I was out for my usual weekend shopping when I bumped into one of my former neighbour, Parshuramji a senior citizen who is also a long time equity investor.
“How’s your portfolio doing?’’ I asked him as equity investments usually formed the crux of our discussions.
“It is doing quite well, except that I lost some money in Leel Electricals”.
“What, Leel Electricals?” I asked him in shock knowing that he was more into defensive stocks with his personal favourites being ITC, HUL, L&T and Maruti many of which he has been holding for more than a few decades.
“Yes and more than losing the money, I am more upset because I didn’t see real picture or what lay beneath the mask” replied Parshuramji.
The Devious Case Of Leel Electricals
Let me give you a glimpse into what happened with Leel Electricals, an electrical component manufacturer that sold off its consumer business and Lloyds brand to Havells for Rs. 1,600 crores in 2017. As a result, the company recorded an exceptional gain of Rs. 946 crore in September 2017 quarter to account for profit on the stake sale, attracting investors such as Parshuramji who saw it as a value buy.
According to a report by the Economic Times, the new management that took charge after the demise of the company’s CMD reversed the gains to the tune of Rs. 310 crores in the subsequent March quarter citing associated costs and expenses. The company also allegedly diverted huge amounts to other businesses of the promoter as capital expenditure and loans for buying land and factories of their own plants.
Without a doubt, it was a case of misappropriation of funds that led the stock to fall from a 52 week high of Rs. 250.90 from April 2018 to Rs. 17.60 in April 2019, thus eroding the wealth of investors. And unfortunately, Parshuramji was one of them.
It is a well-known practice where management fudges balance sheets to inflate or under-report profits/losses.
"No one can long hide behind a mask; the pretence soon lapses into the true character'' – Seneca
This holds true even while investing, as many investors go over the financial ratios and the company’s future prospects while overlooking some softer aspects of the business. As we pointed out in the case of Leel Electricals, apart from the financials and the future performance of the company, there are certain parameters that need to be closely looked at before investing in a company.
Clandestine Factors Behind The Company’s Success
Passion of the management
When Narayan Murthy and his friends started Infosys way back in 1981, they did not have enough capital, but yes they had the passion to move ahead through difficult times and the constant fear of failure.
It is their passion that kept them going and today Infosys is a global leader in technology services & consulting with revenues of over 1,131 crores USD. Even today if you look at Narayan Murthy in his interviews on TV, you can clearly see the same level of passion and commitment.
The confidence of the management
Do you know the actual story behind the success story of Reliance Jio?
It goes back to the year 2010 when the non-compete agreement between Mukesh Ambani and Anil Ambani ended. Over the next 6 years, the company invested Rs. 1,50,000 Crores ($ 22 billion) in building a robust fibre-optic network across the length and breadth of the country.
Rs. 1,50,000 Crores is a huge investment by all standards and is almost twice the combined investment of Airtel, Idea, and Vodafone in the 4G segment.
Despite the huge investment, Reliance Jio did not make any money for 7 years as the company gave 1 year of free service. Mukesh Ambani was quite confident of his vision for the company and Reliance Jio has managed to garner a huge subscriber base. That’s not all, Reliance Jio has already started its work on 5G technology and aims to become the number one telecom player in India by 2021.
Transparency of the management
Do you know what’s common between Infosys, HDFC Bank, and Wipro?
Obviously, they are large-cap companies but take a look closer.
These companies have been ranked as India's most transparent companies, according to a report on Indian corporate governance by the BSE Ltd., IFC and Institutional Investor Advisory Services.
The management of these companies are transparent, honest and provide better disclosures on the website and in their annual reports on aspects of board evaluation, leadership experience and succession planning.
What Lies Beyond The Mask?
As discussed earlier in the case of Leel Electricals, investors may often miss out on some crucial information that tells a lot about whether the management is hiding any information which may in-turn affect your investment.
Apart from the quantitative parameters, there are few intangible qualities that lie hidden beneath a mask. This crucial information could be anything in the form of exaggerated losses or profits or diversion of funds to other entities or shell companies.
I agree that a normal investor can in no way evaluate a company using these parameters.
And that’s what we as an equity advisor take all the pain to identify the softer aspects of the company, leadership and corporate governance policies. We follow a rigorous process to analyse a business before recommending it. This process includes plant visits, talking to the management about their vision and future outlook as well as assessing the ground level reality by talking to distributors, suppliers and retailers.
It is said that the most important part of a conversation is hearing what is not said. With our on-ground investing experience across various business cycles and on-going interactions with the leadership team of the company, we gauge the softer aspects of the company that is beyond the information available.