Learn to evaluate management
Evaluating management is one of trickiest part while building an investment case. Especially, when it comes to small caps and mid cap companies run by first or second generation promoters, were much information about them in not available publicly.
Also many of retail investors don’t have privilege to meet management, time to attend AGMs and question management over quarterly conference calls (if they do). So how does one evaluate management ?
Well I don’t have a panacea but in this post we will try an establish a process which can give us reasonable ammunition to understand and evaluate management. As an investor you start with a hypothesis that management is honest, able, trustworthy and intelligent and then as you run a series of checks, you may find that one or more components you wished for are missing therefore at the end of checks you can take a call whether you want to partner with such management or not.
While there are numerous parameters which you can use to evaluate management quantitatively we believe below are good for a start
- Disclosure Norms
- Skin in the Game
- Regulatory compliance issues
- Walking the talk
Depth – While evaluating depth our primary focus is to understand who is running the show ? What is the organization structure at least 2 level below CEO / MD while many companies will not provide this info easily, Some companies present this info in their annual reports. See example from GRUH Finance’s Annual reports
If not management team at least all companies will report the composition of their BOD (Board of Directors) , Look up the linked in profile of independent and executive directors on board, go through resolution attached with previous 5-10 annual reports whenever a director is reappointmented a brief profile of him/her would be attached. A BOD which is diverse and knowledgeable often means the promoters will have wise counsel.
Most of small companies in India are run by boards stocked with family members, where independent directors would have little or no influence over board matters – take that with a pinch of salt as even industry stalwarts present in Satyam’s board were not able to figure out the ongoing fraud. Be enthused if you see good second rung leadership in company this would mean company can outlive it’s promoters.
Integrity – The dictionary meaning of Integrity is the quality of being honest and having strong moral principles. By reading the definition you would have figured out that it is very difficult for someone sitting outside to judge integrity. Therefore to evaluate – look at how management is transacting and are who is benefiting from those transactions.
Ascertain if management and /or relatives have entered into any materially significant related party transactions with the company, cause that may have a potential conflict of interest for the company at large. It is mandatory for companies to disclose related party transactions in annual reports. You can also use Tofler to know about related parties, See below example of The Byke Hospitality Limited
Pay close attention to special resolutions were management is granted warrants to increase their shareholding in company, some times these warrants are issued for right reasons as company might be in trouble and it is relying on promoters to bring cash on table. But often they are issued by promoters to increase their stake at cost of minority shareholders See below an example from Control print
Finally look for auditor’s qualification in annual reports and go through at least last 7-8 annual reports to see if things are consistently violated, As an example see below from 2014-15 annual report of MIC electronics
Disclosure Norms – Companies disclose information to it’s shareholders through
a. Annual reports (Mandatory)
b. Notification of key developments to stock exchange (Mandatory)
c. Investor presentation / Business overviews / Informative websites – Optional
Management can choose to make critical business information available to shareholders in timely and transparent manner, if it does it we rate management very highly. It is not surprising that many key developments of companies come to a minority shareholder through media and not via notification to stock exchanges. I have found that management which has things to hide will find a reason to cheat you as well.
Compensation – This is really a double edge sword, While you expect management to be compensated well for a job done, what you don’t want it to see is a management getting benefited on expense of minority shareholders. A compensation structure where variable is linked to performance of company will suit minority shareholders.
Watch out for dilutive warrants, excessive stock options to senior management. Always compare how management is compensated when compared to industry peers. The other check is to see how company is compensating it’s employees, to evaluate if its fair or not when compared to management.
Skin in the Game – Management should have skin in the game, There fortunes should be tied to fate the company and that will only happen management owns a significant percentage of equity of the company. All companies report promoter holding on a quarterly basis, see below example of The Byke Hospitality Ltd for FY15 Q4
Also pay special attention to pledged shares, No point in holding significant portion of the company when 90% of that holding is pledged. See this note from this article on perils of pledging
In situations where the proportion of promoter holding pledged is high, a correction in stock prices can trigger margin calls which could lead to more pledging. If the share prices fall below a threshold limit and the promoter doesn’t have additional shares to offer as margin or funds to repay the loan taken, the lender might invoke the shares, leading to a further fall in stock price. There have been cases in the past wherein lenders have invoked the shares and sold them in the market as promoters were unable to pay up on time.
Promoters also risk losing management control if a significant portion of their holding is pledged. “Lenders are price-agnostic and will dump the shares at any available price as they are only interested in recovering their money,”. For the investor, it means significant losses.
Regulatory compliance issues – Just google promoters and name of the company + SEBI strictures /IT raids, BSE/NSE bans /Penalties imposed / environmental issues. Study the results, if you find things which raises red flags write to management and seek their position, Partnering with crooks will not give opportunity to create sustainable wealth. While finishing this post, I saw a fantastic twitter post from Prof Sanjay Bakshi on moral maturity
Walking the talk – is testing on how management has stuck to its stated objectives, is it really planning two steps ahead of the competition and whether it has delivered on commitments. I have found Anil Tulsiram’s work very inspiring on how he traces management walking the talk through Annual reports, you can read them here
My approach is pretty similar, I like to go back 8-10 years and see how management is living up-to it’s commitments, Download the preparatory note I used for my research note on The Byke Hospitality Limited.
All said and done evaluating management is tough, Let us in know comments how you evaluate management.