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Notes of WCS - May2020
Notes of WCS - May2020
Contents
WCS 2015 – Mid to Mega ........................................................................................................................ 4
1. Summary ................................................................................................................................................................... 4
2. Introduction .............................................................................................................................................................. 5
3. What is Mid-to-Mega ................................................................................................................................................ 5
4. Why Mid to Mega?.................................................................................................................................................... 6
4.1 Performance profile of Mid-to-Mega portfolios .................................................................................................................. 6
4.2 Specific examples of Mid-to-Mega....................................................................................................................................... 7
4.3 Matrix of three cross overs and associated probabilities .................................................................................................... 7
5. What is takes to achieve Mid-to-Mega? ................................................................................................................. 10
5.1 M – Mid-size ....................................................................................................................................................................... 10
5.2 Q – Quality ......................................................................................................................................................................... 11
5.2.1 Quality of business ...........................................................................................................................................................................11
5.2.2 Quality of Management ...................................................................................................................................................................13
5.3 G – Growth ......................................................................................................................................................................... 13
5.3.1 Importance of growth ......................................................................................................................................................................15
5.3.2 High-growth situations.....................................................................................................................................................................15
5.3.4 Sustained sector tailwind .................................................................................................................................................................15
5.3.5 Small base with large opportunity ...................................................................................................................................................15
5.3.6 New large investment getting commissioned ..................................................................................................................................16
5.3.7 Inorganic growth through M&A .......................................................................................................................................................16
5.3.8 Consolidation of competition ...........................................................................................................................................................16
5.3.9 Operating & Financial leverage ........................................................................................................................................................16
5.3.10 Turnaround from loss to profit .......................................................................................................................................................16
5.4 L - Longevity ....................................................................................................................................................................... 16
5.4.1 Extending CAP ..................................................................................................................................................................................16
5.4.2 Delaying mean reversion of growth rate ..........................................................................................................................................17
5.5 P – Price .............................................................................................................................................................................. 17
6. How to shortlist potential Mid-to-Mega stocks ...................................................................................................... 18
7. Mega to Mid ............................................................................................................................................................ 19
7.1 Why Mega-to Mid happens? .............................................................................................................................................. 19
7.2 Key takeaways from Mega-to-Mid ..................................................................................................................................... 20
WCS 2016 – FOCUSED INVESTING – POWER OF ALLOCATION IN WEALTH CREATION ............................. 20
1. Backdrop ................................................................................................................................................................. 21
2. Kelly’s Formula – Insights for Equity Investing........................................................................................................ 22
2.1 Kelly’s for Equities – Meaning is more relevant than Mathematics .................................................................................. 22
2.1.1 Insight #1: Look of Asymmetric Payoff .............................................................................................................................................23
2.1.2 Insight #2: Create an edge ...............................................................................................................................................................24
2.1.3 Insight #3: Big Bet ............................................................................................................................................................................24
3. Focused Investing .................................................................................................................................................... 25
3.1 Diversified Investing ........................................................................................................................................................... 25
3.2 Concentrated Investing ...................................................................................................................................................... 25
3.3 Diversified/Concentrated Investing and Nature of Capital ................................................................................................ 26
3.4 Focused Investing – Golden Mean ..................................................................................................................................... 26
4. Four Keys to Successful ........................................................................................................................................... 26
4.1 Clear portfolio goal ............................................................................................................................................................ 26
4.2 Superior Stock Selection – QGLP ........................................................................................................................................ 27
4.2.1 Quality of Business and Management..............................................................................................................................................27
4.2.2 Growth in Earnings ...........................................................................................................................................................................27
4.2.3 Longevity of Quality and Growth .....................................................................................................................................................27
1. Summary
1.1 Definitions
Mega: Top 100 stocks, Mid: Next 200 and Mini: rest
1.2 What is Mid to Mega?
• A company rising over Mid ranks (101 – 300) to Mega (<100) ranks.
Notes of Wealth Creation Studies Page 4 of 90
• This cross over is significant for any company in achieving critical mass and scale of its operations,
and recognition of the same by the stock market
1.3 Why Mid to Mega?
• Industry Leadership: The most striking feature of this study is key role of industry leadership in the
pecking order of Market cap ranks.
• Among the top 100 companies, 88 are leaders in their respective industries
• Even among companies that moved from Mid to Mega, 70% of them are industry leaders
1.5 Mid to Mega, a Lollapalooza effect
• “Lollapalooza effect” - really big outcomes arising from multiple factors acting together.
• Mid to Mega is one such effect
• Multiple factors: MQGLP is needed for achieve this
2. Introduction
• The ultimate objective of all investors is to profit from a massive and rapid expansion in the value of
their stocks, i.e. higher stock price and market capitalization, without major issuances of fresh
equity.
• investors – more so individuals rather than institutional investors – prefer to buy small and midcap
stocks and see them appreciate into large cap stocks.
• In this report, mid and small cap stocks are called as Mega, Mid and Mini.
