Reflections on Quality of Earnings – Part 4

TL; DR Version

  1. Do not confuse pricing with valuation. While pricing is convenient, valuation is more rigorous.
  2. Rigor also demands an eye towards detail and subtlety. Paying attention to quality and building it in valuation is what lifts its accuracy.
  3. When deciding quality, a strong unquantifiable factor is the management of the business. To assess this factor, one must pay attention to the various commentaries, disclosures, and other aspects that the management puts out time to time.
  4. Analyzing these different disclosures is called “Differential Disclosure Analysis”. It involves a simultaneous reading and cross-checking of the disclosures against each other.
  5. In India, with choices of multiple disclosures limited, one should try to explore these three avenues in depth:
  • Annual Reports
  • Conference Call Transcripts
  • In Person Management Visits

Pricing vs Valuation

Conventional equity research in our markets revolves around pricing and not valuation. Applying a PE multiple on a line of business is a classic pricing step and not valuation by itself.

What is the difference between pricing and valuation, then?

Pricing is a matter of relativity. Take the example of a jeweler who wants to find the price of a gram of a gold-copper alloy, made in 50:50 ratio. The jeweler looks up on the internet the price of a gram of gold and a gram of copper. He calculates the value of a half gram of each metal and then sums it up. He marks it up by a percent to reflect his labor cost and he has priced it effectively.

This exercise doesn’t make any attempt to judge if gold and copper prices are reflecting “boom time” prices or “depression type” prices. The jeweler further doesn’t care if his wares are “priced” appropriately taking into account the availability of such an alloy in the market or not.

All he does is “price” the alloy, relative to two other metals.

What does valuation entail then?

Valuation is a much more complicated business where an investor/analyst has to assign a dollar value to an asset irrespective of whether it has a like-to-like comparable benchmark or not.

It is all about accounting for the nuances. As a result, using another existing asset to value the asset in hand, is not valuation.

Put in a concise form:

  • Pricing is Relative, Valuation is Absolute
  • Pricing involves Benchmarking/Triangulation, Valuation involves benefit quantification
  • Any asset can be priced, many cannot be valued
  • Pricing assumes the markets are correct, Valuation doesn’t need a market
  • Pricing works without consideration of nuances, Valuation works when differences are accounted for

Assessing Quality in Valuation

If pricing is the poor plebian cousin of valuation, then quality must be the hand-maiden of valuation. This is because valuation gets more and more accurate when aspects of quality are taken into account.

So while investors focus on objective parameters and valuation/pricing at the expense of focussing on quality, it is ultimately the knowledge of quality that will affect our objective valuation.

Pricing involves generally less rigor. In essence, accuracy is sacrificed to gain ease. But even pricing can benefit from a nuanced view of quality. Simple focus towards the economics of the business (or the line of business), debt to equity ratio affecting volatility, etc. can play an important role in deciding the earnings multiple that should be applied to the target companies.

It is not that, analysts who generate the usual sum of the part analysis don’t involve matters of quality. But they do so, often in a very haphazard and ad-hoc manner. Consider a conglomerate having two business verticals – a biscuit manufacturing line and a real estate development line.

The analyst applies a different PE multiple to the two, often pulled by averaging competitor companies’ PE and applying it to the target companies. This has to effect of removing important considerations like cost of capital, return metrics, etc. from the calculation.

Assessing Quality is not Easy

The judgment of quality requires deep understanding. Understanding demands cross-domain knowledge. It gets complicated by the human side of the business – the management.

While many aspects of a business can be compared, the management cannot be compared quite as easily across competitors. But management plays an important role nevertheless.

Assessing Quality from behind a Veil of Ignorance

If assessing quality was difficult, try doing that from behind a veil of information asymmetry. An investor, how much ever wise or insightful will always be operating with incomplete knowledge of the business.

To counter such a disadvantage, an investor must behave like a hunter. Just like a hunter triangulates the presence of prey by looking for pawprints, markers on the grass, droppings across the field, an investor also must learn to triangulate.

accuracy action active activity

A hunter collects evidence of presence of his prey, before hunting. Photo by Pixabay on


The Meaning of Triangulation, as given by Google

For an investor in developed markets, the choice of establishing a “triangle” is many. But for Indian investors, it is low.

Three Points to Triangulate

  1. Annual Reports/ Letters to Shareholders/Management Discussion & Analysis

    This should be the first port of call for any investor worth his salt. Much of this series and the sister series “Understanding Quality of Earnings” reflect on understanding and analyzing these outputs. But also, in India, there are plenty of businesses which have highly indifferent annual reports. Often filled with boilerplate commentary and macro-economic reporting, the letters to shareholders do nothing much to inform or enlighten.

    In those cases, one should try to supplement by other means- possibly by, looking in annual reports of related businesses. Horizontally across the industry (competitors), “up the value chain” (customers) or “down the supply chain” (vendors) are the logical candidates to asses the industry, ecosystem, and profit pool.

  2. Quarterly Conference Calls/ Company Visits/AGM visits

    Quarterly conference calls are a great way to build an understanding of the company, get up to speed with the questions the informed analysts are asking and supplement your knowledge of the company with additional management commentary.

    Company visits, AGM visits, and conversations with the management are additional ways to generate insights about the company. (Note to Self: write or invite someone to write about the art of interviewing management)

  3. Talking with Vendors/Clients/Employees

   Scuttlebutt, the way Phil Fischer espoused still remains one of the most effective ways of gaining insight into a business. A mere conversation with a vendor or a client makes a lot of difference in understanding the overall product quality, its demand in the market, the relationship a business maintains with its stakeholders, the amount of “taking” attitude (to extract the last bit of penny from a transaction just because one can) a company espouses etc.

All these factors can prove to be important pieces of the puzzle when we try to understand the business. I must admit, I have been saved at least once from making an unnecessary investing mistake when I chose to ring up my friends across the banking industry to get a sense of Jammu & Kashmir Bank’s risk management policies, etc. just after the Indus/Jhelum flood in 2015.


  1. Do not confuse pricing with valuation. While pricing is convenient, valuation is more rigorous.
  2. Rigor also demands an eye towards detail and subtlety. Paying attention to quality and building it in valuation is what lifts its accuracy.
  3. When deciding quality, a strong unquantifiable factor is the management of the business. To assess this factor, one must pay attention to the various commentaries, disclosures and other aspects that the management puts out time to time.
  4. Analyzing these different disclosures is called “Differential Disclosure Analysis”. It involves a simultaneous reading and cross-checking of the disclosures against each other.
  5. In India, with choices of multiple disclosures limited, one should try to explore these three avenues in depth:
  • Annual Reports
  • Conference Call Transcripts
  • In Person Management Visits

Actively pursuing differential disclosures is time-consuming in India. They also do not guarantee the success of finding the next multi-bagger. They are just another set of tools that one must adapt to protect oneself from getting blindsided.

Many investors do quite well without going to that extent. Many investors also fail after doing all this. This is no secret sauce. At the end of it all, it comes down to uncovering what others are ignoring. And hoping that one goes wrong less than one gets to be right.

After all, that’s what makes it so challenging, isn’t it?



Understanding Quality of Earnings – Part 04

This blog post is the fourth(1,2,3) in a series of blog posts that talk about the quality of earnings for a business. Much of the content in this post takes its inspiration from Thornton L. O’ Glove’s book “Quality of Earnings” published first in 1987.

The best way, to peruse this blog post is as an exposition of the classic text. Alternatively, if you would like to read further about the concepts in the context of modern-day businesses, read up the sister series, “Reflections on Quality of Earnings”, each part in the series roughly running parallel to the other(Part 01,Part 02, Part 03(i), Part 03(ii), Part 03(iii)).

A word of caution before I begin. This post will be the least explanative of all chapters of this book. Primarily because the experiences of the U.S. don’t quite travel well to our markets. In this chapter, there is a huge focus on collating different filings and cross-checking them for conflict and inconsistencies in this chapter. In India, my numerous efforts haven’t quite turned up any specific example where one can rely consistently on alternate sources of information for a company, other than the annual report.

I will try to get around these limitations by suggesting other means, but needless to say, this will demand some hard work and patience to stitch together the narratives.

