Chapter 10: Straight from the Management
Description: Amid the numbers and quantitative models, one should pay attention to the qualitative aspects of a business. In this chapter, we will look at qualitative fundamental analysis, which involves understanding and analysing management’s actions. We will also understand the external factors beyond the company’s control that could impact a company’s fundamentals.
So far, we have been focusing on the theory and what the books have to say. While the numbers can tell you a lot about performance and trends, they have limitations. The numbers are good only when you have confidence in the ability and integrity of those who have compiled them.
A company is as good as its management…
It is said that ” a hero is not born but made.” Similarly, a successful company is not born but made by the people at the top, whom we call the “management.”
These people run the company and whose actions can have a material impact on its performance. Our next chapter is all about analysing management’s actions—the source of the numbers seen in the financial statements. You can call it a company’s ‘qualitative analysis’.
To understand and analyse the management of a company, we will look at three things:
- Management discussion & analysis
- Corporate actions
- Corporate governance
Management discussion & analysis
A company’s annual report has a segment called “Management Discussion & Analysis”.
This section’s idea is to give management a space to discuss their take on the earnings and highlight things they want to communicate to the shareholders.
Think of it as a meeting where the business owner tells the stakeholders (all companies and people invested in the business either as a shareholder, creditors, suppliers, customers, or partners) about the quarter or year it was. Companies must focus on three segments:
(i) Operational highlights
Management starts by discussing the one-off things that happened that were different from routine and how they reflected in the earnings. For instance, a new product launch or a power outage affecting factory production. Or maybe a component shortage delaying sales to next month or any government policies that have put the company in the limelight.
A real-life example is that in 2023, when the government increased the GST on gaming apps, it became a discussion point for all gaming companies. The high food prices due to rainfall shortages made it to the MD&A for FMCG and restaurant companies.
Such events may affect business operations positively or negatively, leading to earnings deviating from expectations. Management uses this space to inform investors about these risks and opportunities and how they plan to tackle or take advantage of the situation.
The management will also provide guidance, forecast, and outlook for the next quarter or year. If, for some reason, the management does not provide the guidance, they have to state the reason for the same. For instance, if a company is in the process of getting acquired, it will not provide guidance. If there is too much uncertainty in the business environment, they will state that as the reason.
As a fundamental investor, you can use this segment to prepare before reading the financial statements. You can factor management’s insights into setting expectations for the company’s future earnings.
Hence, a company’s stock price may fall or rise after an earnings call. It may also fall if management gives weak guidance for the upcoming quarter.
(ii) Accounting estimates
The next thing the management will discuss is any change in how it has prepared the accounts. Did it change the way it calculates inventory? Is there an extra day or week in the quarter? Is there any discontinuation of the business or addition of any new business in the earnings?
Changes in accounting policies can help you adjust your expectations of a company’s earnings as a fundamental investor.
(iii) Liquidity and Capital Expenditure
The most important part of the MD&A for investors is the liquidity and capital portion. The management will identify any trends, events, commitments, demands, or uncertainties that could materially impact the company’s liquidity or availability of capital. Remember, a company that runs dry on cash is on the verge of bankruptcy. Investors and creditors invest in the company so that it can make more money and fund its expansion while giving them returns.
You would be interested in knowing how much cash the company has and whether it can meet its current obligations and plans.
Apart from obligations, shareholders and creditors would also want to know a company’s capital spending plans. They would be interested in where the company is spending the money, from where it is sourcing the capital (equity, debt, or reserves), and what kind of returns this capital investment could generate.
Management would want to tell investors if a company’s credit rating has improved or if it has paid down a significant portion of its debt. For instance, Vedanta’s management highlighted the dividend amount it paid to shareholders in 2023, when it paid its highest dividend in the company’s history.
The objectives of MD&A are to explain the company’s financial statements to investors and help them develop realistic expectations of the company’s future earnings.