• There is no standard definition of what constitutes Mega, Mid and Mini.
2.1 Why Ranks
• In any journey, it is highly advantageous to have full clarity on the three key elements – (1) the
starting point, (2) the destination, and (3) the shortest path thereto.
• market cap rank analysis offers investors – and even company managements – a clear roadmap of
the journey that lies ahead.
3. What is Mid-to-Mega
• A cross over from Mid to Mega implies handsome return to shareholders
• Shorter the time taken for such cross overs, higher the returns
• This report focus on a practical time window of 5 years from the year of purchase
3.1 Why Mega?
• Top 100 mega companies form the bed rock of India's corporate sector and capital markets
• Currently they are 75% of total market cap and more than 88% of total corporate profits
• 88 of the top 100 companies are industry leaders i.e. No 1, 2 and 3 in their respective business
Notes of Wealth Creation Studies Page 5 of 90
• It is increasingly difficult to dislodge mega companies from their top 100 category (However one
Mid to Mega happens, some of the companies in Mega gets dislodged)
The process to achieving Mid-to-Mega is captured in the acronym MQGLP, powered by “industry
leadership inside” (inspired by the phrase, Intel Inside)
5.1 M – Mid-size
• The starting point of the Mid-to-Mega journey is Mid-size of the company, defined herein as market
cap rank from 101 to 300.
• Companies in this category have already achieved certain size and scale of operations, and are well
known in the stock market.
• They typically have a fairly long track record of published financial data, which allows for informed
investment decision making.
• Equally interesting is that even among the companies that have moved from Mid-to-Mega in recent
years, 70% are industry leaders
• The rising trend of industry leadership statistically confirms the intuitive understanding that the
larger companies are increasingly becoming more relevant to the economy and the stock markets.
• The concept of ‘Economic Moat’ has its roots in the traditional moat.
• A moat is a deep, wide trench, usually filled with water, surrounding a castle or fortified place.
• In many cases, the waters are also infested with sharks and crocodiles to further keep enemies at
bay, and the inhabitants safe.
• Akin to the traditional moat, Economic Moat protects a company’s profits from being attacked by
competitive forces.
• Two key indicators to test whether a company enjoys Economic Moat or not are:
o A distinct value proposition that gives the company an edge over its competitors, and
o Return on Equity consistently higher than cost of equity (in the Indian context, cost of equity
is 15%, which is the long-period return of benchmark equity indices).
• 73 of the top 100 Mega companies have 5-year average RoE higher than 15% (See image below).
• This juxtaposed with the fact that 88 of the top 100 are industry leaders establishes presence of
strong moats, and partly explains why it is increasingly becoming difficult to dislodge the Mega.
Change in management/ownership: All cases of change in management and/or ownership also need to be
closely examined as they hold potential to alter the fortunes of companies, e.g.
• Induction of N Chandrasekaran as MD & CEO of TCS
• Induction of Ramesh Sobti as MD & CEO of IndusInd Bank
• Acquisition of United Breweries by Heineken
• Acquisition of United Spirits by Diageo.
5.3 G – Growth
• For long-term investing, Quality or Moat is a necessary condition, but not sufficient.
• There is enough empirical evidence that long-period stock price returns are almost equal to long-
period earnings growth
Notes of Wealth Creation Studies Page 13 of 90
• High quality without growth leads to what we call the Quality Trap i.e. typically healthy RoE, high
free cash flow and high dividend payouts, which keeps valuations high, but no earnings growth.
We backtested MQGLP to examine its efficacy in picking Mid-to-Mega stocks and/or delivering superior
portfolio returns. The findings are presented and in the process, suggest a 6-step approach to shortlist
stocks which hold the potential to successfully complete the Mid-to-Mega journey.
7. Mega to Mid
Lessons on how equity investing could go wrong
• Assessment of its converse – Mega-to-Mid i.e. companies whose rank slipped from the top 100.
• 2005 through 2015, there are 161 cases of companies slipping from Mega-to-Mid category (the
number of companies is 112, implying some companies have slipped in more than one 5-year time
window.)
• Stock allocation (How much to buy?) is a powerful tool for portfolio performance, but under
researched when compared to Stock selection (What to buy?)
• Kelly’s formula gives three insights for equity investing (a) Asymmetrical Payoff, (b) Create edge, and
(c) Big bet
• Opportunities for big bets are less; ‘Focused Investing’ is a sound strategy to capitalize on such
opportunities
Notes of Wealth Creation Studies Page 20 of 90
• Key to successful focused investing are (a) Clear portfolio goals, (b) Superior stock selection, (c)
Rational allocation and (d) Active Monitoring
• Disciplined practice gives exceptional returns and not acceptable returns.