Without much ado, what follows after the following section is the fourth chapter of the book, Quality of Earnings- Chapter 04- Differential Disclosures


It’s Quality That Matters – Differing Disclosures

Today’s post is all about deep investigation. When a sleuth takes on an investigation, what does he do?

He gathers all reports he can possibly lay his hands on. Then, he starts reconciling the different versions to arrive at a truth.

In essence, he collects diverse perspectives, opinions, and narratives. If he doesn’t have enough different perspectives to base his investigation on, he is forced to hunt for new perspectives. But collect he must!

In investing, the issue is slightly stilted. It is hard to come across markedly different opinions and perspectives about the same company.

In addition, much of the opinion that is so formed relies on the same “spring well” of information – the company released information. But, this company released information can also be different based on two or three different “intended” audiences.

For shareholders, there might be one version of the truth, for regulators, another, for taxmen, still another.

Yes, you read that right. This is one of the best-kept secrets of the modern corporate world that companies maintain multiple books depending on their use. Generally, it’s 2. One for shareholders and the other for taxmen. For regulators, there is a whole lot of deep reporting that may be going on, which may or may not pertain to shareholder mandated reporting (e.g. liquidity reporting, funding reporting, maturity rollover reporting if the company is a lending institution, etc.) They are not different books but think of it as different systems, different metrics.  I won’t be surprised if there is still another for those companies which are engaged in fraud. 

Differential disclosure is all about reconciling these different views, even if they are coming from the same conceptual source (the business).

Unfortunately, in India, it is not possible to lay one’s hand on regulatory filings when there are (RBI filings for example), and the question is moot when there are not. Combine these ideas together, and it becomes quickly clear that the “raw material” for any sleuthing work in India is severely hamstrung. The cost of generating such different perspectives are too high.

This forces us to innovate. So truly driven, the enterprising investor goes out in the market and engages in scuttlebutt. He works alongside the vendors, clients, suppliers to understand all the different “faces” a company decides to project (or not project).

This can have a truly disproportionate effect on one’s research. I have heard anecdotes where such “plain old questioning” has helped them shed new light on their portfolio companies.

So while this blog post is going to be all theory and no actionable intelligence, it doesn’t do much harm to understand the “approach” the author is espousing.

Chapter 4: Differential Disclosures

What does “Differential Disclosures” mean? O’ Glove defines it thus- “the possibility that what a company says in one document differs from what it says in another. Or there may be more complete information on the same”. O’ Glove clarifies he is not referring particularly to corporate announcements, or press releases, but more dense and thorough reports like 10-K, 10-Q, and annual reports.


#1 Be Cautious of Differences

sliced of citrus lemons

Different versions of truth must be reconciled. Photo by on

Be cautious about different versions of the truth. O’ Glove alludes that between a government-mandated report and stockholder report, it is often the stockholder report that paints a rosier picture.

He humors, that no CEO will go to jail for failing to hold up on promises made in the heat of the coitus with the shareholder. However, he will be in serious trouble if the government mandated reporting is suspect or contains misstatements.

In simple English, while the narrative bits in the shareholder communication is put together with ample help from public relations experts, the hard truth of regulatory filings are reported after burning midnight oil with the CFO and Chief Accounting Officer, in some cases.

#2 Do not shun narratives…But be not enamored by it either..

administration articles bank black and white

Annual Reports must be engaged with the same attitude as we engage with media- skepticism, but open-mindedness Photo by Pixabay on

Why so?

Because even if the annual reports are products of public relations, one can come across valuable bits of information about the management, their decisions and the rationale behind it.

One may even come across future plans (if they have any) if an investor is fortunate. It will be wrong to forsake numbers in pursuit of a narrative, and stilted to sacrifice narrative at the altar of objective truth.

So, since information emanating from the company is itself scarce- peruse everything. Occasionally, one may come across inconsistencies between different versions that companies release from time to time (quarterly vs annual, regulatory filings vs shareholder disclosures)

#3 Euphemisms, Image Manipulation, and Critical Eye

Differential Disclosure is as much about matching the numbers and reconciling them, as much it is about reconciling the narratives (or absence of it).

Annual Reports may play up the role of a business line in good times, but during its cyclical downturn, may downplay its importance. As Kissinger said- “intentions can change overnight, but capabilities can’t”. So too the capability of a company not to be reliant on a particular business line for its revenue/profitability.

A business line on which the company is reliant for growth/margins/revenue when suffers will always light up the financials. Even if the management doesn’t quite talk about it.

This will get easier to understand from a case study that O’ Glove presents. Academy Insurance Group (ACIG) was an impressive business concern on the fast pace of growth from late 1978 to 1983, racking up 22 consecutive quarters of earnings growth greater than 35%. Quite a mean feat! In its hubris, it expanded into other allied (Amistad Savings and Loan) businesses and non-allied businesses (Time Sharing Resort Complex in Poconos)

As can be expected with such a scorching pace of growth, the stock price rose by an astounding 68x during this period. While in 1983 Annual Report, it presented and up-sold the story of a diversified conglomerate by highlighting flattering pictures of Poconos resort, come Q1’1984, when insurance business suffered a downturn, it went silent on its timesharing business.

The surprise? Revenues generated from timesharing business formed an astounding 40% of the total revenue for the past few quarters and “threatened” to contribute an even larger share of the pie.

But the catch is, the company was loathe to get classified in the minds of shareholders as a time-sharing resort complex business. As one can ascertain, while insurance business earns a regular stream of dollars without having to spend an incremental amount(, once a revenue stream is established), the same is not the case with a time-sharing business. This business commands a lower earnings multiple than insurance business. Talk about a problem!

#4 Piecing together a puzzle

assemble challenge combine creativity

Photo by Pixabay on

A deeper understanding of problems come up with collecting, mixing and matching information culled from different sources at different points of time. This is a serious endeavor and requires a certain amount of diligent mindset.

The author narrates an incident about a particular bank, which for the previous year gone by, made related party loans for a sum total of $545MM.In itself, the author himself admits this is not wrong and doesn’t think too much about it. But shortly thereafter the company sends across a proxy statement to shareholders along with an agenda of voting in the upcoming AGM.

The statement notes an observation/claim by the regulator that as per a particular bylaw, any such related party transaction has to be essentially on the same terms as loans made to other parties. Good to know, but not much of “actionable intelligence”

But in the consequent quarterly results, the business revealed that approximately 14% of the related party loans had gone sour! This completes the entire picture of the loan book.

The author reasons, if related party loans were made with the same quality diligence as the usual customers, then who is to claim that the same degradation in quality has not taken place across the loan portfolio?


Reading annual reports is one part of the exercise. Piecing an entire puzzle together with information disclosures spread across time and sources is the highest degree of skill in this business. This business demands a large degree of detective mindset. Patience is a virtue and attention to detail is a weapon. Perhaps that in certain ways explains the large success achieved by people with non-normal behavioral patterns (repetition, focussed attention, etc.)

However, the bar of the minimum required “focus” is so lowered (owing to our competitors not really engaging in them much), that all it takes is the intention.

Reflections on Quality of Earnings- Part 03(iii)

Taking off, from the previous post where we discussed one portion of the shareholder communication, we redirect our attention to the second portion.

AR 2017-18

Analyzing the “Message from CFO”

There is an increasing risk of client concentration (can be put on the flip side as, deepening relationship) for Mindtree, with its top customer driving the growth in the digital business.

While the company claims to expand in the cutting edge technology innovations that are spreading across the world -AI/Blockchain/Cognitive Computing etc. the success, extent, and the conversion to hard profits is suspect at the best (Sidenote: I have come across only TCS with its Quartz implementation that successfully rolled out a blockchain based solution).

Coming back to its sales pitch on “digital business”, the company has purposefully kept the definition vague.

Mindtree and Digital

Mindtree and its concept of “digital” business. Source:

However, what can be understood is this: Digital is merely the automation, infrastructure management, and development in a brave new world. 

Put even more simply, it is this:

Mindtree, Digital and Case Study

Business via Cloud (Salesforce, AWS, etc.), UI design/redesign and Omni-channel UI are what I would consider are Mindtree’s forte/definition in digital business.

