Guest Author: Dhruv Rathod
I really like the Nalanda way where Anand Sridharan sir says “Who am I backing here?”
I recently visited a famous restaurant chain and there was a lot of rush. The restaurant had 8-10 waiters but all of them were stuck in taking orders continuously. When I raised my hand and it went unnoticed by the waiters a man just walked up and started taking the order and, in a few minutes, the same man started serving the food as well. When I paid the bill on the counter I just asked “Do you work here” and he said “I am the owner sir”
The owner of such a remarkable restaurant chain serving and taking orders and when help is needed is also entering the kitchen. Seemed surprising but that hunger to grow and make the chain even bigger is driving him.
So, this shows that management or the business owner can make or break a business. There are multiple factors which need to be analyzed and some of those are covered in today’s blog 😊
There are two broad factors on which management should be judged. The first one is integrity and the second is competence. One without the other will not be of any use.
Let’s take two cases and understand things better.
Last year met a Pune-based startup. The founder was the most truthful founder I had met and he also took care of the employees very well he used to pay them on time he used to have long breaks so employees are comfortable they used to shut the production at 4.30 pm sharp and he used to never withdraw shareholders funds for personal use. In the end, we ended up saying we met a great man a very kind-hearted promoter but we can’t back him given he is not able to use the plant capacity well. Now the founder had all ticks in his integrity but the competence is something which wasn’t up to the mark.
Cut to a recent case that I came across. A listed Indian company that had been seeing great tailwinds and the numbers seemed to be attractive. When I did a deep dive, I came across a list of related party transactions where loans were given to related parties and weren’t paid back, forget the loans they didn’t even get back the interest on the loans and finally the loans were written off. Now this is a serious destruction of shareholder wealth. This is a case where competence had all boxed ticked but had integrity issues.
Now one must understand when we say a perfect world it’s all imagination so you need to see the intent behind the things and get an understanding so let’s discuss how to judge the intent and the management.
1. The showrunner – Before analyzing the management your first job should be to understand who is the showrunner or who takes all the decisions. Most people think that CEO runs the show but it’s not always how it looks like.
Case in reference – I recently met a startup founder who used to live in the neighborhood. The startup was in the business of 3D printing. When I asked him why you are the CEO of the company and why don’t go in offline mode like setting up a shop or something like that so his answer was that my father doesn’t allow the same. Now optically looks like the CEO is running the show but he is just a puppet.
2. Under promise over give– Many listed Indian companies make many promises. Some fulfill them and some do not. One must always look for the track record of the management team and understand whether are these the people you can trust when they make promises. A simple way is to check what management promised in the past and are those things fulfilled. You should analyze management behavior in bad times.
Case in reference – We all know about the “King of good times” but when it came to bad times he disappeared.
3. Qualifications say it all– It is very important to understand what is the background and education of the promoter and the management team. It is important that the management is educated or has experience in a related industry. Listen to the management team on whichever forum you can and understand the depth of their thoughts.
Case in reference – While analyzing a platform business, I heard the CFO on the conference call which happens every quarter. She took about 20 mins to explain a simple bookkeeping question and that was also not answered properly. Now she might be very well educated but these are situations where you need to stop for a moment and think.
4. If you pretend to pay they will pretend to work– Everyone wants to make the most amount of money. Until a person is not incentivized he or she won’t give their best efforts unless it’s a social cause. I remember while meeting various startups with people who were much senior in age and experience to me would have their first question to the promoter “How are you meeting your family expenses?” I was way naïve then to understand such questions. Now after analyzing a handful of businesses, I understand the importance of remuneration. One must always check remuneration relatively. You can compare it with peers and also compare the salary of the CEO with the CFO or CTO.
Case in reference – While analyzing a new age business with a PBT of 25 crores. I noticed that the CEO takes a salary of 4 crores (16% of PBT) and CFO takes 30 lakhs (1.2% of PBT) such a huge mismatch in salary so when I went deeper I got to know that CTO was paid 40 lakhs (1.6% of PBT) and most of the key employees were paid this.
Now there might be 3 reasons:
I. The team will not stick to serving the organization for a long time. As the remuneration seems low.
II. The team isn’t that well competent so they are okay with this remuneration
III. There is a possibility of cash transactions happening in the firm. (Typical Lala behavior)
5. Incentive to run– Always think that what is the promoter or management’s incentive to run the business. If the management has a more profitable business with higher interest, then one should take a step back and think that this can be a promoter who can be backed.
Case in reference – A promoter of a meat processing company has an entity that is owned by the promoter and it is much larger in size and more profitable than the listed entity. One more key thing to be understood here is the promoter has a 100% stake in the unlisted company and 52% in the listed company so any profit in the listed company would be shared but that’s not the case in the unlisted company.
6. Shortchanging minority shareholders– In a conversation someone said “Indian promoters and managements have different targets for themselves and different ones for their shareholders” We have come across many instances where promoters have bought company-owned subsidiaries for a cheap valuation or sold their company to the listed company at a euphoric value.
It has also been seen lots of times where promoters have given loans to their friend or relatives and that has never come back, forget the interest the principal also gets wiped out.
Case in reference – A promoter of a listed Indian company lent his friend an amount of 5 crores which was an interest-free debt. First of all, one should question why has this money been given out interest-free because this money also belongs to shareholders. Finally, after 2 years this loan gets written off and this is the silent looting of shareholder wealth.
7. Obsession with stock price– This is a point with which many people don’t agree. One should become slightly cautious when management speaks about stock prices more than the business itself. Now this doesn’t mean after reading a tweet or a comment by management you would just sell off the stake it’s a more softer aspect and helps you understand the promoter’s nature.
Case in reference – A promoter of a home development products-making company tweeted “Price of our stock is as strong as the built-in quality of our products”
8. Capital Allocation– One of the two factors which can kill a business is Capital misallocation. A simple way to keep a check on this is to check the inflows and outflows of a business. It is very essential that business invests in their own operations and its also important that they penetrate enough before they diversify.
Case in ref – There were two competitors in fluorochemicals and refrigerant gases. Company A was the leader and started to diversify into wind power and other entertainment businesses. While company B stayed focused and created the leading brand in the space. Today Company A isn’t the leader and has destroyed value for shareholders.
9. Leverage– Now one would invest in the business to bring growth but in initial years it is difficult to fund operations from internal accruals so businesses tend to go for debt or equity financing. There’s nothing wrong in taking debt or equity financing, till the time one does not over-leverage the balance sheet (Net debt to EBITDA less than 3).
I remember going to this retail chain with my father on Wednesdays (For their Maha Bachat offers on Wednesdays) Now, folks younger than me won’t be able to connect. The entire downfall of this retail chain happened due to the mentality of the Growth at any cost model where the promoter took heavy leverage for bringing growth.
10. Succession Planning– After a point, you get comfortable with a promoter but as he or she gets old there should be someone after them who can run the business as good as them or better than them. So one must understand who would run the show after the current showrunner walks off stage.
Case in reference – While analyzing a company we like everything about the business but we couldn’t get clarity on the next generation. The promoter had a single son who studied in Germany and settled there and had a shoe-making business there. He never showed any intention of coming back to India and the promoter was already 68 years old.
So concluding now, There would be a lot more angles one can actually look for which may not be mentioned here. One must always look at things together and understand the intent behind the activities of promoters and management. The biggest moat any business can have is a great management team.
Hope you found the blog helpful. See you next time, until then Happy investing! 🙂