Highlights of Wealth Creation Studies 2011-16
1. Backdrop
20 Studies on “What to Buy”: First one to “How much to Buy”
• Despite the above impact, it is surprising to find that very little literature is available on this critical
aspect of investing
• Academicians believe that stock allocation, even more than stock selection borders the art more than
science, thus greatly depending on individual style and temperament
• Kelly’s Formula – Analyze the only semblance for a framework of allocation and derive insights for
equity investing
• Focused Investing – enable to exploit the power of allocation by placing sizeable bets on 15-20 stocks
to generate exceptional returns over the long term
• Keys to successful Focused Investing
o What to Buy – QGLP
o How much to Buy – CAP (Confidence Adjusted-Payoff)
Where:
f is the fraction of the current bankroll to wager,
b is the net odds (expressed as rupees to be won for every rupee bet) or win-loss ratio,
p is the probability of winning, and
q is the probability of losing
• In gambling:
o Both odds/payoff and Win-Loss probabilities are known in advance
o The payoff is usually 1:1 and win-loss probabilities are 50:50
o In cases of Roulette the payoff is higher while the win probability is lower
o Net-net, a win or loss is purely an outcome of luck
• In Equity investing,
o Neither payoff or the win-loss probabilities are fixed
o Stock price is known, and an investor has to calculate the upside-downside and associated
probabilities
o Investors with better knowledge, skill and process can identify (1) Favorable pay out and (2)
Favorable probabilities for a big win
• In gambling the bets are sequential – The outcome of one bet decides the strategy for the next
• In equity investing a investor has to make simultaneous bets on multiple stocks
Given these differences Kelly’s formula is not relevant to equity investing. However, there are some
meaningful insights.
2.1.1 Insight #1: Look of Asymmetric Payoff
• The ‘b’ variant (odds) of the Kelly’s formula can be modified slight to suit the needs of equity
investing
• In gambling:
o Odds are quoted as b:1 i.e. Rupees ‘b’ to be one for every Rupees 1 bet
o Losses are always 100%
• In equities:
o Losses are not 100% (Unless a company goes bankrupt)
o The b can be interpreted as the ratio of “Upside-Downside”
• Substituting this U/D in the formula:
which simplifies to
Where:
f is the fraction of the current bankroll to invest in a stock,
U is the possible Upside in the stock,
p is the probability of such Upside,
Notes of Wealth Creation Studies Page 23 of 90
D is the possible Downside in the stock, and
q is the probability of such Downside.
• The above variant of Kelly’s formula clearly outlines the factors that influence stock selection and
allocation
o Upside
o Downside and
o Their probabilities
• The most favorable situation that an investor must look for is:
o Asymmetric payoff (High upside and low downside) coupled with
o High probability of win
2.1.2 Insight #2: Create an edge
• Another variation of Kelly’s formula is by author William Poundstone in his book, Fortune’s Formula
Where:
f is the fraction of the current bankroll to invest in a stock,
edge = bp – q or Up – Dq, i.e. the expected value of the financial proposition, and
odds = b or U, i.e. the amount expected to win if one wins.
• Estimating quarterly/annual earnings and comparing with actuals to ensure that the original thesis is
on track
• Keep self updated on the latest development in company and sector including periodic interaction
with management
• Maintain corroborative evidence: Interaction with suppliers, competitors, dealers and ex-employees
• Watch irrational stock price movements (Both up and down) and action plan for such cases
• Constant search of investment ideas better than the current one
4.5 Common Mistakes of Allocation
• The common mistakes are (a) Overestimating, (b) Underestimating and (c) Overstaying with losers
and winners
• These mistakes are associated with common psychological/behavioral biases
• Investors focus on stock selection, but the power of “Stock allocation” is a area still untapped
• Kelly’s Formula
o Provides some semblance for portfolio allocation
o This is suited for gambling like situations where payoff and odds are known
o There are some take aways for equity investing
▪ Identify asymmetric payoff – High upside potential with low downside risk
▪ Create edge – Information or analytical
▪ Bet big - When both the above coincide
• Focused investing
o Markets are fairly efficient and opportunities for such big bets are seldom
o Focused investing helps to capitalize on such opportunities by investing on 15-20 stocks with
strong favorable odds
o Focused investing is a golden mean of Diversified and Concentrated Investing
• Four keys to successful focused investing
o Set portfolio goal – Guide post for stock selection and allocation
o Superior stock selection based on time tested philosophy or process
o Rational allocation
o Active monitoring and improvement
• Disciplined practice of above leads to exceptional rather than acceptable returns
Two real examples are given below. It is to be noted that the returns during the CAP is meaningfully higher
than the non-CAP.
Key Takeaways
• Beyond 8 years most of the companies were in the F-F or U-F quadrant i.e. The ones with strong
corporate strategy
• All the 16 companies with full 20-year CAP are in the F-F quadrant i.e. Favorable Industry structure
and Favorable corporate strategy
• Companies in the favourable industry with a strategy enjoyed long CAP (Ability to maintain RoE
above Cost of Equity for a long period of time.)
• A portfolio of such longevated CAP companies meaningfully outperformed the bench mark indices.
• This forms the base rate for growth in most of the industries
• Domestically rising per-capita income leads to exponential spends in discretionary consumption.