To be fair, Mindtree doesn’t really claim otherwise, that digital is a new kind of client demand is the way it showcases revenue split in its quarterly releases:

Mindtree Quarterly Revenue Reporting.PNG

Nevertheless, it can be slightly complicated for a lay reader to understand the true meaning of digital business, without quite getting to know what it actually is. So what looks actually, is a flattish growth in EBITDA margins (2017 to 2018 and now to 2019): 13.7% to 13.6% to 15.2% currently.

The CFO makes one observation, that is laughable:

Our recent acquisitions have enabled us to expand our service offerings across verticals.

Why is that laughable? Acquisitions in IT industry seldom work out well. Infosys-Panaya, Infosys-Skava are good examples. But for Mindtree, it has been a string of failures one after another.

In FY 08, it acquired partially AztecSoft and acquired fully in FY11 for 400cr INR. Immediately after, the subsidiary saw a drastic (approximately 75%) reduction in revenues. Assuming that was because of the GFC and the associated belt-tightening, yet the subsidiary could never really justify its price tag. Outsourced Product Development line of Aztecsoft suffered a blow right in 2008 because of a fall in VC funded startups who engaged in Aztecsoft’s services. The PE services this subsidiary was brought for earned approximately 71cr in FY11, 83cr in FY12 and 166cr in FY’13. By FY16, PE services stopped getting reported and the company started calling out its revenue lines by “service offerings”.“Engineering” drew just 9% of the total revenue of 422cr. (To be fair, the testing vertical started playing a significant role by this time, and would become a key domain in the next 3 years)

Then Kyocera Wireless acquisition came in the same year as Aztecsoft’s total integration- FY’11. The mobile handset business was an unmitigated failure, which had to be written down just a year after. This had the effect of pushing Ashok Soota out of the business. The resultant goodwill impairment was INR 21MM in FY 2012.

At the same time when Aztecsoft was being partially acquired i.e. FY’08, the company went on to acquire TES-PV for $6.5MM. TES-PV, subsequently renamed as MTPL was a chip designing subsidiary of TES- a European chip designing giant. The company said it as “This acquisition helped us double our IC design team-size and strengthen our presence in the Japanese market“. This transaction resulted in goodwill of INR22.3crores. Yet, no mention of MTPL or TES-PV could be found in the annual report of Mindtree in FY11. The reason was simple, the company stopped mattering as early as FY09. Revenue was negligible, profits were minuscule.

In May 2010 (FY11) Mindtree acquired assets of SevenStrata, a remote infrastructure management company for INR 77MM. The conference call of Q1FY11 doesn’t even broach the subject of these assets.

In the fag end of FY15, the company acquired four other companies, Relational Solutions, Discoverture, Bluefin, and Magnet 360. We don’t have much clarity on Relational and Discoverture as of now, except the one-off mention of property and casualty successes. Management in FY18 was still holding the hope of a turnaround in Magnet 360 while Bluefin posted positive earnings after lackluster FY17.

So long story short, acquisitions is not really a game Mindtree should be playing. The letter from the CFO wraps up with a tour of CSR activities, the company’s increasing inclination towards training the new hires while they are right in the college (a testament to the absolute shoddy nature of education we in India engage in) and concludes with its successful completion of buyback.

On a parting note, it reiterates its focus on three pillars: Domains, Digital and Run Pillar (maintenance services).

Assumptions for the Analysts

The combination of different factors precludes any assumption of gangbuster revenue growth. Primarily because the domain of expertise Mindtree has chosen (or rather it has been pushed to) is Retail. Retail businesses world over are getting disrupted by either their online competitors or the market leaders who shifted online before the rest. This leads to low growth numbers, optimistically 10-12%.

This results in a tapering of high margin growth for Mindtree. Unless BlueFin and Magnet 360 are somehow able to bring back growth.

Secondly, Mindtree is focussing on digital and “run” pillar. Either due to compulsions or choice. I suspect the former. This business choice will ensure, that the company’s EBITDA margins always hover in mid-teens (13-15%).

What can change this assumption, is a dramatic increase in the consulting business. If it is able to re-invent itself as a desi-Accenture, only then the margins can see an improvement.




Reflections on Quality of Earnings- Part 03(ii)

The first subpart of Part 03 of this series is here. That article analyzed the annual report of Unichem Laboratories through its previous 5 years and ended with a promise to take up Mindtree in the next.

This post intends to keep that promise.

But before I begin, a bit of a backstory. Mindtree has always held a special place in my heart and head ever since I came across it about 14 years back. In 2005, I was still an engineering graduate, immensely interested in chip designing, product engineering, and innovation. In came, Mindtree with its wonderful story of how 10 friends came together with a vision of something different.

MindTree logo

Mindtree to its credit told its story wonderfully to everyone it came across. Especially in an environment where the idea of a startup didn’t yet capture widespread attention. The story wrote itself. 9 people coming together, under the aegis of a wise man, sharing the values of egalitarianism, generosity and a passion to create a difference. (It was also one of the first companies which gave me a job offer right after college, which I didn’t take up later on.)

But there was always a “gap” somewhere. Years later, as I took out the rose-tinted glasses and started thinking critically, there seemed always a tonal mismatch. A CEO was not really CEO, he was Chief Gardener. An FTE in Mindtree is not an employee, headcount or associate- she is a Mindtree Mind. The wise man leaves the business and starts another IT company called “Happiest Minds”.  5-6 CEOs in the company(at one point), each heading their own business verticals.

But in spite of all these posturings, Mindtree couldn’t really post the growth numbers that a startup of modern-day aspires to. In short, a lot of posturing, a lot less delivery.

No wonder, its annual reports and the letters to shareholders read like a lot of self-congratulatory, wildly promotional monologue than an attempt to enlighten. It was also very difficult for me to separate the wheat from the chaff because when everything is positive beyond wonder, the true positives are always washed out.

A clarification is due here. I am not alluding that its self-congratulatory tone is a consequence of any malice. As far as I can perceive, the management is truly honest and may very well be well-meaning. But somewhere in its bid to make a difference to those around, it has (in my uneducated opinion) lost sight of the priorities and what matters most.

A certain kind of attitude is required to steer a company through growth pangs into greatness and do good in the process. It is not easy to juggle these priorities which sometimes clash. I believe it was this attitude which was amiss from the management team. In spite of all the posturing, the management team never really tried to protect their business. It never tried to buy back the shares of the founders who were exiting the business. As a result, those shares ended up with outside entities.

Be that as may, this post is a discussion of their annual reports and not really a rant for their inability to ringfence their business. But the outcome of their promotional communication style was a “difficult to decipher” annual letter to shareholders.

AR 2017-18

Analyzing the “Message from Chairman and CEO”

If there is one thing that this letter has ensured it is that this message carries the highest amount of drivel per unit of sensible information. A bit too harsh but sample this. In the opening columns of this letter, addressed to shareholders, the Chairman & the CEO choose to highlight the results of an internally held customer satisfaction survey as the first and foremost point.

Deal win statistics, with the biggest deal, won in the history of the company (~$1B) ranked second in the scheme of things. The successful completion of the first buyback program was third. The letter went on to quote, quite proudly, that annual compounded total return to shareholders came to 15.7% since IPO. Is that naivete or genuine self-congratulatory message, I am not quite sure,  but in an environment where the broader index has returned 16% compounded, it can barely be called an outperformance.

To compare its performance with the IT bellwethers, will also project it in an unflattering light, however, to be fair it has outperformed NSEIT index during this period. But, the bone of contention is not really the interpretation of these numbers. It is the stunning lack of any worthwhile information relevant to an investor reading with a critical eye.

The letter moves on to the challenges that the business faces. While the letter doesn’t quite articulate forcefully, those challenges are definitely the most acute. The letter goes on to mention, that the fast-changing technology landscape is posing a significant issue for the company. This is to be expected. Since, while the needs of the clients have pulled away into a different orbit, dominated by new technologies and new paradigms, Mindtree is still hired to do the old world job of testing, technology and infrastructure maintenance. These three together, contribute to 51% of the revenue.

