If you are so profitable, where is the cash?

(This appears in the latest issue of Moneylife, the personal finance magazine) KICKING THE TYRES- LOOKING AT EARNINGS QUALITY Stock picking theories are many. Right from ratio analyses, industry analyses we have technical analyses and astrology. The average investor survives only because of luck. He has generally no clue about what he is buying or selling. His long term investments or holdings are often an outcome of a short term trade he initiated. He simply hates to sell below the price at which he bought. Well, let us keep all the analysts to one side. To me, the quality of management is perhaps the single most important factor after a cursory financials and business analysis. Ultimately, when we buy a share, we are becoming a part owner of the business that is run by someone. We are dependent on him to deliver a bang for our buck. However good a business or industry be, it cannot be better than the man at the helm. Often, I come across some incredible set of headline numbers and everyone talking great things about the company. Often, it happens in businesses that are fundamentally weak. The first disconnect for me is when a company stands out in a weak business. That is the first red flag. Then we start going deep in to the numbers and basic analyses throws out a con game. Of course, no one is immune to a structured fraud (like Satyam was), but most inconsistencies show themselves early- Bartronics Ltd, Opto Circuits, KS Oils, etc. So what do I look for in terms of numbers or inconsistencies? I will try and list out a few pointers and hope that some of the readers may benefit by it. The first test is to see whether a company has got any ‘free’ cash flow. For example, there is Profits After Tax. To this one can add depreciation. That is the first level of free cash flow generated by a business. However, this is only the surface. To reach this level of profits, I also like to see what happened to the working capital needs over two balance sheets. For example, the level of debtors has increased. This means cash is locked up there. Similarly, inventory could have gone up. And cash flow gets a boost by getting some credit on purchases. So, to the Cash Flow after taxes but before depreciation, we have to add or subtract the changes in working capital. Hopefully, this number is still positive. From this, I also like to knock off things like increase in loans and advances and a normal level of capital expenditure that is required. Let us assume that the depreciation is probably the amount needed to be reinvested in to maintaining its fixed assets. In such case, the FCF is really PAT +/- Changes in working capital +/- changes in loans and advances. This FCF is available to pay dividends. Now, in many companies, you will find that for years on end, FCF is negative. Obviously a Ponzi is on. In a case like Opto, the FCF was also diluted or negated by the buyout of new businesses on a continuous basis. In 15 years, the company bought 35 businesses!!. Obviously it needed cash. Already, the FCF was negative. So, it frequently raised capital. In one sense, dividends were paid out of fresh capital raised!! There are many other pointers- Does the company have too many subsidiaries in which a lot of money has been lent or invested? If so, do these associate or subsidiary companies pay market rates of interest? Why does the company have associates (businesses where others have a stake) ? To me, the presence of many associates and subsidiaries is a big red flag. Then I have to sit down with the subsidiary accounts (which mean writing to the company and then getting them) and see where the cash is going. I try and see ‘transactions with related parties’. The higher the value, the more suspect the numbers. I also like to see companies with no debt. When they have debt and it keeps increasing, I worry. I have seen companies where the borrowings increase by more than the sales numbers. Surely a great sign of trouble. Taxation is a great give away. If a company pays less than marginal tax, there is a very high probability that the profits are inflated. Similarly, depreciation is something I like to see. When depreciation rates are very low, I worry. I also like to see addition of vehicles etc. Just to get a feel of how much of personal expenditures get dumped on the company. Of course, a corporate jet is a big sign of a rip off and I try and stay far away from such managements who do not like other mortal means of transport. I also like to do some back of the envelope checks. Often I find companies understate their borrowings. For this have a look at cash and bank balances. When a company has borrowings as well as huge cash, something is wrong. Also check the interest outgo and try to relate it to the borrowings. One thing I like to do is to compare ratios and numbers with competition. If the numbers are way off either way, then I smell trouble. One company I was analysing was in to technologically advanced products. In one place they boasted about the total number of employees. Taking that and relating it to the total wage bill, I found that the average annual pay was under Rs.10,000 per month for those highly skilled persons. Each line in the accounts tells a story. Ideally one should look at ten to fifteen years of numbers if possible. Of course, there are things like Board of directors etc, which I ignore. In reality, there are no independent directors. Most are cronies of promoters and simply there to enjoy the perks of holiday homes and the commissions they get. So the Board tells us nothing. Board compensation also does not matter much, except a few of the directors now seem to be blatant about pocketing a few crores per year as compensation for self, spouse and children. Dividend payout is something I pay attention to. The higher the dividend payout, the greater is my belief on the cash flows. A low dividend payout is a flag. After Satyam, one is not sure even about balances in banks and mutual funds as reported in the balance sheets. I also tend to ignore asset values of land and property. Often, I have seen that the gains of these rarely accrue to the minority shareholder. Best to buy a predictable business where one is comfortable with the past. I am also sceptical about companies where the inventory and receivables keep going up disproportionately. Often, they are indicators of companies trying to show higher level of sales and profits than what is. Whilst investing, it pays to be cautious and sceptical. At worst we may miss an opportunity. But at least it will help us stay away from rotten apples.