I was recently referred to an article by Prof. Bakshi (read here). Prof bakshi has written about a few companies which seems to be cash bargains (selling less than cash on the books), but are suspect due to their accounting and corporate governance.
Readers of this blog would be aware that I have a bias for companies with low debt and high cash on books. I do not get excited by growth as high growth companies are usually fairly valued or overvalued. However slow to moderately growing companies with a solid business model are frequently undervalued. Excess cash on the book only adds to the attractiveness of these companies.
Low debt and cash on books is usually a good thing, but excess cash holdings for long periods of time are not good for shareholders. It usually signifies that the management is allocating capital poorly and in absence of high return opportunities is letting the cash idle. This is ofcourse better than spending the cash on stupid acquisitions. However a shareholder friendly management should return the cash through dividends or buybacks.
The above holds true if the cash is actually present. After the satyam episode, one cannot be completely sure of that. I have always looked at the management quality and corporate governance of a company in the past, before committing my money to it. It is easy to identify cases of bad (see aftek here, which the prof has also referred to in his article) or good governance. The problem is identifying managements which are not good, but not overtly bad. The bigger problem is identifying complete frauds, where the !@## (put your choice of expletive) auditors are hand in glove with the management.
There are books, which discuss this topic (of financial fraud) in detail (see here). There are no clear-cut formulae to identify aggressive or fraudulent accounting. A deep understanding of accounting and experience, will throw up red flags when one is reading and analyzing the annual report of a company. A single red flag may not be a cause for concern, but several of them together should alert you. I will be covering some of these red flags in a future post.
Let me come back to another example in the article – HTMT global. I have discussed about the company in the past and have a small holding in the company (it is part of my diversified graham styled portfolio). The key reasons for my investment are – cash on books higher than the market cap, decent topline and bottom line growth and ultra cheap valuation. However the negative on the stock is corporate governance. As indicated in the article, the cash is held in a subsidiary in Mauritius.
The CFO indicated in the analyst meet that the cash is being held to avoid the 30% tax and for acquisitions. During the analysis of the company, I read this explanation (I was searching for it) and found it plausible. However on reading, prof bakshi’s article I was disappointed to read this
HTMT has deposited cash in Mauritius. When asked about keeping its money outside India, Anand Vora, CFO, said: “We have been getting a lot of queries, because PwC is our auditors and have a considerable amount of cash on our books. We don’t want to comment till we get a clearance from our legal team. So, while your questions (on overseas accounts and account balance and cash on books) may not be very sensitive issues, we will still like our legal team to go through it.”
There are two red flags in the above statement : PWC and the reluctance of the CFO to give a straight response. If you have cash on the books, why do you need the legal team to go through it?
Does the above mean that the cash does not exist? Should one exit the stock? To be honest, I don’t have an answer for that. If one cannot trust the management and the auditors to tell the truth, then it is not possible to invest in a company. The entire financial system depends on this trust. No one will invest, if the management and auditors cannot be trusted to tell you the truth.
So where do we go from here? For starters I am reviewing all my holding to check their cash holdings closely and tie it with the interest income. I have checked these numbers in the past, but with only a passing interest. I will however be looking at these numbers far more closely now.
In addition, though I have focused on corporate governance in the past and rejected several ideas for my core portfolio, I have been more tolerant in my graham styled portfolio. I plan to give more wieghtage to this factor in my stock picks in the future. I have purchased companies, which are statistically cheap, even if they are not upto the mark in corporate governance. I plan to put more wieghtage on this factor going forward.
I am still thinking about HTMT and have not decided yet. However my comfort levels have dropped a lot with this company and my gut feel is not good (yes, I listen to my gut feeling ..ignoring it in the past has been costly). I may decide to exit the company even if I have to take a small loss. This may be an over-reaction to the satyam episode as there is still no factual basis to distrust the company. However there should be no tolerance on corporate governance and transparency. In the end i would rather err on the side of caution than repent later.
Added note : I just glanced at Satyam’s annual report. The company reported 3300+ crs of cash with scheduled banks and an interest income of 270 Crs. The scheduled banks seem to be bank of baroda, BNP, citibank, HDFC, HSBC and ICICI bank. How the hell did the auditors certify the cash if the management says all this cash was fictitious ? If this news report is true, then one can derive comfort that the statements were not fraudulent and the cash was actually siphoned out.