• Increased saving and investment leads to higher derived demand for capital goods, construction
and engineering. (Not able to understand or convince)
Linear increase in Per-capita income leads to exponential growth in discretionary
• India has added its 1st Trillion dollars of GDP in 2008, after 60 years.
• It is expected to add every NTD at a faster pace.
• This would give rise to demand in consumption of goods and services.
Value Migration
• Products with low penetration enjoy high level of growth for prolonged period of time
• Cars and air conditioners in Indian market compared to China
• Such companies have a long favourable GAP
New Industry / Product
• Completely new industries have a long run way till they reach maturity
• Such companies enjoy a high level of GAP
• Example: Ipod in US and Air Coolers in India
Change in Five Force Structure
• Any change in industry structure would have a favorable or unfavorable impact on GAP
• Nestle withdrawing Milo, benefited GSK Horlicks – Favorable impact
• Patanjali entry affects incumbents like Colgate, Unilever and Dabur – Unfavorable impact
Regulatory Changes
• Sustaining profit growth of 15% for a period more than 9 years was challenging
• Only 30 companies had 15% profit growth for a 9 year period. Out of this:
o 20 companies (67%) were in H-H quadrant
o 4 companies (12%) were in L-H quadrant
• Thus 80% of the companies with a GAP of 9 years and profit growth of 15% comes from company
growth mind set (Second factor)
• Two outlier companies in the L-L quadrant had a GAP of 11 years. They are GSK and Colgate.
This same analysis was carried out for secular and cyclic companies. Which had the following outcomes
Notes of Wealth Creation Studies Page 47 of 90
• Irrespective of secular or cyclic, it is difficult for companies to have GAP more than 9 years.
• Of the 30 companies that had GAP of 9 years, 80% of them were from secular industries.
• In terms of GAP height, cyclicals tend to have higher growth than seculars at the beginning of the
cycle. However, on a longer duration, seculars have a higher growth.
Shortlisted companies
• Long GAP companies are secular business which have high profit growth over long periods of time
• High GAP companies are typically cyclical business that give super normal profit in a short burst.
The maximum number of occurrences can be seen in two quadrants shaded in grey. They determine the
characteristics to determine CAP-cum-GAP companies.
• Industry score more than 2.5 was assigned a favorable (F) and below assigned as unfavorable (U).
• Clear company strategy assigned a favorable (F) and no strategy was assigned as unfavorable (U).
• This gave the CAP quadrants F-F, F-U, U-F and U-U
Putting GAP and CAP together
Given this CAP and GAP performance it is no surprise that their stock returns have been wonderful. HDFC
Bank had price CAGR of 27% and HDFC had price CAGR of 25%.
This performance is not limited to the main companies, but also by Gruh Finance (58% Subsidiary of HDFC).
This company however does not appear in the study because of not meeting the cut of PAT INR 5 Billion.
Notes of Wealth Creation Studies Page 54 of 90
There is more to follow from the HDFC house. HDFC Standard Life and HDFC Asset Management company
are already listed. At a later date this could be followed by HDFC Ergo General Insurance.
8.1 What is the secret sauce behind HDFC group?
We analyze some industry level and company lever factors what may serve as a checklist to analyze any
long-term prospect of any company in general
8.1.1 Huge Profitable Business Opportunity
• Finance services a profitable and growing business all over the world (not only in India).
• The opportunity size is so vast that the companies need not engage in competition fight within
themselves.
Implication to investing:
High growth industry with a favourable competitive structure gives enough room for new and old
players to have a high and profitable growth
8.1.2 Consumer Facing Business
Most of the business of HDFC group are Consumer facing business, which is secular in nature.
Implication to investing:
As a rule of thumb, consumer facing business are generally secular in nature. If companies offer a
unique value it gives rise to consumer royalty and potential for repeat business.
8.1.3 Strong Leadership
Group companies have dynamic leaders – Mr Keki Mistry in HDFC, Mr Aditya Puri in HDFC Bank, Mr
Amitabh Chaudhry in HDFC Standard Life, and so on.
Implication to investing:
A strong leadership with entrepreneurial mindset is a common feature of CAP/GAP companies.
8.1.4 Understanding the 90% Rule
• Every company has the ’90% Rule’, the one factor that is essential for success of business.
• In Finance industry the ‘90% Rule’ is “Underwrite Well”.
• Nobody understands it better than HDFC.
Implication to investing:
Conclusions
CAP and GAP help to harness the power of longevity of wealth creation
• Longevated profit growth companies are very few. CAP and GAP frameworks increase the probability
of identifying those companies.
• CAP is the time during which the company RoE is above cost of equity. Longevity of CAP is ensured
by (1) Favorable industry structure and (2) company strategy.
• GAP is the time during which the company grows it profits above the benchmark indices. Longevity
of CAP is ensured by (1) Industry growth coupled with (2) Company’s growth mind set
• There are two aspects of GAP height (Growth rate) and length (Length of time). Longevity and speed
of growth are inversely proportional.
