Are you aware that there are around 5,000 odd listed companies on the BSE? It is one of the highest in the world. And certainly this is not to our surprise (Hence no exclamation). Indians are known for their entrepreneurship.
An individual or a concern typically starts out a venture with limited capital. But as time progresses, the desire to expand raises the need for additional capital. And the capital market is the best way to garner that capital. Have you ever wondered why?
The capital raised in the markets is "costless" from a promoter's perspective. It has no immediate outgo associated with it in the form of interest payments. Agreed that the promoters are paying the price for raising additional capital by diluting their stake. But only the owners know what they are selling, isn't it? They can sell you an old toy in a new basket.
Thus, you as an investor have to take a call on management quality when you invest from the basket of 5,000 companies listed on the BSE. Mind you, we are not taking about business here and just quality. An average business run by a competent management is a better prerogative than vice-versa.
But how would an investor ever know about the intentions of the management. It is very difficult to take a call on someone’s intention to deceit. It is as good as gambling. And gambling is best suited for casinos and not stock markets.
So, is there no way out to judge the intentions of the management? After all it is due to the faith in the management that you give your hard earned money to them.
We hereby take an effort to highlight few key factors that can prove to be of some help in judging management quality However, they should not be considered the be-all and end-all. Nor are they any set of guidelines from SEBI's manual. These are just general observations that have evolved over time.
Dividend payout: A good business is one that distributes excess cash generated to the shareholders after taking care of the financing needs. Distribution of excess cash in the form of dividends is at the management's discretion.
Now one might wonder what has the decision of payout to do with the intentions of the management. The answer is straight forward. The excess cash generated from the business belongs to the shareholders. And if the management does not foresee any value creating opportunities in the near term, it should be returned to the rightful owners. Hoarding excess cash on books when the company is in the maturity cycle of its business is a warning signal unless the company discloses the reason for the same. Excess cash on books without a cause sends a wrong signal to the markets.
"We are on look out for acquisitions" is the most common excuse. Better watch out for it.
Now it should be noted that we do not mean to say that the companies which do not pay dividends have fraudulent intentions. Bharti Airtel, for instance had not paid dividends for a long period of time. But at that point, it was into the expansionary phase of the business cycle. So it plowed back the excess cash into the business itself rather than paying it to the shareholders. On the other hand, you have a lot of construction companies that raise equity capital every quarter and still pay dividends. What a stark contrast, isn't it? You need to understand what stage of the cycle the company is in and then use your judgment to determine whether management has taken necessary steps to channelize these excess funds.
Share pledge by promoters: Promoters generally pledge their equity holdings to private lenders largely to raise personal loans. Such pledges dilute the equity of the promoters if they are not able to pay the loan on time and could also lead to possible takeover situations. Satyam’s Ramalinga Raju who confessed over the accounting fraud to the tune of several crores is believed to have pledged almost entire of his equity stake to private lenders to raise cash.
Assume you own shares of company "A". The reason you buy is because of sound fundamentals of the company and able management. Suddenly the company faces cash crunch and the promoters pledge their shares to raise loans for the company. Just in case the promoters are unable to pay back the loan on time - the lender can effectively sell the shares in an open market to recover his dues. Not only have the shares changed hands in this transaction but also the intentions.
Preferential allotment of shares: Companies typically have enabled provisions to allot equity on a preferential basis to promoters after paying in the margin money. So effectively by paying in just say 10% of margin money, the promoters in effect have a call option to buy further equity in the company. If the prices rise, promoters will exercise the option to buy additional shares at lower cost. And if the prices fall, they have to forego their margin money. Fair enough.
But why is this option not on par with other minority shareholders?
Apart from promoters, even minority shareholders are owners of the company. But still they are not given the privilege to buy additional shares by placing in the margin money. Agreed, promoters have the technical know how to run the business but this does not give them the right to acquire additional equity on a preferential basis at the cost of minority shareholders.
Although preferential allotment of shares is not a direct measure of intention to fraud, it does give us an idea of promoter perception towards the minority shareholders.
Thus, if one keeps these few aspects in mind before investing in any company, he/she may not fall prey to the next Satyam or Enron.