Corporate actions
Beyond the management’s discussion of the company’s operations, you might also want to understand the nature and behaviour of the management. The company is made by people who make decisions according to their behavioural traits. Some are aggressive, some risk-averse, some innovative, some conventional, some quality-driven, and some quantity-driven. These traits and the company’s cultural values are embedded in its management style, operational strategies, and decision-making processes.
Corporate actions, including stock splits, dividend distributions, mergers and acquisitions, rights issues, spinoffs, divestitures, restructuring, and liquidations, can help you understand the company’s DNA.
Corporate actions can have a significant impact on the company’s earnings and need the approval of the board of directors. Some actions like mergers and acquisitions (M&A) also need the approval of its shareholders as well as the regulator. Corporate actions could be voluntary like buybacks and dividends or mandatory such as divestiture of a business segment in a major acquisition to avoid too much market consolidation.
Divestiture
Divestiture is when a company disposes of its assets or a business unit through a sale, exchange, closure, or bankruptcy. The company could divest a business unit which is loss-making or it is streamlining its business operations to focus on something else. For instance, Bombardier sold its loss-making train business to train-maker Alstom to focus on business jets.
Discussing every corporate action could be cumbersome. So we will focus on a few major ones and see how they affect the company’s fundamentals.
(i) Stock split
Returning to the chapter where we discussed shareholder’s equity, every share has a face value of ₹10, and the company can split it until the face value becomes ₹1. So if you own 10 shares of Nestle worth ₹27,150 per share, and the company announces a 1:10 split, you will get 10 shares for every 1 share, and the price per share will fall to ₹2,715. This price will be adjusted to Nestle’s stock chart, and the entire historical price chart will show the adjusted price.
The stock split does not change the total value of your shares; it just increases the share count. For instance, you can divide a pizza into four or six pieces. That does not change the size of the pizza; however, it dilutes the size per slice.
Companies generally do stock splits to make their shares more tradeable and support retail investor participation. Think of it yourself: would you buy a share of Nestle at the ₹27,000 price point? Many investors might be unable to invest in even a single stock at that high price. But at ₹2,700, you can consider buying Nestle shares and also shares of other companies with the same ₹27,000.
Shares | Share Price Feb 2009 | Share Price Aug 2024 | Number of Shares Purchased with ₹1 lakh | Share count post-split | Value on August 2024 |
Eicher Motors | ₹22 | ₹4,800 | 4545 | 45,450 | ₹21.8 crores |
MRF | ₹1,632 | ₹137,000 | 61 | 61 | ₹83.57 lakhs |
Eicher Motors’ iconic 1:10 stock split in August 2020 made the stock more affordable at ₹2,000. In four years, the stock price surged past ₹4,800, running on solid fundamentals. Long-term fundamental investors, who had invested ₹1 lakh in the stock in February 2009 when the stock traded at ₹22 got 4,545 shares. The split increased their share count to 45,450, and they are worth ₹21.8 crores in August 2024.
Let’s take the example of MRF Tyres. One share is priced at more than ₹1.37 lakh because the company never did a stock split. So if you invested ₹1 lakh in MRF in February 2009 when it traded at ₹1,632 per share, you would have 61 shares worth ₹83.57 lakh in August 2024.
While the companies’ fundamentals drove the stock prices of both, the stock split made Eicher Motors shares more affordable to retail investors and helped them benefit from the company’s growth.
(ii) Mergers & Acquisitions
M&A is the best way to understand the company’s DNA—how management thinks and acts. Avenue Supermarts—the company behind D-mart—has a risk-averse business model. Using its retained earnings, it acquires land in less expensive areas and builds the supermart where it is assured to get a strong footfall. It grows its stores gradually, ensuring each store pays off the amount invested in it in certain years.
Reliance Retail, on the other hand, follows a more aggressive management style of investing a large amount of capital in one go. It acquired all Future Group stores and renamed them Reliance Smart. Reliance is known for acquisitions and market disruptions, using the financial backing of Reliance Group.