• There are three characteristics of CAP-cum-GAP companies (1) Clear Strategy (2) Growth Mindset
and (3) High growth industry situation.
• Two of the three characteristics above pertain to management. Hence in analyzing the industry,
through assessment of management. In words of Philip Fisher, Management is 90%, Industry is 9%
and all other factors are 1%.
• The two drivers of Intrinsic Value (1) High RoE and (2) Earnings growth are important
• Intrinsic Value can grow only when the RoE is higher than Cost of Equity
o Low RoE companies must focus to increase the RoE
o High RoE companies must focus on Earnings growth
• Difficult to sustain high RoE and high Earnings growth for long periods of time
• PE-G < 1 is near infallible method to create outperformance
• Current valuation are very high indicates earnings growth expectations. Hence market to remain
soft
Objective, Concept and Methodology
• The foundation of wealth creation study is to identify and buy stocks substantially below “Intrinsic
Value” or “Expected Value”
• Higher the Intrinsic Value to the current market valuations, greater is the margin of safety
• YoY WCS aims to cull out the characteristics of business that create value to shareholders
• Phil Fisher - “It seems logical that even before thinking of buying any common stock, the first step is
to see how money has been most successfully made in the past.”
• WCS uses the past as a guide to gain insights into various dynamics of stock market investing
Concept and Methodology
• Wealth creation is the process of enhancing the market value of shareholder’s capital.
• This is the basic measure of success for any business venture.
• Wealth creation can be defined as the difference in market capitalization in the last five years after
adjusting corporate events like buy-backs, mergers, demergers etc.
2013-2018 Wealth Creation Study highlights
Three categories of wealth creators: Biggest, Fastest and the most consistent:
• HDFC Bank is the Biggest Wealth Creator for the first time ever
• Indiabulls Ventures is the Fastest Wealth Creator
• Titan Company is the Most Consistent Wealth Creator (All the top 10 Consistent Wealth creators
are consumer-facing companies)
• Financials is the biggest Wealth Creating sector for the second consecutive year
o Biggest Wealth Creator (Private banks and NBFCs)
o Biggest Wealth Destroyer (State-owned banks)
PEG is a solid formula
• For the purpose of PEG calculation, the trailing 12 month PE and 5 year future earning CAGR is
considered.
• If a stock in 2013, had a PE of 20 and the 5 year (2013 -2018) CAGR was around 25, then the PEG
ratio is 20-25 = 0.8
2. Evolution of Valuation
• Different valuation was used in different times – The concept is evolving
• The journey is from Book value-based bargains from the times of Benjamin Graham to RoE based
approach by Warren Buffett
• There is never going to be a final say for valuation
• New tools and techniques will evolve
• Practitioners use what is best suitable for them
3. What is Value
Investopedia defines Intrinsic value as “The perceived or calculated value of a company, including tangible
and intangible factors using fundamental analysis. The intrinsic value may or may not be same as current
market value”
• Intrinsic value calculation is very sensitive to required return (discount rate is the term as used in
the bond/fixed income securities).
• In stock market, every investor has their own expectations on return.
• Accordingly, they arrive at their own Intrinsic Value.
• Choosing the appropriate return value is very crucial for calculation of Intrinsic Value.
• The last case of RoE – 15% would need fresh capital infusion.
• Takeaway: RoE must be above the growth rate to avoid any additional capital requirements.
Balance Sheet and Core RoE
• Many Indian companies over a period of time have accumulated a huge amount of cash, more than
what they needed for their immediate requirement.
• This huge cash may earn 4-5% post tax.
• This low return on cash component mutes the overall RoE
• Thus, comes two kinds of RoE –
o Balance Sheet RoE
o Core RoE
• The issue now is which of the RoE must be considered in the calculation that we discussed in the
previous section.
• Market is efficient to compute the core RoE and value the companies accordingly.
• But in some cases, market fears of capital misallocation and hence have low valuations.
• Companies must reduce the gap between Balance sheet and core RoE by a combination of:
o Higher dividend payout and
o Share Buybacks
• If RoE < Cost of Equity, then higher growth reduces firms value, as more capital has to be raised from
equity holders to fund growth. (Refer case of RoE 10% in the table).
• If RoE = Cost of Equity, there is no use of any level of growth. The PE in this case is 1/(Cost of Equity)
= 1/13 = 7.7 (Refer case of RoE 13% in the table)
• Growth adds positive value only when RoE > Cost of Equity
• If Growth = 0, any level of RoE does not add value to the company. The PE in this case is 1/(Cost of
Equity) = 1/13 = 7.7
• Nearly 60% of companies have a 5 year PAT CAGR of less than 15%.
• Remaining 40% companies are almost equally divided to 15-25% PAT CAGR and 25%+ PAT CAGR.
Notes of Wealth Creation Studies Page 66 of 90
• Hyper Earnings Growth is rarely retained above 5-6 years.
Implications to Stock Investing
• What is the difference between valuation and pricing of any asset, in our case stocks?