Mindtree-Revenue by Business

This snapshot compares the revenue by businesses across the functional verticals

Even the largest deal in the history of Mindtree, (the before mentioned $1B deal) is in testing. One of the flagship projects in FY2017-18 that Mindtree delivered for its client (one of the world’s largest insurance carrier), was also Testing & QA based. The upside of testing and QA is the efficiency ease that one can build in this business via automation. The downside is, this business is highly undifferentiated and low-value in the larger scheme of things. Development and Engineering need to be closely looked at for any potential sparks of growth. But given the tone, tenor and the lack of detail in the letters to shareholders, an analyst is left guessing as to the nature of the function.

Nebulous comments like- “We embraced the technology revolution and led the thinking for our clients. In many cases we paid the short term price, either by cannibalizing our revenue or sacrificing margins by making investments to prepare for the changes.” are abound in this annual report.

Such sentences are often followed by conflicting information like this – “That call proved to be the right one. We started FY2017-18 with 11.1% EBITDA margins in Q1, but ended the year with 16.1% in EBITDA margins in Q4, in a period when the appreciating Rupee ate away 0.7% of our operating profits.

Q118 lower revenues

Excerpt from Q1’18 conference call transcripts explaining the reason for softer than usual EBITDA margins.

Slight digging of individual quarters’ conference call transcripts, shows a stark picture. It is not that Q4’18 was extraordinarily strong (QoQ growth of 100bps, out of which only 30bps was operationally driven). It was that Q1’18 was a softer than usual quarter because the business took a revenue hit on one of its subsidiaries Bluefin Solutions.

However, the reader should not lose heart, at such misdirection. This is par for the course when reading annual letters to the shareholders.

The second challenge the letter elucidates is the effect of technology change on the workforce and their skills. In short, how to reskill the workforce to adapt to the technology change. True to character, the drivel continues with statements like -“media articles about the effects of technology change on the workforce continue to bombard us. Consistent with our philosophy that our passionate and expert people are the most important ingredient for us to create value for customers, we saw the Tsunami a long time
ago and prepared adequately.”

The solution the company adopted was investing in an internal training platform called “Yorbit” where the aggregate workforce of the company spent slightly over 100 hours per head learning new technologies. How effective is this approach in adapting to the technology changes happening in the world- I don’t really know. But I can bet with a decent wager that a substantial portion of these training modules must be firm-wide compliance modules like cybersecurity best practices etc.

A slightly different way to think about the trainings on Yorbit. Mindtree intends to move into path-breaking technologies (think Blockchain, AI, etc.) and it attempts to do this via employee reskilling and training through Yorbit.

Question: Who is really designing these courses on Yorbit for the consumption of employees?

Follow up Question: If he is that good, why is he not coding?

Follow up Question to the Follow-up Question: If the teacher is not that good, then how good the taught must be getting?

The truth is, specialized knowledge on cutting edge topics can seldom be found in pre-packaged, ready to eat courses on internally developed platforms, where the teacher will have to build his knowledge first and without any expectation of incentive, will teach to his brethren.

Lastly, Mindtree added new members to the Board, who are veterans in Retail & CPG industries. This is the most unadulterated signal from the company about its “push” in the business. Its retail analytics solution Flooresense, goes head to head with TCS’s business in CI&I for Retail. How successful this pivot is, needs to be monitored.


The letter concludes with a 6 point laundry list of goals- divided into pairs among finance strategy and workforce related.

Among strategies, Mindtree makes it clear that it intends to accelerate its uptake of “run-the-business” programs. The meaning of this “silo” is explained in the Message from CEO, which defines “run-the-business” as, integrating infrastructure (DB, Networks, etc), Applications and testing, along with modernizing the IT operations. Kind of “you-run-the-business, I run-your-IT-enablers” kind of a value proposition. Needless to say, this kind of program needs strong contacts, client connection, and marketing push. Will we see an increase in marketing expenses over the course of 2018-19?

The second growth cog will be Digital. Preliminary readings of Mindtree’s conference call transcripts do show a healthy rise in the digital pipeline.

On a parting note, deciphering Mindtree’s letters to shareholders took me far more time and effort than I originally anticipated.

And the message from the CFO is yet to be analyzed…

To Be Continued in the next post

The next post is here.







Safety of Bonds, FMP and HDFC pulls a rabbit

The Maze from Westworld

Call it the “Maze”, “The Circle of Life”, “The Secret”… every journey towards self-awareness starts from the same point. Image Credits: HBO, Westworld

“Every Limit is a Beginning as well as an End”

-George Elliot, Middlemarch


My attention got piqued when I came across this tweet

It got me wondering. The link in the tweet starts innocently enough,

“HDFC Asset Management Co. Ltd on Wednesday said that it has extended the maturity date of fixed maturity plan (FMP) Series 35 to April 29, 2020, from April 15, 2019”

Interesting. It confuses more than it informs.

Did I get this thing right? An investment grade debt fund in India has unilaterally extended its maturity date.

In short, it has refused to pay on time.

To understand this issue deeply, let us take a small detour.


The Setup

Not allowing redemptions is not a new thing. It means the fund is facing a liquidity crunch (not able to pay immediate dues).

Hedge Funds, Equity mutual funds, Credit funds do this commonly under liquidity crisis. Commonly, because all three straddle the riskiest corners of the market.

But for a traditional investment grade debt focussed fund to do this is slightly rare.

The Point Of Explanation

Okay, its time to explain what is an investment-grade debt fund?

Why is it different from equity mutual funds or credit funds?

And why does it matter?

Think about all bonds lying arranged on a ladder by their riskiness. The top end composing of ultra-safe bonds, and the bottom end being ultra risky. The ones that are ultra-risky pay handsomely. But every once in a while blow up!

Mushroom Cloud

If you play with extraordinary risks, burn you will

Blow up, implies literal blow up. Turn your money into poof! cinders. Smoke. Air. Choose your matter.

The safe ones can be safe, like government bonds, but they earn pretty low returns. People found out that if one sacrifices a bit of “safety”, he can gain relatively higher returns. For example, by investing in bonds of the most stable corporate firms, one takes slightly higher risk compared to lending to the government but earns much higher returns.

Such bonds are called High-Quality bonds. Go down the ladder, sacrificing safety progressively down the rung. Under the high-quality rung appears the Investment Grade (IG) and then Speculative Grade (HY) which yield very high returns.

Even amongst the speculative bonds, one can have junk bonds with extremely high credit risk with borrowers facing a very real risk of going under.

The mutual funds who invest in these corners of the markets are called “Credit Funds”. They invest because they believe they can separate distressed companies that will survive from those that won’t.

But if you play with fire, burn yourself you will. So the occasional defaults sinking a credit fund is not unusual. In 2015 December, a fund in the US had to close down owing to their default

Equity mutual funds are easier to understand. Since they invest in businesses directly, they are party to their risks, rewards, joys, sorrows and defaults too.

Understanding Fixed Maturity Plans

Fixed Maturity Plans are innovations particular to India. We are debt loving population. We don’t like “specific risks” about companies, valuations, growth potential, etc. We don’t really understand them.

Instead, we like to invest in things we can see. Interest income, timely payment, peace of mind. So towards debt, we veer. We invested in government bonds, bank deposits all these years. Now slowly we are investing in debt mutual funds. In the world of debt mutual funds, FMPs are just another flavor of the same. Except that there are a few subtle difference.

Fixed Maturity Plans can be understood by these three behaviors:

  1. They invest in fixed income securities (non-convertible debentures, commercial paper, securitized receivables, gilts, treasury, etc.)
  2. They exist for a fixed period only. Hence they invest in bonds that mature on or before their maturity date
  3. They can use various “methods” to generate interest income including investing in foreign bonds, securities lending, collateralized borrowing & lending obligations, etc.

In simple words, they generate interest income, for a fixed period using any or all combinations of bond-like instruments. 

Our story of bad choices

It ain’t what you know, that gets you into trouble. It’s what you think you know, but that ain’t


I used the term “bond-like” instruments for a reason. A transaction can use financial instruments that are not bonds, but when put together can mimic a bond. For example short a forward derivative and go long on the underlying and one will receive a risk free return, equivalent to investing with Government of India.

It is possible, to do just the opposite too. Put covenants in a debt agreement that create something other than a plain bond. For example, a bond that is callable at the option of the borrower. This is a bond with a real option. Similarly, a bond that is convertible to equity at the option of the lender. Again, a bond with a real option!

