learning agrees. “What the Satyam episode has exposed is the penchant among investors,both institutional and retail,to chase momentum. If a large number of people buy a stock at higher and higher prices,everyone feels that the company must be good. Someone must have done the homework — goes the thinking. Little wonder everyone seems to have been collectively wrong.”

Shashikant emphasises that to invest in equity is to invest in a company,and getting to know a company takes time and effort. “We still do not have a widespread and respected culture of informed investing. We continue to covet traders and speculators. Warren Buffet remains the model for very few. We obsess about price and refuse to spend time on understanding the factors that lie beneath. This is why companies spend time and energy creating a network of subsidiaries,funding brokers,and fostering networks that spread favourable tips,and actively engage in trading their own stock through dubious means.”

Clearly,if there is one lesson that the Satyam episode has taught,it is that investors must get to know the stocks they invest in quite intimately. Since doing this takes quite a lot of time and effort,you need to change your approach towards investing. Instead of flirting with a hundred stocks,invest in just a few — barely a score — so that you can track them closely. If you know your stock well,it is unlikely that unsavoury practices by its management or promoter will catch you offguard. u

Games promoters play

What are some of the devices promoters employ to siphon off money from listed companies? And what are some of the warning signals that the company’s management puts its own interests before that of investors?

Salaries and perquisites of the promoter and his family members,or stock options,far in excess of the norms for that industry,or the worth of services performed.

Own properties that they sell or rent to the corporation at above-market rates.

When the company purchases supplies,the company pays a higher price to the supplier,and the supplier pays a kickback to the promoter. Suppliers are not competitively selected; contracts are given out instead to relatives.

Often sales are channelled through broking companies owned by family members that take a percentage but provide little value in return.

Promoters claim they need money for smoothening bureaucratic hurdles. So every time a deal is done,a certain proportion is paid in cash to the promoters who line their own pockets.

Unnecessary expenses of management. When the group is large,it is okay if the promoters buy a corporate jet (if the cost of the jet is small compared to the firm’s revenues). But a lot of times promoters of mid-sized companies buy them. Does it have any utility,or is it an exercise in building up the promoter’s image at the shareholder’s expense?

Did you know?

Since news of the Satyam scandal broke,a new terminology — forensic accounting — has entered our lexicon. A forensic accountant combines the skills of an accountant,auditor and an investigator and tries to detect instances of accounting fraud. Post Satyam,the demand for such accountants is said to have increased at the research divisions of mutual funds and broking houses.

Hall of shame

A few examples from the western world of how companies have in the past massaged their numbers:

In 2001,Enron and Qwest needed to boost their revenue and profit figures and hit upon an ingenious scheme. They swapped optic fibre network capacity and recorded these as sales. The questions: when Qwest already had an excess of capacity,why did it need to buy more? And given the existing capacity glut,how could they justify transactions at such high prices?

The most common trick is to register sales that have yet to occur. In the past,Motorola,Lucent and Nortel have all boosted sales by lending large amounts to customers. Many of these accounts later became uncollectible and were written off.

Xerox,in one instance,boosted its earnings by allowing its Latin American,Canadian and European units to book as one-time revenue all the cash that would be paid over several years for copier leases.

Several airlines reported sales but didn’t report the rebates given to make those sales.

Source: “A Random Walk Down Wall Street” ,By Burton G Malkiel

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