5 Points to Check Management Quality Before You Buy a Stock

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In my early investment years what puzzled me most was the Quality of Promoters of the stocks I invested in.

Management Quality is fairly elusive and some veteran investors like Vijay Kedia had an interesting solution: He goes and visits management in person. There, what he focuses most is on “How management is treating its peon/helping staffs?”

His point is simple: If the Promoter treats badly/disrespectfully with his employee then his treatment towards minority investor would be worse than that, for sure.

A simple but effective hack!

But all minority investors can’t be meeting promoter before investing. So here is an investing framework for common investors to solve the puzzle.

The Framework to Assess Management Quality

How to assess management quality

Post-screening of investible stocks, a common investor should develop a sense of the value of the business and then comes the most crucial part: management quality assessment. ]

We have created a 5 point checklist for that:

checklist for management quality

In this blog we are going to discuss first 2 checks, rest we will follow in the next blog. We would be analysing Management Quality of Apollo Tyres using 5 point checklist for clarification purpose only.

 

Check 1: Promoter Background Check

In this step, the investor should wear a bad cop hat and conduct a forensic google search of promoter/company with keywords such as “Fraud”, ”Issues”, “SEBI”, “Court ” etc.

The idea is to get to know the promoter’s history to understand whether you should invest in him or not.

As Warren Buffett has famously said this:

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Look out for any disputes with SEBI or other regulators.

Example: Assessing Management Quality of Apollo Tyres

Anything that questions the integrity and character of the promoters should be looked with suspicion. Further study should be done on management quality to confirm or dispel doubts about the news or allegations.

 

Check 2: Board of Directors Check

There are 2 kinds of directors:

  • How Independent are the Independent directors?

One should focus on the Independent directors whether they are independent or not?

Have board members been appointed by the company for their decision-making ability and for value add because of their Skill Set (skill) or are they appointed only because they are familiar with the promoter?

Incase of Apollo Tyres, 2 Independent Directors namely Ms Pallavi Shroff and Akshay Chudasama are managing partners of Shardul Amarchand Mangaldas & Co (a law firm).

Their law firm has been paid a fee of Rs 1.28 crore during FY 2018 for the advice provided by Apollo Tyres. This shadow’s the “Independence” of the Independent Director.

If the ratio of Independent Directors & Executive Directors on board for a company is more than 50:50, indicating their Corporate Governance.

  • Check Committee Compositions

Board works on the shoulders of various committees, so the investor should look at the composition of mainly 2 committees, namely: Audit Committee & Remuneration Committee

In Case of Apollo Tyres: Mr Onkar S. Kanwar (The Promoter i.e. MD) himself is a member of Remuneration Committee which explains high promoter remuneration of Rs 87 cr in FY19.

The conclusion for stocks which fail these 2 acid tests, is pretty clear: Avoid At Any Cost

Also Watch: How to Assess Management Quality of a Company

Check 3: Promoter Remuneration Check

The prescribed limit from Company Act on each director

The prescribed overall salary limit from Company Act on all directors

Some criteria to apply to identify good management are:

Although the limit set by Company Law is 11%, most good companies limit promoter salary to within 2% to 3% of Total Profit.

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You can find about the management compensation in the Annual Report.

Criterion 1: Is overall management compensation is more than 5 % of the total profit? (If the co is making a handsome profit let us say more than Rs 100 cr ).

Criterion 2: Compare Profit Growth Vs Promoter Salary Growth. If it is very high means the promoter is greedy.

Also, you can find about the Median Salary vs Executive Directors /management compensation in Annual Report by simply doing Ctrl + F Median, which brings to the third criterion.

Criterion 3: Compare the Average of company employees (Median) salary vs. CEO/CEO. If it is above 500-600 times, generally it means that the Promoter might be using his powers to his own benefits.

Warren Buffett believes that stock options do not align the incentives of management with those of other shareholders because they represent a free transfer of wealth from the latter to the former.

Incentives would only truly be aligned if managers purchased shares in the open market like any other shareholder.

Criterion 4: If the company is issuing employee stock options (ESOP), its Vesting period should be more than 3 years for it to be called as good for minority investors.

Case Studies: Check No. 3

Management Quality Check - Apollo Tyres
Management Quality Check – Apollo Tyres

Check 4: Auditor Check

First, let us understand how many types of opinion an Independent Auditor can give? Well, the answer is 4.

4.1 Auditor Check (A): Independent Auditor Report

If you are a serious stock market investor then you should dig deep in the Independent auditor’s report. You should Read Qualified Opinions, Adverse Opinion & Disclaimer Opinion once because Opinions Matter. At least in the stock market.

If there is Adverse Opinion: Red Flag

If there is Disclaimer Opinion: Red Flag

If there is Qualified opinion: Yellow Flag

Also, Read comments on Auditor’s Company’s Internal Control capability

4.2 Auditor Checks (B) : Auditor Resigning

Resignation of Statutory Auditor/Company Secretary/Compliance Officer.

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This is a Red Flag that states that these officers may have resigned because of violation of rules in the company’s Accounting

Management Quality - Auditor Resigning Check

Impact of resignation by Auditors signify bad management quality and as a result, same day stock price reflect the same.

 

Check 5: Promoter’s Intent Check

Promoter Intent vs Capability

The intent of management is a difficult part to understand.

Management’s ability is displayed from the financial Statement, so a careful analysis gives a picture of whether the management is able to grow the company or not?

All the cash from operations of the last 10 years should almost match with the company’s 10-year profit

Criterion 1: Share Pledge

Avoid investing in stocks in companies that have more than 15% of Promoter’s share pledges. Find out where Promoters has used a loan raised from the share pledge?

Criterion 2: Related Party Transaction

Companies Act 2013 defines Related party as:

  1. director or a key managerial person or their relatives or
  2. a firm, private company in which the partner, director/ manager or his relative is a partner or
  3. a private company or a public company in which a director or manager is a director and holds along with his relatives, more than 2% of its paid-up share capital.

Related Party Transactions are not banned per se. They are regulated by certain conditions as these transactions should be disclosed to the Board and shareholders for them to ratify.

Case Study: Apollo Tyres

Apollo Tyres Management Quality Check - Related Party Transaction

Also Watch: Learn How to Invest Using Management Quality Checklist

 

Summing Up

Assessing company management quality requires some time and effort. However, don’t skip this part as it is an essential aspect of the fundamental analysis of the company.

Follow the steps mentioned above and ensure that you analyze the management quality of the company thoroughly before buying.

Read Research Reports of Indian Companies here.

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Amitabh Vatsya
Amitabh Vatsya is an active Investment Vlogger (http://youtube.com/c/Sadhansimplified) | Loves to share his ideas at http://wealthsutra.wordpress.com | Follow him @amitabhvatsya
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