But it is not really necessary to go to such complications to generate an un-bond-like economics. Bad choices are enough.

How? Why do bad choices play a role here?

The answer can be found in economic policymaking. One answer: unintended consequences. The idea is simple. An act of preventing an illness can cause a different ill. 

Our act of reducing one form of visible risk, changes the nature of reality, forcing other risks to manifest. Even those risks that were remote before, may manifest with greater vengeance.

For example, after life insurance covers started covering for pregnancy condition, there was a sharp increase in cesarean deliveries.

Which leads us back to our discussion on bad choices. Traditionally a risky bond is lowered in risk by asking for collaterals. In usual parlance, it is called “secured lending”. A home loan is secured by the mortgage on the home. A personal loan is secured by gold jewelry.

The choice of collateral always revolves around three principles:

  • Coverage
  • Quality
  • Stability

Put in other words, collateral has to be sufficiently high in value to cover the obligations and then some. It has to be sufficiently high in quality, to be readily converted to cash. And it has to be stable enough in price so as to be unaffected by specific or systemic risks.

The last point can be phrased as – low correlation to the borrower’s fortunes. That is, the collateral must not suffer if the borrower suffers.

What if, we violate one of the principles of a sound collateral? It is easy to imagine the consequences. (Hit me up in the comments section below, if you disagree with any of the points)

The Sword of Hyper Competition

“I’ve become, I think, much more self-aware over the years about the problematic nature of a lot of competition,” 

-Peter Thiel

I am not quite sure why do mutual funds dilute their mandate, take unnecessary risks or sacrifice safety at the altar of yield. But I anticipate its because of too much competition.

Is it possible that fund managers of HDFC AMC FMP Series 35 wanted to compete with their credit fund brethren? Is it possible that they were competing with other fund managers for returns?

I can’t possibly know for sure, but what I do know is this- HDFC FMPs along with FMPs of other AMCs like Kotak, prominently, combined with hybrid funds across the industry have lent somewhere in the region of 13,500 crores (~$2B) to Essel Group of companies.

This debt was secured by “collateral” against the shares of the publicly listed entity of Essel Group, ZEETV, at 1.5x the cover.

The Con is Complete

This arrangement broke all the three principles of a sound collateral.

  • It is not adequate (usually its a 2x coverage),
  • It is not high quality (the equity shares of no entity can be called high quality when that company had to borrow money outside the banking system)
  • It is not uncorrelated to the fortunes of the borrower. Heck, it is the very “fortune” of the borrower.

What essentially the lenders effectively entered into, was an agreement to buy convertible debentures at the option of the borrower.


The borrower merely needs to default, for the debt to get converted into equity, ensuring a dilution in the holdings of the promoter.

This is laughable, ironical, convoluted and completely insane to say the least. Fascinating because at no point did the lenders wish to enter into an equity transaction. At no point, did the lenders wish to enter into a risky transaction. At no point, did the lenders wish to lose control over the entire proceedings. But the invisible hand of economics ensured that they were left holding the bag!

Problems of Today, in books of Yesterday

“History repeats itself, first as a tragedy, then as a farce”

-Karl Marx

I do believe old sacred books contain all the wisdom that one needs to solve modernity’s problems. I am not talking about Torah or Tripitaka. I am talking about the only holy book, one needs to read in investing, even if he is an atheist. The one and only – Security Analysis.

So what does Mr. Benjamin Graham have to say?

On ZEE TV’s Credit Worthiness


A loan to ZEE TV is capped by the value of the business itself, which was in a precarious position. Source: Security Analysis, p 113


Quality of Collateral


Safety of a bond is not measured by the ability of collateral to pay for it, rather on the ability of the borrower to pay back Source: Sec. Analysis p144

On the soundness of a Convertible Bond

Value of Convertibles

A bond secured by equity shares of the same promoter is only a convertible bond at the option of the company. Mr. Graham makes his thoughts adequately clear. Source: Security Analysis p319

On a final warning to the equity holders

Warning for Equity

An equity share is defined by its position in the hierarchy as much as its profit potential. If it is preceded by debt that is worthless, then what is the value of the common stock? Source: p118 Security Analysis, Wiley

In Retrospect

But what does it mean when a mutual fund house like HDFC decides to extend the maturity date by 380 days!

Put in simpler words- it has defaulted, sat along with itself (the fiduciaries of the lenders), renegotiated with itself and restructured the debt.

A pretty convenient arrangement, don’t you think?

Reflections on Quality of Earnings – Part 03(i)

This post is an application/case study on an Indian business, of the lessons learned from the O’Glove’s wonderful book- Quality of Earnings. This is the third post in the series, where I ruminate and try to apply the lessons in an Indian context. For the first and second post in the ‘Reflections” series, peruse this and this respectively.

If you would like to peruse the lessons from O’Glove’s book, I highly encourage you to read the sister series called “Understanding Quality of Earnings”.

For the posts in the “Understanding Quality of Earnings” series, please peruse Part 01Part 02 and Part 03 again respectively.

Analyzing Letters to Shareholders: A Tour Through the Letters

The act of interpretation is an intensely personal act. Very silent, very subjective. One man’s surprise is another man’s expectation. Showing the act of “interpretation” in action is a difficult job. Hence any act of “teaching” how to interpret is an exercise fraught with risks and allegations of post-facto justification.

Be that as it may, I will still venture out to read, analyze and subsequently walk you through my conclusions and findings after reading individual letters to shareholders written by Chairmen of different companies. Readers will also blame me for post-facto bias if I attempt to analyze historical annual reports. But readers will have to take my word for granted and have faith in my intellectual honesty here. Any claim seeks evidence, and I will try to justify this. I will upload snapshots of my notes onto this blog to allow judgment of my honesty. Later, I will also try to conduct this tea-leaf reading (I definitely won’t blame you, if this is called so) with the latest annual reports.

Tea Leaf Reading or Method to Madness

Interpreting Letters to Shareholders in a gamut of rules 

I have followed three rules in my exercises when perusing these letters. These three rules stem partially from human psychology but mostly from cynicism.

  • Management is always wildly optimistic. Do not get sucked into this
  • Pay attention to the choice of words and question their use
  • Validate each subjective claim with numbers

These three rules will guide you towards an understanding of the industry, in general, the business in specific, but most importantly will help to make an informed guess about the growth rate in the coming years.

Sometimes, and very rarely they can also divulge about strategy. I have not come across them much. An expectation setting is much needed here: – being able to read these letters will not impart some immediate material secret knowledge about the businesses, but they will help an investor in asking the right questions and making informed guesses about a business’s future potential.

A Study in Unichem

The conclusion from reading AR 2013-14: Unichem Laboratories is an Indian generic drug manufacturer with the main focus on bulk drug manufacturing and their formulations. It has a strong R&D presence but focussed primarily on process innovations (attempting to build APIs with an easier and more efficient process “pathways”- yield and purity are important metrics here). Main focus on India, US, EU. Segment wise focusses on Chronic and Acute Therapies.

The following section picks statements from the letters and is immediately followed by my interpretations/questions and my ideas about those statements. I will also upload a snapshot of my notes if you would like a more “real-time” picture.

Excerpts from Letters to Shareholders in AR 2013-14

“last few years have been difficult years for Indian pharma industry”

Slowing growth? Regulatory Challenges (FDA observations)?

“In this environment, our growth rate also has been sluggish. Our prices also has been affected”

I read it as “Don’t diss us for our lackluster growth.” It was surprisingly forthright in my opinion for management to discuss their challenges so openly.

“restructured our domestic formulation business”

Streamlining/Building production efficiency? We should expect a PAT margin improvement?

“Acute therapy segment has begun to show higher growth rate well above the industry average”

Possibly a small area of the overall business. Possibly a low base effect playing in.

“Chronic therapy segment. We expect that in the coming years we will be able to accelerate growth rate there too”

Stagnating market? Efficiency wins will seldom win the growth war(Post-note note: Why did I write this sentence?)

“Our international business has already crossed 40% of our consolidated turnover driven by our consistent push in US market and our contract manufacturing business”

No comments made

“After prolonged and sustained efforts our subsidiaries have begun to turn corner”

You mean, “they have started turning profitable?”. Were they bad acquisitions to start with?