• Valuation is fundamental assessment of intrinsic value of a stock based on the expected future cash
flows.
• Pricing is more empirical and heuristic.
• The basis of such pricing is using appropriate multiples PE, Price-Book, Price-Sales and EV/EBITDA etc.
• Pricing is likely to relative more than absolute i.e. depending on what the comparable stock or
benchmark is priced at.
• Four pricing techniques were studied PE, PE relative to market, PEG and Payback Ratio.
6.1 PE
• This is the most used pricing ratio.
• The common mantra is ‘Buy Low-PE Stocks’
• This is about offering a unique value proposition to the clients which is not easily replicated by the
competitors.
• This ensures consumer royalty, higher sales, profit and RoE.
• E.g. All the consumer facing companies offer something unique to its customers
Low Cost
• Where product differentiation is not possible, low cost in comparison with peers is the only option
to sustain competitive advantage.
• E.g. Products like paper, steel, cement etc. are undifferentiated in the eyes of the customer.
Focus
Interesting Insights
• In equity, Management is 90%, Industry is 9% and rest all is 1%. Hence getting the management
right is the first and critical step.
• There is only one way of writing honest accounts and infinite ways to manipulate them
• Sharp practices are intended to inflate profits and stuff “Financial Trash” in balance sheet
• P&L statements are easy to manipulate and hence companies must be mandated to present a
simplified Cash Flow statement
• Auditors must be made accountable to minority shareholders to avoid sharp practices by
management
• Investor must have forensic mindset to get management’s explanation for perceived sharp
practices
• Discuss with all stakeholders – Customer, employees, suppliers and competitors – Till you arrive at
a moment of integrity
“The best defence against fraudsters is to run away from them as fast as possible at the first hint of sharp
practice. With more than 50,000 different stocks available to investors in this country, it is not only
unnecessary but downright stupid to buy into a company run by men of doubtful integrity.” (Thomas
Phelps, in his book, 100 to 1 in the stock market)
1. Backdrop
• Number of companies listed in 2014: 3440
• More than 1/3rd of the companies have lost market value of more than 70%
• The reasons are due to business down turn and corporate governance issues
• In the QGLP philosophy all elements are multiplicative rather than additive
• So even if one of the element is zero, the output is zero
• Q -> Quality of Business and Management
For the purpose of simplicity, this study combine growth mind set as a subset of demonstrable
competence. This is to create a 2x2 grid with Management Integrity and Competence. Only those
companies with rank high in both these aspects needs to find place in an investor’s portfolio.
• Growth mania
o Wide spread reason for Sharp Practices is to demonstrate (or even manufacture) growth
o Growth mania is not only with investors but also with owners/entrepreneurs
• Raising equity capital
o Many business (Especially Finance sector) need regular infusion of capital for its growth
o This capital is mainly raised through equity
Notes of Wealth Creation Studies Page 77 of 90
o Higher the stock prices, better it is for the incumbent shareholders
• Compensation linked to stock performance
o Many senior manager compensations are linked to stock price performance
o Hence, they are motivated to maintain elevated stock prices
• ESOP
o Many senior managers own ESOP of their respective companies, which again motivates to
have higher stock prices
• Mcap is currency
o Companies with high growth mindset use their Mcap currency to acquire another business
through equity swap route rather than cash purchases
• Personal wealth enhancement / Halo of Mcap
o Higher market cap significantly enhances the worth of owners in a social setting
o Some promoters are in the contention for the global pecking order of the wealthiest
individuals
Apart from these factors, there are other motivators like meeting debt covenants, maintain credit ratings,
meeting stock market expectations of previously given guidance and a penchant (Meaning: Liking) for tax
evasion are a few to name
• Weak Board of Directors, which fail to challenge the senior management on issues like accounting
policy, related party transactions, senior management compensation etc
• Management devoid of checks and balances, invariably leads to an alpha leader who takes all major
corporate decisions
• Auditors lacking objectivity, independence and due diligence
Where does compromised Management Integrity reflect? Enter Sharp Practices! The management now
uses all tricks in trade to present a rosy picture of its affairs, when it is not.
• Sharp Practices – Ways of behaving, especially in business, that are dishonest but not illegal
• One Sharp Practices is started, it is tough to say when it degenerates into intentional fraud
• Accounting related
• Non-accounting related
Note: The Sharp Practices covered here pertain to non-financial sector, where money gets converted to
raw materials, finished goods leading to sales and back to cash. There is also a capital expenditure overlay.
However, in financial sector, money retains its forms in all stages of business. This makes it difficult to
identify Sharp Practices and Management Integrity in financial sector.
6.1 Accounting Sharp Practices – The backdrop
“I can’t afford the operation, but would you accept a small payment to touch up the x-ray?“ — Warren Buffett
• Authors Howard Schilit, Jeremy Perler and Yoni Engelhart use the above quote in their book
“Financial Shenanigans”.
• A company’s financial statements, X-ray of its financial health.
