We have often spoken about high quality businesses that we like to invest in – companies generating a high return on equity, having consistent free cash flows and hence low debt, having a competitive edge or ‘moat’ and good corporate governance. We would like to devote this letter to the inverse of our preferred set – low-quality companies ie companies that we want to stay away from in our portfolio. We particularly want to focus on the corporate governance angle as that assumes importance in the current context.
Low-quality companies typically have a return on capital employed which is below the cost of borrowing money – in essence, they are destroying wealth over the long term. These companies are typically very capital expensive – both in terms of fixed assets and working capital. As such they are always capital hungry and are continuously raising money either through debt or equity issuances which dilute existing shareholders.
What we particularly want to run away from as investors, are companies with poor corporate governance. One of the tenets of value investing is that when you buy a stock, you are not buying a scrap of paper whose price is fluctuating on a daily basis, but you are buying the underlying business. However, we as investors, are not running that business – some one else is running it for us and unless the manager of the business treats us fairly as minority investors, our entire investment hypothesis will fall apart.
Poor corporate governance presents itself in many ways – we will try to name some instances, though this list is not exhaustive:
- Gold plating capex – this is a common practice among poor quality management, particularly of capital-intensive businesses.
- Compensation for promoters – in many companies, promoters take away a large percentage of profit before tax through their disproportionate compensation.
- Royalty payments to the MNC parent – sometimes these can be excessive.
- Transactions between group or associate companies – in many instances, these transactions can be structured, either a merger or a buy-out or other such transactions, in a way that favours the unlisted entity over the minority shareholders of the listed entity.
- Related party transactions – a large number of such transactions which can create an element of doubt among investors.
- Conflict of interest – promoters may have different companies in same/similar lines of activity and one of those companies may be favoured over others.
- Shady accounting – accounting which may try to present a more favourable situation than actually exists within the company whether with respect to the Profit and Loss Account or the Balance Sheet.
- Serial acquirers – companies which make many acquisitions, particularly when paid for by an inflated stock price of the acquirer.
- Cash transactions – companies in which a lot of transactions take place in cash.
- Expanding working capital cycle – a company whose inventory and receivables are growing at a much faster pace than revenues can also be a red flag for investors.
As we said earlier, this list is not exhaustive and poor corporate governance may present itself in many ways. We as investors need to watch out for the various shenanigans of the management by which they favour themselves over minority shareholders. In our experience, we have found that companies with poor corporate governance have a history of doing these things and a study of history can be a guide in this respect.
What motivates managements who indulge in poor corporate governance? For a high quality company life is relatively simple – generate a high return on capital employed and reinvest into their business to grow steadily over time. Managements who pursue poor corporate governance, are usually stuck in hum drum businesses, which are not earning an adequate return on their capital. However, they have big ambitions and want to take a short cut to become big or rich. This leads them to cut corners, maybe indulge in some creative accounting or use other measures to grow fast. We have learnt over time that wealth can only be generated slowly, over time by investing in high quality businesses which are generating a good return on their capital employed and the free cash flows generated from the business are invested to grow the business. We don’t believe in short cuts as short cuts not only lead to loss of capital over the long term, but also loss of sleep.