Niche Gen Ltd (UK) has improved its profitability and Unichem Pharmaceuticals (US) has posted a robust sales growth of over 45%

Low base effect?

“To exploit the foundation laid by the US Subsidiary, we are accelerating filings of our ANDAs”

Options of growth for the next 2-3 years?

“I can say with confidence that after a long and patient journey in these international markets we are about to see major turning points”

Too optimistic? A “sense of relief”?

“Several cost reduction & productivity optimization measures”

Boy, the times must be really tough!

“Special interim dividend out of the proceeds of plan sale”

Why pay the dividend, when you are optimistic about growth?

The Picture

Unichem Laboratories is facing a tough time. Its core warhorse/cash cows/growth engines have slowed down to sputter and the management has gone down to the bunkers to streamline and make things more efficient. It has made multiple claims of “turning corner” and “accelerating growth”, but they largely conflict with the overall tone and tenor of the letter. So it must be concluded that these instances are small entities and have very little effect on the larger financials.

Times are tough!


Unichem Industry indeed faced a very lackluster growth year of 4.7 %, partially inferred by the verbiage of the letter. The restructuring of operations was primarily marked by a sale of its MP plant of bulk manufacturing (reasons unknown) and centralization of all its R&D facilities in a center of excellence in Goa. This will help it to cut overheads by reducing fixed assets. The growth aspect of “Acute” business is overplayed as it is not the main driver of the business, Chronic therapy business is. Among its subsidiaries, only one has turned profitable i.e. Niche Generics Ltd (UK). The growth in its subsidiaries being high is purely optics as it indeed is a growth from a low base.

Excerpts from Letters to Shareholders in AR 2014-15

“Unichem focusses on improving the quality of medicines available, and to make the medicine available to a large section of society at reasonable prices”

Boy, O Boy, are you in the crosshairs of “regulators”? Are you fending off, serious attention of sub-par quality medicines/ production during this time? Or is it because you have made peace with the government’s populist policies of medicine price control?

“… we had realigned our acute business and this led to acute business showing consistent growth”

“consistent growth” term is a stretch. It has shown growth only beginning last year after restructuring/streamlining and also contributes about 41% to the business.

 “Similar realignment to our chronic divisions- CNS have started showing encouraging results” 

Read it as: “be patient”: our efforts will bear fruit in the coming years. This was not done as easily as acute business perhaps because it is more complex and widespread than acute business.

“In the last leg, we have undertaken this similar exercise in our cardiac divisions”

Why are divisions being taken up one at a time? A hint of complexity?

“I am happy to share with you that our performance in the key market of U.S. remains robust, where we have reported over 100% growth in topline”

(This bit is an apriori knowledge, gleaned from reading previous years AR)  Low Base Effect!

“We continue to invest significant portion of R&D for the regulated markets, especially U.S”

Why? What kind of R&D? Is it a red queen effect?

 Belief in “Quality & Reliability”, “…right side of stringent regulatory audits”

Read it as “don’t be afraid dear shareholders, your company will not face FDA censure”.Around this time, there must have been a lot of license cancellations in the industry

“4 manufacturing plants which have various accreditations including USFDA… extremely happy to share 3 plants were recently inspected by USFDA and …. no critical observations”

Further placating and assuaging shareholders.

“We expect more and more molecules and their combinations to come under price control in the near future as the government has made its objective clear by stating that more chronic/ lifestyle diseases drugs, antibiotics, etc., may come under the price control net.”

Posted right at the fag end of the letter. This is a serious development and very adverse news for the shareholders. If I am an analyst, this will force me to revisit, revise and re-align my growth forecasts for the India formulations business. 

Alternatively, if I am a strategy guy, I will have to develop a completely new strategy to generate growth.

 “Aggressive capex program covering all areas of businesses like formulation & API” 

Increasing expenses generally is a positive sign, but the question is, what is the growth strategy on which the management is betting? Is it the US push that the management is still betting on? All actions point to that.

Some further quotable quotes from Management Discussion & Analysis

“In the International business, regulated markets like the US remain the key focus areas for your Company as it searches for its next leg of growth. The growth so far in the USA region has been significant.”

(Emphasis added)

Your Company’s strategy is to scale-up operations for sustained growth over time. The revenue from the US market showed a robust growth of over 100%
as compared to the previous year. Going forward, we expect this business to grow at a robust pace despite bleak approval outlook.

(Emphasis added)


The business is facing severe constraints on growth. On one hand, the Indian side of the business is seeing price controls and subdued growth, on the other hand, there is a renewed focus of FDA authorities on India based production plants. Post selling of the previous bulk manufacturing plant and acquisition of the new plant in Kolhapur (not mentioned here, but mentioned in the AR), the management is trying to make a renewed and last-ditch push to break into American subcontinent.

There are some very fine points made in the annual reports of 2015-16 and 2016-17 in the Letters to the Shareholders section as well as Management Discussion and Analysis. I happened to read through them and pleasantly I must say, I wasn’t surprised to see the management decide the actions that it decided in FY 2017-18.

The Status 3 years down the lane: FY 18

  • Unichem sold its India business to Torrent Pharmaceuticals along with all the formulations, people, assets, production lines etc.
  • It retained the right to market its formulations in off-shore geographies
  • It also generated some revenue by in-licensing other formulations in India business. How much this will continue post-sale, is hard to decide but a reasonable guess will be zero.
  • The management renewed its push in U.S markets and in the process incurring some losses after the sale of its Indian business, which took the lion’s share of its revenues.

Keys to Valuation

The growth profile of this business will have to be modelled like any new business, with a “portfolio” of real options. Its profit and revenue pattern will also behave like one, where its “accounting profits” will be negative for some time (a few years at least), as it tries to set up its business by making high investments.

Its revenues will see high growth (J-shaped). Shareholders and management should start building the expectation of dividend being cut down to zero. We can have either growth or income.

Some Further Notes for Valuation

Owing to my myopic nature of reading annual reports with an outsized focus on determining the valuation assumptions, I found that an analyst trying to value this company will not have to make many quality adjustments.

The accounting quality looks good(save for one item line), reporting quality feels high and communication quality feels assuring.

A good accounting quality helps us in predicting our line items with a higher degree of confidence. A higher reporting quality helps us build and test our valuation models with a higher degree of confidence. Finally, the communication quality helps us in setting expectations about growth and future strategy, which in turn helps us to form expectations about the balance sheet.

The Snapshots of My Notes are here:

2013-14 PART 01

2013-14 PART 02

2014-15 PART 01

2014-15 PART 02

Tomorrow, we will be analyzing the annual reports of Mindtree for the years from 2014 to 2018. The second part of the series is here.


Understanding Quality of Earnings – Part 03

Think of this section, as a blog post within a blog post. A section in the article that connects to its analogous section in the previous article (“Its Quality That Matters – A continued take”) and is a predecessor to the next article (“Its Quality that Matters – Differing Disclosures”). While “Reflections on Quality of Earnings” are focussed “meditations” on the crux of the matter, this is a mere discussion on focussing on things that matter – quality.

What separates “high-quality” management from a not so “high-quality” management? What should be the focus aspects of “high-quality” management? What should be the ideal skill sets of a business owner/manager? How much of a particular skill is too much?

It’s important to think about these questions, yes. But it’s even more instructive to think about a business, from the general perspective that answering these kinds of questions bring – a wide view, quality judgment, and skepticism.

At the risk of oversimplifying, high-quality management believes in doing the right things, the right way, no matter how difficult it might be.

But what are those things?

 For the starters, the management must equip itself with tools of capital management. Right capital allocation is a key differentiator among businesses and many managers are simply unaware of it.

Secondly, the implications of operating in a particular industry structure should be crystal clear to the owners.

This is my understanding that while in the placid times a manager understands what ought to be done, he loses his cool during times of rapid expansion.

An understanding of the industry structure and the various forces is important and should come naturally to the management

Frivolous investments in unrelated fields, losing sight of the industry structure and succumbing to analyst/investing community pressures- they are all symptoms and signs of management who has lost it.  Especially the last one.

As much as I consider manager/owners to be a mixed bunch, there is no love lost for the analyst/investing community as I find this community has created a set of wholly unfavorable practices and pressures for long term success of a business.