• Buffett warns investors about companies that try to hide their true and fair financial view by merely
“touching up” the financial statements.
• Buffett adds, “In the long run, however, trouble awaits managements that paper over operating
problems with accounting manoeuvres. Eventually, managements of this kind achieve the same
result as the seriously ill patient.”
• Schilit et al identify two broad categories of accounting shenanigans or Sharp Practices –
o Earnings manipulation
o Cash Flow shenanigans
Notes of Wealth Creation Studies Page 79 of 90
• The relationship between Earnings and Cash Flow is somewhat similar
• Companies try their best to project the best earnings, only to dump financial trash in the Balance
sheet, reflecting in Cash flow
• The double entry accounting term for this is: Credit P&L A/C, Debit Balance Sheet
• There are two components of Balance Sheet debit side in the asset side
o Working Capital
o Fixed Capital
• Items credited in P&L, charged to Working Capital side (E.g. Debtors) gets captured in Operating
Cash Flow
• Smart investors are aware of this and hence closely monitor OCF apart from profits
• But now companies have become much smarter
• They now charge operating cash outflows to the Fixed Capital side, so that OCF remains robust
• To complete the cycle resort to lower depreciation policy, so that the loading of Fixed Capital side
does not hurt P&L
Example:
A hypothetical example presents P&L, Balance Sheet and Cash Flow Statement in 3 cases –
1. True Case i.e. how the books should actually have been in Year 1 compared to Year 0
2. Case A of Sharp Practice 1 in Year 1, inflating Sales by 200 in the P&L and Debtors by 200 in the
Balance Sheet
3. Case B of Sharp Practice 2 in Year 1, capitalizing R&D costs of 200.
The P&L, Balance Sheet and Cash Flow Statement of all these 3 cases will appear as follows.
• Accounting standards offer company managements the leeway to capitalize some operating
expenses (labor cost, interest on loans, etc) in specific situations such as projects under
construction.
• Sharp Practice: Over-capitalize such expenses, thus inflating current profit and bloating fixed assets
on the Balance Sheet.
• The double-entry here is: Credit Expense A/c, Debit Fixed Assets A/c
• Similarly some companies may capitalize R&D expenditure or heavy brand-spend on grounds that
the benefit of such expenditure will accrue for multiple years in future.
6.2.3 Recording revenue too soon
Sharp Practice: In cases like construction companies, which may bill revenue before the due share of
contract is completed, or at times, before getting the customers’ approval.
6.2.4 Boosting income using one-time activities
• During bad times, companies may resort to practices such as one-time sale of land or other assets.
• At times, companies may even resort to sale and lease-back of their core operating assets, optically
boosting profits and return on capital.
6.2.5 Shifting current incomes to the future or future expenses to the current period
• Most companies are focused on inflating current profits, and hence, this Sharp Practice is rare.
• Still, some companies may prefer to smoothen their annual earnings growth by shifting some
incomes to a future period, or by creating floating provisions for expenses which may be incurred in
the next accounting period.
6.2.6 Sharp Practices during acquisitions
• Many times, companies try and clean up their accumulated Sharp Practices only via acquisition of
another company.
Notes of Wealth Creation Studies Page 83 of 90
• Satyam Computer attempted to acquire Maytas Infrastructure from the promoter group to settle
the inflated cash balance.
• Sharp Practices such as unrelated acquisition or overvaluation of assets acquired are commonplace.
6.2.7 Off-Balance Sheet Sharp Practices
• Companies many have many RPT with subsidiaries, associate companies and key management
personnel
• This is the key modus operandi for siphoning funds by managements with low integrity
• RPT details are available in annual reports
• Investors must go through this to get vital clues to Management Integrity
6.3.2 Earnings guidance
• Companies hold investor calls with equity analysts and investors post quarterly results
• During these calls, it is common for managements to give guidance on future revenue and earnings
• Managements with low integrity misguide investors or conceal known future disappointments
• Large ticket size lending, increases the lumpiness of stress for lenders and makes it difficult to
navigate during tough times
• Classic case the power crisis – Low demand and lack of consistent fuel availability led to significant
crisis to lenders
• This sector had increased its loan book drastically over 2005 – 2010
7.3.2 Large Collateral
Biggest folly in collateral based lending
• In collateralized lending, liquidity is as important as the size and value of the collateral
• Larger the size of the collateral, lesser the liquidity and hence lesser is its worth (Rendering the
collateral useless)
• Example: Loan against shares – A 20% stake of promoter with Loan to Value (LTV) of 50% may be a
tougher collateral to liquidate than a 0.1 stake in the same company of a retail investor with even a
higher LTV
7.3.3 Large Loan Book
• Not even a single NBFC was rated below AA whose loan book was greater than INR 300 Bn as on
Sep 2018
• Size begets rating and rating begets more funding which in turn leads to bigger size
7.4 Trade checks and Sample study
• There are shenanigans in every sectors and most of them are perennial borrowers
• These persons are mostly black listed in the trade but have favour of some lender
• A quick check of industry participants can give a good sense of quality of the borrower and in turn
the process of lender
7.5 Organization structure
• Look at the organization structure of lending institutions i.e. Segregation of Credit Appraisal and
Business
• The credit team is the most effective internal auditor had a bank has, and if its incentives are linked
to the business of the firms, then it is recipe for disaster
• They are like brakes to car and imagine a situation brakes not working in a speeding car
Notes of Wealth Creation Studies Page 85 of 90
• The second aspect is look for the subtle difference between retail and wholesale lending structure
o With the advent of credit score and big data analytics, the function of collections can be
undermined
o In retail lending getting collection is more important than credit and lending
o In whole sale lending, appraisal takes centre stage
• This difference should be investigated before investing in lending organisation
• It is easy to manipulate P&L but much more difficult to escape its aftermath in the Cash Flow
Statement.
