INTEGRITY SCREEN

Shake hands but count how many fingers you get back

In 1996, stung by experience, we initiated what we called the ‘Integrity Screen’ as a filter for our investments. A conscious decision to avoid investing in companies with suspect corporate governance. No matter how large they were. No matter how much weight they had in the index. No matter how much important they were. 


We called it “shake the hands and count your fingers back” – a test of treatment of minority shareholders. 


If they did not pass this test, we will avoid investing in those names. 


The integrity screen is what we believe is called the ‘G’ – Governance in “ESG”.


Below are snippets of our view on corporate governance and India Inc at different points in time:

September 2008
The excesses are being flushed out. – Why we avoided ICICI Bank and Indian Real Estate stocks.

While India has none of the colossal problems of a highly leveraged consumer base, highly leveraged financial firms, or highly overpaid CEOs and executives, India has its share of excesses.


1)    At the risk of being outcasts, we had stayed away from investing in financials like ICICI Bank. Their rapid growth in the loan book and their relentless focus on market share at the possible cost of profitability was typical of businesses built for high octane GDP growth levels. In a harsher risk-return environment, growth for the sake of growth is no longer rewarded. On September 30, the Reserve Bank of India – the central bank - had to issue a statement confirming that ICICI Bank was healthy and that the RBI would be willing to give it funds to match any withdrawals. We have no such “insolvency” concerns on ICICI Bank. We only had an issue with likely profitability and the valuation.

 

2)    Another “contrarian” call we made was on real estate. We stayed away from the hype surrounding the “land banks” that were being built. Lehman, Wachovia, and a host of international groups were happily shovelling money to Indian developers and acquiring properties with some pretty ambitious assumptions on selling prices. With mortgage rates headed northwards (from 7% to 13% over the past 2 years) we were not quite sure how people would be able to pay for the homes that are needed. XL sheets create monsters that even a Harry Potter would find a challenge to overcome. 

January 2009
Why we never invested in Satyam

Satyam, in an Indian and emerging market context, also highlights the risk of investing in managements that have parallel – and sometimes multiple - business ambitions. The Raju family has interests in property and infrastructure. Our thesis is that cash flow from Satyam was used to build those fledgling businesses. Political connections (which Mr. Raju seems to have plenty of) are required for most land and infrastructure projects in India. As trustees of your capital and your reputation, we have often stayed away from popular companies which are known to have built their business franchise on political friendships. Though this “hurts” near term performance numbers, we know that a Yukos event is not confined to Russia. India has its share of a potential Yukos and Enron.

We did not own any Satyam stock because we were “uncomfortable” with Mr. Raju. We cannot fully quantify our decades of past experience in selecting managements to invest with – and it does not show up in any Sharpe ratio evaluation of our track record. But we have a process that should allow us to continue to avoid companies where we believe the businesses are run by founders and managements that live off their political connections. Or where the rights of minority shareholders are at risk of being compromised. Or are run by crooks.

The collapse of Satyam validates the blunt questions we ask managements in company meetings in order to duck the bad apples. We believe there will be a larger fraud if the government wishes to dig around a bit.

April 2009

That’s why investing in solid managements - who are committed to their businesses - is a key criteria for a stock to find its way into the portfolio. 


Flirting around with many of the companies listed in Table 3 above is an invitation to be mugged.

May 2009

While many of the surging stocks are, in our humble opinion, devoid of fundamentals or continue to be run by managements we would rather avoid, the folks at the bar don’t seem to mind. Like tequila shots, the depth of the concoction is shallow but gives an immediate boost. Unlike a tequila shot, though, this blood rush to the NAV may be illiquid.

October 2009

When elephants fight (fight between Ambani brothers), everyone will feel the tremors. Even though your portfolio has the unique distinction of not investing in any Reliance entity, the side effects of “sentiment” will always affect the rest of the market – and companies in your portfolio.

November 2009

Dubai Default - India, in our opinion, will be one such patch of grass where they will continue to chew away in relative peace.


So, don’t sell Indian stocks because of Dubai; but remain wary of businesses built on debt and rapid growth that are monetizing future cash flows.


we continue to build your portfolio around the peg of value reinforced by the integrity of managements who run businesses we like. 


We are decidedly boring: no need to stir and shake the pot for the sake of stirring and shaking.


We leave the mirage of grandiose Dubai and mesmerising Macau to those who are willing to dance in shifting sands.

June 2010
Beware the animals

The representatives of Indian industry - fondly referred to as “corporate honchos”, “leading industrialists”, “captains of industry”, “the face of new India”, or just plain “filthy rich” – are at the gates of heaven, poised to rush in.