Too high focus on numbers, earnings forecast and news creates a complete smorgasbord of skewed incentives.

Pennywise, Pound foolish is terrible. But even worse is robbing the future to pay the present.

Letting the capitalist forces work its magic is one thing, but distorting those forces to extract pennies in the short term is whole lot debilitating.

Thus, to a huge extent, the management which runs its business with its eyes half closed towards the exchanges and the associated ecosystem is considered high quality by me.

But it is also possible for a manager/owners often in the quest to disregard the pressures of the analysts err too far on the opposite side. They ignore even the sane practices of capital allocation that ought to be followed. This is clearly a case of too much of a good thing.

A wide-eyed fascination for swinging prices, earnings multiple, etc. pose its own set of problems. Often the management reduces its responsibilities to “share price management” rather than business and operations management. Talking up the price, wild projections, focus on market capitalization are common sins and reflect skewed priorities.

While a discussion on the quality of management demands its very own space, it is instructive to peer into the minds of management every once in a while (ideally annually). What else is a better tool than perusing carefully, letters to shareholders?

Chapter 3: Person to Person: A Shareholder Letter 

O’ Glove pulls punches left and right in this chapter, and pretty heavily that too.

Though his focus in this chapter is to “teach” the audience to learn to read 10-K and 10-Q, the overarching lessons and observations are equally relevant for geographies (like India) where companies do not file 10-K and 10-Q with their security regulators.

For a more focussed treatment on Indian scenario, please peruse the relevant post in the Reflections series.


#1 Rise of Public Relations Expert in Regulatory Filings

O’ Glove observes that over the years, PR professionals have invaded the last piece of corporate communications – that with its shareholders.

It has turned its annual reports into artwork, more suited to coffee table than the analyst’s desks.

O’ Glove, wryly observes that if companies do away with such fancy publishing, their EPS might jump by a few cents.

Jokes aside, with growing modernity and innovation in information disbursal (internet), accessing annual reports have become a lot easier. (There are few companies, if any, in India, which does not upload its AR on its website, as opposed to a substantial chunk some 10 years back)

The author also subtly makes an important point, though I am not quite sure if he intended to.

A lot of people around me are intimidated even if they do not admit to being so, of reading 100 pages-120 pages long reports.  He mentions that there is always something to be learned of value about the business and management from these reports.

In fact, there is a veritable goldmine of information that can be gleaned purely because the management is bound to release a lot of information by decree.

However, there is an attempt to bury it in pointless information.

#2 Do not read Annual Reports in a vacuum

It is important to peruse annual reports within a broad context of information. Often they allude to developments of previous years, so pull up the previous year’s annual reports and quarterlies.

The idea is, do not peruse annual reports as a “happy” document, meant to inform you about unfolding opportunities.

It should be viewed in the same way as one would view a potential minefield – with skepticism, caution and looking actively for signs that earth in a particular spot has been tampered with.

Also, understand if a particular AR is designed in-house or outsourced. Often big corporates take the responsibility in-house to give the management a greater say in subterfuge(my words not his). On the other hand, mid and small enterprises outsource it to third-party firms.

In the former case, the choice of illustrations and cover page tells a lot more about management’s intention to focus on a particular image about a company’s business.

#3 Reading the Letters to Shareholders

Peruse the letters and try to gauge the tone of the letter – is it a good letter, which sheds light on the operations, talks about the challenges and engages in candor or frankness?

Is it a bad letter, where the management leverages this medium as a means to talk up his “stock” and spin his failures into matters completely out of his hand?

Or are they indifferent letters, where it is the same drivel, year in and year out?

Often, without intending to do so, letters to shareholders can reveal a lot about the management’s intentions than the company. The trick is to read them slowly and critically.

Those areas where management discusses numbers and they can be cross-checked should be done so. In many cases, the letters to shareholders draw the attention of readers to a particular figure to project a flattering image, while the truth(from the back of the report, financial numbers) reflect something else. 

Understand that while a letter is signed by the management and or the chairman, it is designed and written by a PR professional. It is designed to look flattering, and just as a veil on a striptease dancer serves a purpose and then serves no purpose, letters to shareholders allow us to glean but not understand.

It is again important to look back and understand the tone and tenor of the management in previous years. How good were their forecasts and estimates? Were they always optimistic about the light at the end of the tunnel? Are they complacent about the good times, engaging in straight line projections?

Also, look back to the specific years when the company was going through a struggling time. If the design of the annual report depends on the overall popularity of the stock and collective imagination it has managed to garner attention from the investing community, then we all understand what it tells us about a management’s priorities.

O’ Glove says, such comparisons might reveal little 90% of the time, but the rest 10% will save you enough to be all worth it.

#4 Reading Poetry of the Letter with the Prose of the Numbers

As highlighted elsewhere, it is important to validate “claims” with evidence. Remember the general philosophy – every claim needs to be backed by evidence, extraordinary claims by extraordinary evidence.

Please peruse a portion of the letter:

To Our Stockholders

SUCCESSFULLY, meeting challenge is a 150 year tradition of this Company. 

In 1831, Cyrus McCormick and his reaper were tested and proved themselves in the market place. Today, the people, products and strategies of the Company which started with McCormick’s reaper are successfully meeting the new challenges of our second century and a half as a world leader.

International Harvester enters 1981, following a tightly focussed long term strategy to improve our cost structure, advance IH product and market superiority and make maximum use of company resources – both human financial.

Our accelerating progress towards these goals was dramatized in the contrasting markets of the last two years. In 1979’s expanding markets, we stretched our productive capacity, gained market share, cut excess operating costs, increased investment in the future and earned record profits. In 1980, we met the challenges of sharply lower demand in our industries, escalating interest rates and a strike which idled most U.S. plants the first six months of the year and increased Company debt.

INTERNATIONAL HARVESTER’s performance in the last half of fiscal 1980 proved again the basic strengths of this Company, and the effectiveness of its long-term strategy. 

IH forged a strong recovery of market share that had been eroded by inventory shortages during the strike. Agricultural Equipment Group set an all time quarterly sales record the last three months of the year. Truck Group resumed leadership in U.S. medium and heavy duty registrations during the same period. The newly created Diversified Group increased its market share in both its financial services operations and most turbo machinery models. 

This market recovery reflects the established and growing customer preference for IH products and services. It also clearly proved the strength of our dealer and distributor organization now some 5800 strong. This sales network quickly moved product to our customers once U.S. manufacturing was resumed in May.

Our strategy to maintain lean dealer inventories during the declining market strengthened our sales network by helping IH dealers avoid the high interest costs and price cutting which penalized our competitor’s dealers.

Your company continued its strategic drive to improve the use of financial resources. Despite reduced manufacturing volume, IH exceeded its cost improvement targets for the last six months of the year. Today International Harvester’s annual operating costs are more than $400MM lower than they were three years ago. By better use of financial resources we need significantly less working capital today to operate our business than we would have at our current level of business five years ago. 

During the fourth quarter, IHC reduced its short term debt by $562MM and total debt by $488MM from the peak third quarter levels caused by the strike. 

Can you note the overall tone and tenor of the above letter? It is upbeat, full of optimism, draws focus on the “best days are ahead” spiel.

Did you notice how it started by invoking its 150 years heritage?  Read it as “we have been here for long, we will be here for good (this current stress notwithstanding)”

It claims, Agricultural Equipment Group (AEG) registered record quarterly sales. Elsewhere in the report, the numbers claimed a different story- year over year; the business registered a drastic contraction in quarterly EPS. While drawing focus from wood to the trees, the management wanted us to believe in a more flattering picture of the business.
Half yearly comparisons did show robust growth, but of course, as mentioned in the letter, the first half was marred with strikes. So any comparison here is a wash.

Also qualitatively, pay attention to the prime location of the words “tightly focussed long term strategy to improve our cost structure”- such words the author observes are flags of trouble.

#5 Notice the subtle change in verbiage

Humans are contrast seeking animals.

We are not comfortable in detecting minor changes. Even more so, when the messages are spread across months and years.

O’ Glove, shows us the case of Apple. For quarterly reports of Q4’85, it wrote in its letter “innovative new marketing programs… great new products” etc.