• However, the current three-tiered Cash Flow Statement – Operations, Investing and Financing –
does not present investors with a clear picture of the P&L-Balance sheet sharp practices.
Notes of Wealth Creation Studies Page 86 of 90
• Hence, we propose that companies be statutorily asked to present a simplified Cash Flow
Statement along the lines shown below.
Conclusions
Invest only if you can arrive at that Moment of Integrity
• In equity investing, management is 90%, industry 9% and 1% everything else. Hence, getting
Management Integrity right is the critical first step.
• There’s only one way of writing honest accounts, and infinite ways of manipulating them.
• The first hint of compromised Management Integrity can be found in the published financial
statements of companies.
• Most Sharp Practices are to inflate profits and stuff the “financial trash” in the Balance Sheet
(Credit P&L, Debit Balance Sheet). Hence, it is very important to juxtapose a company’s Cash Flow
Statement along with its Profit & Loss Statement.
• Profit & Loss statement is easier to manipulate; hence, managements must be statutorily asked to
present a simplified Free Cash Flow statement.
• Auditors must be made more accountable to minority shareholders to avoid Sharp Practices by the
management.
• As an investor, have a forensic mindset to get management’s explanation for all the perceived
Sharp Practices.
• Finally, interact with various stakeholders – customers, employees, suppliers, competitors, etc – till
you arrive at that moment of Management Integrity.
ANNEXURE
Sharp Practices – A few Indian Case Studies
Sharp Practices Case Study #1 - Satyam Computer Services
Satyam Computer’s case study arguably takes the dubious distinction of the mother of all corporate frauds
in India.
Modus operandi
• The key behind Satyam’s fraud appears to be its promoter’s keen interest in real estate.
• Ramalinga Raju even inflated the payroll and embezzled money out of the company by way of
salaries to fictitious employees.
• All the while, he also inflated the company’s cash balances which were visible in the system.
• By 2008, the “cash balance” had ballooned to over a billion US dollars.
• That’s when Raju sought to merge the group’s real estate business into the company, so that there
may be real assets created against the fictitious cash.
• However, that deal did not go through, forcing Raju to do the confession
The red flags & the bust
• The fraud was so well managed (most likely in collusion with internal and statutory auditors) that
there was hardly any trail of evidence.
• In hindsight, the only weak case was the company’s Other income, which was very low compared to
its cash balance. (Not clear)
• Incongruence in market share data, too-good-to-be-true growth and industry-leading margins were
the red flags prior to the auditors resigning in May 2018.
• In FY19, the company wrote down its sales and receivables by issuing a credit note of INR 1.8
billion, and providing for a credit loss of INR 1.2 billion on its receivables.
• To divert funds, capital work in progress and capital advances seem to be inflated as well.
• An amount of INR 2.7 billion has been provisioned for losses in FY19.
• The promoters were jailed for GST fraud in May 2019. The company has deposited INR 178 million
with the GST authorities under protest to secure their release.
Sources:
[1] – Business Today, 9-Oct-19 – “Is Manpasand Beverages among the biggest corporate frauds in India?”
[2] – Money Control, 31-May-19 – “How a Rs 40-crore GST fraud unfolded at Manpasand Beverages”
• The company sold equipment to schools which was financed by Educomp and recognized it as
revenues.
• The schools were unable to repay the loans and the assets (mostly computers) had lost significant
value leading to little recovery.
• Aggressive Accounting with respect to booking revenues upfront for asset sale. This led to creation
of assets through borrowings and the same was booked as revenues and profit.
• Continuous negative cash flows meant that the pace of asset sale was much faster than the
revenues coming in.
• In FY13, the company went into debt re-structuring and by FY17, the company’s net worth was
negative.
• High Receivable days of at least 150 days and going up to 300+ days in the period FY08-14.
• Inventory buildup was also significant which eventually saw significant write down in 2014.
• Promoter pledge and share price – In July 2013, SEBI barred the promoter of the company Mr
Mehul Choksi and 26 other entities from trading in the market for a period of 6 months. It is
believed that the promoter along with these entities was indulging in market manipulation of
company's shares. This led to a huge correction in stock price.
The red flags & the bust