At the same time, Tata Group is known for acquiring iconic companies at depressed prices, turning them around through efficient management, and injecting more capital. The classic Jaguar Land Rover (JLR) acquisition, the Corus acquisition, and now the acquisition of Air India are a few examples. All these companies are loss-making but have the most valuable assets (factory, technology), tremendous market outreach, and well-established brand names.
Mergers and acquisitions significantly alter a company’s fundamentals, forcing you to rewrite your analysis in a fresh light. In such decisions, the qualitative aspect tends to generate more value than the quantitative aspect.
What Ford Motors couldn’t do in 18 years (1989 and 2007), Tata Motors did in six years. It turned around the loss-making JLR into a profitable venture by introducing new products, and targeted investments during the 2008 Financial crisis, expanding its market beyond the West and bringing it to the Asian countries. It made its own cars (Tata SUVs) more advanced with JLR’s technology.
Corporate governance
Knowing what the management has to say about the operations and plans for the business gives you a sense of how your money is being used. However, you want to be sure that what is reported in the annual reports and financial statements shows the actual picture of the company’s financial health. That is where corporate governance comes in.
You might have heard the term “corporate governance” often. Many companies highlight it as their ‘top priority.’ But what exactly is it?
Many family-run or founder-owned businesses, as they evolve, might continue to act as owners, giving priority to their personal interests and sidelining the interests of other investors. To ensure businesses balance the interests of the company’s shareholders, senior management executives, customers, suppliers, financiers, the government, and the community, the system of corporate governance was formed.
This system lays down rules, practices, and processes for controlling and managing corporations. The system ensures the companies:
- Maintain transparency and accountability,
- Comply with the existing laws and statutes,
- Protect the interests of shareholders,
- Maintain ethical and moral business practices,
- Make adequate and effective decisions that are in the best interest of stakeholders.
Companies that protect shareholders’ rights and interests enjoy strong investor confidence as you know your money is being used ethically and for legal business.
(i) Why is corporate governance important?
Companies with poor corporate governance can significantly risk investors’ money. Poor corporate governance means companies might hide facts or report inaccurate numbers in their financial statements or practice unethical behavior, polluting the environment or putting investors’ money at risk.
Most accounting frauds and scams have shown signs of corporate governance failure. Some extreme cases are the Satyam scam of 2009 and the Yes Bank failure in 2018. These events eroded shareholders’ wealth due to wrong or unethical decisions by management.
Satyam scam is a classic example of corporate governance failure, which led to changes in the law and how a company’s audit is done. Satyam Computer Services founder and chairman Ramalinga Raju and top executives manipulated accounts by making fake invoices and reporting revenue and profits that never existed between 2003-2008. Almost 94% (₹7,800 crores) of the company’s assets and 75% (₹5,040 crores) of its revenue were overstated. He transferred the profits to his family’s enterprises, such as Maytas, to invest in real estate and other projects.
The scam was discovered when the 2008 Global Financial Crisis hurt the IT sector, and creditors and lenders asked Satyam to settle its loan obligations. In such a situation, Raju offered to use Satyam’s financial reserves to buy Maytas for $1.6 billion, creating an uproar among shareholders and board members who saw this transaction as a conflict of interest. Although Satyam received many awards for corporate governance, it was a significant failure. The company lost investor confidence, and shareholders’ value vaporized.
It was a landmark case that highlighted the importance of corporate governance. There are many cases worldwide, like WorldCom and Enron in the US and Volkswagen in Europe. While these are extreme cases, many frauds can be avoided with proper governance structures and a vigilant board. Satyam’s case was a well-planned and well-crafted fraud; the auditor and the board failed to do statutory checks.
Such incidents have strengthened the corporate governance system, making it more and more difficult to commit fraud.
(ii) Red flags of corporate governance
As a fundamental investor, you can check for corporate governance through various red flags. While there may be awards and accolades, small checks can make you vigilant.
Firstly, companies with poor corporate governance cannot withstand an economic or industry crisis and collapse.