Since the breaking of the various scandals over the Commonwealth Games, Adarsh (real estate), spectrum, oil and gas, iron ore, and coal the wonderful friendships and special relationships that many in Indian industry have had with their political partners and their allies in the bureaucracy has been in the spotlight. 


And being in the spotlight means that no new deals have taken place: no progress on “resource allocation”. No “resource allocation” means that the investment in the machinery to extract the maximum value from the resources given to the industrial houses on the cheap have been on the decline. 


This decline in lower purchases of machinery has resulted in a lower GDP (Chart 1). The media – owned by industrial families – is now in lobbying mode.


The facts may be different from the media perception. For example, if the government gave me spectrum at some 2003 price in the year 2007, it would be in my interest to buy and install as many telecom towers as I could. If raw material prices are gifted to me at 1/6th of their true cost (as per some estimates in a report by the Comptroller of the Auditor General) I would be a fool not to install towers to maximise the use of that spectrum. 


All those telecom towers I build to transmit my spectrum require raw materials like steel and cement and people to install. And once built, I would like to see the spectrum utilised so I start to spend money on advertising. And then I get customers and I get an army of service people to sign up subscribers, answer complaints, and process all their payments. The people I hire - and the people I buy all these materials and equipment from for my business - have their own consumption, their own economic activity.


A virtuous cycle is created. There is economic activity. GDP grows. India shines.


A small detail: as the original owner of the cheap spectrum and the catalyst of the India shining story, I become very rich in the bargain. Chances are I am now a US Dollar billionaire with a lot of personal wealth and a lot of money to buy more favours.


If you break that chain of free spectrum, oil and gas, iron ore and coal, and land, the economy slows down.


My market cap and wealth collapses.


And I do what I know best: get my friends in the media to focus on the terrible data “coming out” of India. This distracts from the real and important debate of how India builds a sensible, sustainable, long term policy in place of one that allows the industrialist to pay a below-market price for resources that belong to the nation. The media hype orchestrated by me, frightens the nation into believing that the end of the world is upon us and we need a quick solution.


It really is that simple. 


Add the fact that the global economy is in a terrible condition helps the industry-friendly press cook up the “news” that India is no longer shining. India is flat on its back and this “policy paralysis” must go. The government needs to act. Sorry, the government which is run by the friends of industry, needs to act.
The industrialists’ stranglehold over key national resources had been broken. Investments are down because the industrial families are not getting resources on the cheap like they did before. An alternative, transparent, and sustainable structure of finding a way to make the system of handing out resources to fuel economic growth is not in place. And it doesn’t look like it will be given a chance to be in place. The old “crony capitalist” system may be back.


The only, long-term, sustainable solution to improving investor sentiment is to have:


1)    A transparent mechanism of resource allocation in the economy which ensures that tribals and citizens get rewarded for what they own,


2)    A stable and sensible tax regime, not a regime based on vindictiveness,


3)    Sensible and transparent platforms and products that take the large savings that we generate as a nation each year and use these savings to fund the development of the economy.

No, we don’t need any animal spirit.


We need transparent systems.
 

December 2012
Beware the Drummers and their enchanting beat

Higher share prices have ignored the lack of “value creation” at corporate India and the macro and social tensions that have, in our opinion, worsened in the past year. India remains enveloped in corruption. The renewed call by Prime Minister Singh to revive the “animal spirit” could exacerbate the economic divide between the few who have v/s the growing number of those who are denied a fair share of the economic pie. Most Indian business groups continue to generate wealth based on connections. On a recent interview, I asked the anchor of a business TV channel to name me 10 Indians who have made USD 100 million over the past decade - and earned it honestly. She shook her head in silence. We are dancing on air.

Beware the drummers and their enchanting beat.


The drum-roll of “reforms are back on track” and the flood of money entering India have, true to form, caused a widening gap between perception and reality. Shares of many companies run by managements we would not trust your capital with, are not only showing signs of rebirth but are prancing around in a fashion that would make Gangnam style moves seem like a duck walk. The Mayan calendar predicted the destruction of the bad stuff on 12/12/1/2 from which better life forms were to evolve. Punters in India’s share bazaar seem to have missed that message and are content to worship the stone idols.


The continued rise in many small-cap and mid-cap stocks and in companies run by less trustworthy managements will see us begin to “underperform” – just as we did in the BRIC go-go days of 2005-2007. As long term investors loathe to forget the lessons of the past, we are committed to pursuing a disciplined approach to investing – though the environment has become a little frothy.


While this animal spirit stuff is good for a few rounds of dancing around the tribal fires, the underlying strength of businesses built on sound strategies run by sound managements have served your portfolio well over longer time horizons. Stone idols don’t impress us.
 

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