Lesson 4 – Importance of management in stock analysis

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Lesson 4 – Importance of Management in Stock Analysis

In the last lesson you read about sustainable competitive advantages. You understood how these advantages or moats can protect a business from competitive forces. Such companies are worth considering seriously for long-term investment.

In this lesson you will study,

  • Ownership
  • Board of Directors
  • Management
  • How to judge management quality
  • Sources of information to judge management quality

 

Lesson 3 – Homework

I had asked you to study Nestle and WABCO.

You would have seen that for Nestle, the parent brand Nestle or individual brands like Maggi are the biggest moats. Ask yourself, how many other noodle brands apart from Maggi do you remember? When you want to eat noodles at home, do you say “Let us eat Maggi” or “Let us eat noodles?” Their brand has been built up over many years and gives them a dominant market-share and pricing power over consumers.

You can study WABCO in greater detail. Click this link, WABCO report by Spark, and then come back to Lesson 4.

 

What is ownership?

If you buy shares of a company you are part-owner of the company like I discussed in an earlier lesson.

We will do a small practical exercise,

  1. Click here to see shareholding of Mastek on NSE
  2. Click the link for the latest quarter.
  3. Click Promoters.

You will see a list of names. These are the people who have started Mastek. Imagine another case where the original promoters sell their stake to a new set of people. Then, the names you see might be the entities who are currently the promoters of the company.

The promoters are in the driving seat. Individual shareholders, at least in India, are usually co-passengers in the vehicle.

You will reach your dream destination in safe condition only with a good driver. Similarly, a good promoter can grow the business in a ambitious yet safe and profitable manner. If the business does well, the stock price will do well in the medium to long-term. This is the dream destination that you seek in the stock market.

 

What is a board of directors?

In a theoretical setting, the board of directors is supposed to protect the rights of the shareholders and work towards their betterment.

Management reports to the board of directors.

Practically, promoters usually are present in the board of directors as Executive Directors. “Executive” suggest that they have a managerial role in the company’s affairs too. This is a conflict of interest.

That is why the laws stipulate that there need to be independent directors who are not related to the promoters to have balanced decision making. In reality, if I were a promoter, I can bring in close buddies as independent directors and make a mockery of the spirit behind the regulations and laws.

Independent directors of good reputation is a positive signal. But then again, we have had cases like Satyam where independent directors did not see the scam coming.

 

What is management?

The management is the set of people who are expected to set into action the plans and resolutions that are decided by the owners / shareholders and signed off by the board of the company.

They can execute the company’s plans to the best of their capabilities and the company’s strengths.

You hear of top management designations like Chief Executive Officer (CEO), Chief Financial Officer, CEO, CFO, and Vice Presidents and Business Heads. These designations are usually given to professional management. They primarily receive salary benefits and perks. They usually don’t have stakes in a company to the extent of a promoter’s stake size.

Professional management has to follow what the board decides. If the board has heavy promoter influence, then it means that the management follows the promoters.

You have to also consider Executive Directors who also play managerial roles.

In many companies in India, which are family run, management practically means Executive Directors + professional management.

 

How should you judge management quality?

  • Past performance
  • Clean management or crooked management
  • Is there a second line of management or is it a one man show?

Judging past performance

You need to ask questions like:

  • What decisions have they taken in the past?
  • In the context of the environment or situation in the past, how good were the decisions?
  • Were the outcomes of the decisions as expected or are they the equivalent of having won a lottery?
  • Try to differentiate between skill and luck. Some managements might have got plain lucky. Luck might not help them the next time.

Some common symptoms of bad management are:

  • Rash acquisitions.
  • Wasteful expenditure.
  • Debt addiction.
  • Growth at the expense of profit margins.
  • Inefficient use of capital.
  • Financials which are wavering and unsteady.
  • Consistently missing commitments to shareholders.

Clean or crooked?

Remember, that in India, if the promoter is crooked, you are fighting a losing battle from the start. It is pointless.

There are a hundred ways to siphon off cash from a company. The number of dud companies on the BSE and NSE are proof enough.

In India, corporate governance is not the best in many companies.The first check is promoter reputation. Look in the media if the promoter has got into tangles with the regulator SEBI, or excise departments or income tax departments. Examine the merits of the allegations if they are not proven yet.

Shady management can help a company when the business environment is crooked. Remember the Coalgate scam in India. One might argue that the only path to success in such a twisted environment was by paying off politicians and bureaucrats.

But if the environment changes, what are you left with? More importantly, do you think a crooked promoter will spare you, a minority shareholder? Would you even know if your pocket was picked?

Second line of management

It is essential to have an able second line of management below the top management. This can include professional management or promoters.Sooner or later the present generation will have to pass the baton. What happens then?

Be very wary of promoters who bring their sons and daughters to the top floor of the company too soon. There is no harm in a son or daughter getting an Executive Director’s position as long as they prove themselves worthy of it.

 

Where will you get the information to judge management quality?

  • News articles
  • Company profiles, interviews in financial magazines
  • Research reports that describe company developments
  • SEBI announcements
  • Company website
  • Financial results
  • Management earnings calls / transcripts of calls (Researchbytes.com)
  • Annual reports – Management Discussion and Analysis section, financials, schedules and notes.
  • Other sources like your friends, colleagues who might work in a company or in a competitor company who know how the management operates

 

Lesson 4 – Summary

You have studied,

  • Ownership
  • Board of Directors
  • Management
  • How to judge management quality
  • Sources of information to judge management quality

 

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