The Meaning of Management Quality: The Importance Of Valuing A Process

Sanjeev

Sanjeev

The markets have gone crazy. The tell-tale signs are all over the place…I will only recount a few. One, (in many sectors) an industry leader with good management is often valued at lower valuations than the second/third/ nth rung player, who makes a lot of noise, has his mug plastered over the TV news channels, talking up his stock up with stories about how he is “the next Infosys”.

(Disclaimer: This article was originally written in Oct 2005.)

When “the next Infosys” is valued higher than the original, you wonder…….. is it because while the original is too busy with his “core” business of textiles/sugar/auto or whatever, the copycat has got on to this new and temporary ‘business’ of raising stock prices, making private placements, private equity or IPOs……. in other words, harnessing the insanity of the poor fools who invest based on what they see on TV, read in the pink papers or hear from their colleagues and compatriots in Nariman Point/ Fort.

Two is this phenomenon called “competitive insanity”. I got some personal experience of this (comical) craziness recently. I am the CFO and Vice-President (Group Corporate Strategy) of a “hot” auto component co, that recently saw a “bulk deal” at a price premium of over 20% over the then market price. Suddenly, we (my CEO and I) were deluged with calls from all the leading TV channels to get on to TV and join the “talking heads” on the great prospects facing our company.

When I pointed out that NOTHING new had happened to our co, the tone of the underlying business fundamentals had not changed at all, and I had NO IDEA why somebody would want to pay 20% extra for my stock, I could almost hear the journalist at the other end gasp, “hush! Hush!… Don’t say that in a loud voice”. They were completely deflated at our refusal to go on TV and join the cheerleading brigade.

I asked rhetorically, “Why now? Why not yesterday? Or why not tomorrow? Why all this interest in my mug, merely because some fool wants to lose his shirt in my stock?” The response was stunning: “Ok, but PROMISE……..you won’t talk to any other TV channel!”

So that is what it was, is it?  That somebody else shouldn’t “get the story”……..even AFTER you know very clearly that THERE IS NO STORY. So much for “informing the public”…!

Three is this new and temporary disregard for what a company does, where its business is going, and what its management is prone to do over the longer term. Theoretically, the stock market is supposed to discover prices based on an assessment of the future cash flows of the company. Implicit in this principle is that there are foreseeable profits, and the market has an assessment of the management track record in re-investing those profits for sustainable growth.

In actual practice, however, the stock market often loses sight of its actual objective.  Prices get ‘discovered’ based on a simplistic projection of current reality to infinity (rather like the hefty 150% growth rates of the IT companies got projected to infinity during the IT boom of 2000, leading to valuations of 200 times earnings across the sector). 

Take a look at the “Carbon Credit Boom”, one of the component bubbles of this ongoing “India-flavoured bubble 2005”.  A one-time accidental cash flow, even if spread over a period, is discounted by the market on a forward-pricing basis as if it will continue to perpetuity and is part of a management-driven process that is controlled by the company.  Did you know that some of these companies are today valued higher (on forward earnings) than Infosys?

When you look at specific companies, you notice they have poor track records of investing their past cash flows delivering incremental returns on capital employed of 10% and sometimes even below.  Why would this new bonanza be invested with any greater wisdom than in the past?  One company that I looked at has gotten into, blown up, and exited 9 businesses in the last 14 years destroying capital that must be equal to its current Net Worth.

This brings me to the big point that I am seeking to make (and the explanation for the headline).  The major components in the valuation of a company are the business prospects facing its sector and its managerial capability.  Warren Buffet immortalized this concept when he said that he would instead back bad management in a good business than good management in a bad business.  This idea might hold a gem of truth in developed markets with good corporate governance standards but should be applied with caution in underdeveloped markets like India. 

If you look at some commodity markets in India (sugar, textiles, leather, etc.) you might characterize these businesses as inferior over the long term.  Yet, good management, ethical corporate governance, and an aggressive growth stance have created excellent companies which would have made Buffet jump for joy. 

Without getting into an argument over the relative importance of either of these two components, I just want to focus on Management Quality as a process.  FMCG was an attractive business until the end of the last century.  Few would characterize it as a cutting-edge business today.  Despite such a sluggish business, there are quite a few FMCG companies that still deliver EVA in substantial measure.  At the core of this capability is a managerial process that would perform regardless of the underlying business fundamentals. 

Let us take HLL/ Brittania as an example.  If, for some reason, the underlying businesses in these companies were to suddenly disappear, the core capability of being able to develop new products, manage a brand portfolio, advertise well / achieve brand salience, distribution effectiveness, and good working capital management, …..  these key business processes would still allow the company to redesign its business around the capabilities mentioned above. 

When you value a business, it is very important to separate the valuation of this “Management Quality” from a valuation attached to the fundamentals of the sector.    So there is some valuation that you would attach to the IT sector (say) and another valuation that you would attach to the processes that Infosys/ Wipro uses to extract greater value as compared to their peers. This can often be measured by measuring “peer outperformance” and putting a weight to it…..this is the value of “Management Quality”.

If we were to apply the above concept to these new Johnny-come-lately(s), a rational investor would factor in their past track record in blowing up businesses and destroying capital.  Even as we talk, up to 30% of the Capital employed in some of these companies is NPA.  You only need to know where to look……but the market is too drunk to look.

If we all agreed that HLL/ Britannia would command a valuation even without an underlying business, then equally a corporate governance track record that tells you clearly that the promoters would siphon out half the profits that the company will make……..should have got factored into stock prices.  This is what makes such companies excellent short-sell for the intrepid trader. 

When we look around the market, there is a consensus among us contrarians that there is absolutely no “value” (as defined by Graham / Buffet) to be found in this market except on the short side, i.e. there are over-valued companies which will give huge returns to the Bears once sanity returns to the bulls.  The last time such “value” occurred was in the middle of the IT Boom.  Imagine going short (like I did) on DSQ at 1170…….I would have put my shirt behind that punt if I had known how things would eventually turn out.  Of course, I would have had my heart in my mouth as I saw the stock spike up temporarily to 2820.  If you can put up with such pyrotechnics, and you know the Principle of Rupee Cost Averaging, then this is the only sure-shot value pick in the market.       

In all this madness, what helps is a ‘contrarian mindset’, that looks beyond what public consensus is right now. I’ve written a detailed article on the subject of ‘Contrarian Thinking‘. Please check out and join me in the discussion.

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Regards,

Dr Yatin Shinde
Indapur

Career Guru

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