Secondly, the financial statements and management actions might need to be in sync. They won’t add up and you might feel something is missing, as in Satyam’s case. Here are some red flags you can identify:
- The company might report significant profits but need better cash flows for several years. Looking at the trend of accounts receivables can give you a hunch.
- Management might speak highly about the company and its plans without highlighting the risks before raising capital to artificially inflate the stock price.
- The chairman’s speech might be distorted from what the financial statement says.
- Senior executives resigning or leaving the company abruptly could signal caution and call for detailed scrutiny.
As you read and analyse more statements, you will gain a better understanding of the qualitative aspects and be able to differentiate mere marketing tactics from actual, hard facts.
While the financial statements, corporate actions, and governance are things the company’s management can control, things beyond its control can affect its fundamentals.
External factors influencing a company’s fundamentals
A company operates in an economy and interacts with several entities, such as customers, suppliers, regulators, government (policy makers), investors, courts (in case of lawsuits), banks, and more. Any significant change in its surroundings can also impact the company.
Think of a company like a ship sailing on water. Any turbulence in the sea or winds will affect the ship’s motion. At the same time, it will also be affected by the course of other ships sailing in the sea.
Macro factors: Inflation, GDP, interest rate, fuel prices, favorable government policies and incentives, taxation, government investment, pandemic.
Government subsidies drove demand for electric vehicles, and food inflation affected the profits of FMCG companies. The pandemic served as a boom for hospitals and IT companies while disrupting the airlines and hotel industry.
Geopolitical environment: Trade and financial relations between countries could significantly alter the business environment for companies doing business with that country.
The Russia-Ukraine war benefitted Indian oil companies, as they purchased Russian oil at low prices when the U.S. and Europe banned Russian oil imports.
Environmental factors: Weather, natural disasters, climate change, limited natural resources (coal, iron).
Regulatory changes: Banks, Pharma, and food companies are highly regulated.
An FDA approval can change the business dynamics of a pharma company. RBI can ban a bank from conducting business if it fails to comply with regulatory standards.
Consumer trends: The disposable income of consumers, consumption patterns, and trends.
When consumers have more money to spend, automotive and luxury goods companies flourish. The real estate and automotive sectors saw a significant jump in sales post-pandemic as disposable income increased.
Competitors: Technological advancement, better business strategies, more investment
A fundamental analyst takes a 360-degree view of the company and the environment it operates in to build an understanding of the business and build earnings expectations. Once you build your analysis, you must keep modifying it as per the developments in the situation. The future is always in motion, and so should your analysis.
Now that we have all the fundamental analysis jigsaw puzzle pieces, it is time to make the big picture join the pieces. You can approach equity research in various ways.
In football, every player has a different approach to achieving a goal, but the rules of the game and their training are similar. Till now, we have covered the rules of the game. In the next chapter, we will train you on how to play the game by the rules. You can apply what you have learned and build your approach to the game with practice.
Summary
- One significant aspect of fundamental analysis is knowing the people running the company and assessing the management, their strategies, and actions. For this, you have to look at three segments:
- Management Discussion & Analysis: Management narrates the business operations, any off-beat events, changes in accounting, liquidity position, and capital spending plans. They also give guidance on the upcoming quarter or year.
- Corporate Actions: Management makes several decisions, such as paying dividends, stock buybacks, stock splits, mergers, and acquisitions voluntarily or mandatorily. These decisions tell you a lot about management’s style and strategies.
- Corporate governance is a system that lays down rules, practices, and processes to manage and control corporations and make them work in the interest of all stakeholders. Failure to implement corporate governance leads to scams, misleading accounts, and unethical practices that are detrimental to shareholders.
- However, red flags such as senior executives leaving a mismatch in management’s statement and financial statements could hint that something is not right, and investors should remain cautious.
- External factors like macro, geo-political, environmental, regulatory, consumer trends, and competition could affect the company’s fundamentals.