Drawing sharp focus on the rivalry with IBM, it said “…the two-horse race for leadership in the personal computers market…” and supplementing it with a call for the final push- “we will keep pushing … and leading”.

Two quarters later, it subtly changed its verbiage to say, “we have announced a strategy to coexist with IBM” [emphasis in the original]

That is quite a comedown. This is also indicative of competition heating up and killing the profits.

#6 An ideal gameplan

O’ Glove says, when we detect the management engaging in hype, it need not be a short sell right away.

Stocks move up on hype more than they do on reality. Conversely on finding oneself with a frank and honest letter, shouldn’t mean it is a buy right away. We have just one piece of the bigger puzzle sorted.
O’ Glove, suggests a “game plan” in a passing, which I believe to border on recklessness.

One might consider taking a punt on stocks where management is engaged in hype, precisely because in short term market is gullible.
That aside, O’ Glove has certainly sage advice for what would be considered as credible communication.

  • Projections hold no meaning without evidence of reasonability
  • Frank dissection of challenges and difficulties
  • Offers an improved picture of the company’s true prospects


Reading annual reports and interpreting letters to shareholders can be an exercise in smoke and mirrors. It requires patience to master this art, practice to be aware of the patterns and healthy skepticism of salesmanship.

Is it hard? Yes. It takes a lot of focus and energy to keep one’s System 2 engaged for the duration of 2.5-3 hours one takes to read an annual report. But then, no one said, it’s easy.

Reflections on Quality of Earnings – Part 02

For the post that discusses on O’ Glove’s chapter, click here

Introduction to the Blog

Much has been written and explored on the aspect of auditors failing to live up to the standards of being an independent watchdog of a business. Along with independent directors, activist shareholders, they play an important role in ensuring that management doesn’t go haywire in its fiduciary duty to deliver shareholder value.

But an ordinary investor must not rely on auditors to warn them against impending time bombs. This post tries to shed some light on this directive.

Trusting someone else to do a good job…

Relying on the auditor to “think” from the perspective of a shareholder is to believe that an auditor will benefit from such thinking. Put in simpler words, an auditor will never try to uncover frauds, misstatements, question accounting choices primarily because it is not in the interest of an auditor to do so.

The usual argument of how incentives matter and how there is a lack of incentive should ideally follow, but I will spare you the details. It’s usually the same thing. No incentives to do hard work implies no hard work. But I will raise a point that is far less discussed and far more ignored not only in India but also abroad. Are auditors with their traditional accounting knowledge really well equipped to sniff out accounting shenanigans?

Short of outright fraud, where an auditor asks for evidence, and management unable to furnish it, an auditor is seldom well poised to uncover such issues. If an auditor does uncover such an issue it will be more out of luck than any organized “investigation”.

Yet, let us come back to the question, that was raised earlier. Let us also paraphrase it slightly differently – “what makes us believe, an accountant is well equipped to sniff out accounting issues?” In my experience, my respect for chartered accountants of India, and this degree has enjoyed great respect in my eyes as late as 5-6 years back. Oh! what a fall, it has had in my eyes.

Chartered Accountants, I believe are under-equipped in terms of the entire examination structure, syllabus and rigor to analyze anything beyond adherence to the accounting standards. Note this observation carefully.

I repeat, chartered accountants, are just equipped to spot inconsistencies with accounting standards. Nothing more. Put in other words, they are rote “appliers” of IFRS/Ind-AS rules and they leave it at that. Coming back to the point of pedagogy, CAs seldom have any deep education on forensic accounting, behavioral psychology (did you know a CEO going through a divorce is more inclined to commit fraud?) and/or the interplay of financial markets with accounting.

Let me elucidate. An accounting choice that inflates 30-40 paise per share in EPS, adds 7.5-8 INR in the price of the share (assuming a PE of 15). A “market forecast beat” result that surprises the market on the upside can lead to rallies that can add 10-15% to the price of a share all by itself. Then, after all this, there is momentum to take care of. Conjectural, yes, but the result of an aggressive accounting choice, made at the right place, can inflate the price of a share by anywhere between 15-20%. This move needs to be only monetized by the management selling some of its holdings in the market etc.

Put all of this together, and there is a strong incentive for management that is not able to find ways to grow the business, to engage in such activities. For an auditor, not being well equipped to understand these ideas puts a large cognitive cost on him to link and make sense of all this. On top of it, there is no incentive for him to do so as well since he is ultimately at the end of the day hired and paid by the management.

Also, this is not to be forgotten that an auditor’s scope of work is only to check the accounting and rarely extends to anything beyond that.

But having said that, let us turn our attention to the spectacular case of Ricoh India. To quote this article

But a decision by the management in 2012-13 to make a shift from hardware retailing to IT services saw the markets sit up and take notice of the stock. Even as the management set out fanciful targets to foray into cloud computing and end-to-end document solutions, investors latched on to Ricoh India as a newfound ‘Digital India’ play. Ricoh’s revenues quickly moved into fourth gear, shooting up from 633 crore in FY13 to 1638 crore by FY15, with losses (1.3 crore) turning into profits (33.9 crore) in a short span. This triggered a manic rally in the stock, which rose vertically from sub-100 in November 2013 to over 1,000 by June 2015.

It was at this high point that the company began to drag its feet on filing quarterly results. After scheduling a board meeting to approve its Q3 results in November 2015, the company pushed back the date several times, citing delays by its new statutory auditor (BSR & Co). By April 2016, the cat was out of the bag. The auditor had refused to sign off, citing financial irregularities and had recommended a forensic audit of the firm’s accounts.

This is one of the only cases I have come across where the auditors pre-empted the management’s expectations of toeing the line and resigned citing forensic audit. But what’s surprising is that a set of accountants with access to the books of the company themselves are asking for a “forensic audit”.

Isn’t that an accountant’s job too? Or is the nature of forensic audit different because there is unfettered access to the company’s books (true)? If so, then how much can a general auditor’s opinion be relied upon, who don’t have such access.

But let us turn our attention back to Ricoh India. The article goes on to cite:

PwC’s limited-period forensic audit for FY16 has unearthed wide-ranging attempts to cook the company’s books. It has found that the company had made “unsupported out-of-book adjustments” to net sales, expenses, assets, and liabilities, converting losses into profits.

Wait, what? A forensic audit of FY 16 books showed the company engaged in accounting that violated the accounting standards itself (the easiest to pick). This after a forensic audit of results that were already audited and published for 3 quarters!

Shouldn’t one ask, what the auditors were doing all these years? But further, we should ask, why didn’t the auditors let the charade play, why exactly did they resign? Most probably, because turning a blind eye is a fine game of charade- it takes two to play. When the management itself was unable to come up with numbers to back its story, I suspect the auditors had to pull the plug.

Accountants play a fine game of pretend in this dance of economics. Sometimes accountants are okay to take on risks of censure from the government, if it pays some extra million in fees. Take KPMG for example. Its blatant use of tax shelters to protect its clients attracted heavy penalties in the US from 2003-2007, attracted monitorship and wide censure.

But is it fair to question auditors when Handbook of Auditing Pronouncements, released by ICAI says, “ An auditor, on the other hand, ‘is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error’.”

This is a vague statement all by itself. Think about it for a moment, a child will get assured by tales of Santa Claus, but seldom will an adult allow him/her to be assured with this.

Assurance is a terrible word.

But how can one explain active fraudulence on the part of auditors to promote, protect and preserve frauds? Consider the case of IL&FS and this article in particular. Auditors failed to detect liquidity issues, serious asset-liability mismatches, unchecked subsidiary investments and a host of cockroaches.

But acts of commission aside, auditors are often unable to detect if fraud has occurred, and that too by their own admission! Deloitte Haskins & Sells has admitted its inability to spot if fraud has indeed occurred at Fortis hospitals.

While, this post can go for a few hundred pages, enough to become a paperback of sordid tales, it is the investors each time who are losing out for the infarctions of their auditors. Even the management when it comes to truth-finding missions are unwilling to trust certain auditors of such a responsibility. Take the example of PNB and PwC. After SEBI banned PwC from doing any auditing work in India, due to its involvement in Satyam scam, PNB rejected the proposal of PwC to conduct the forensic audit. With such a glorious past behind, should investors really assume a green light of auditors imply that everything is A-ok?

Perhaps not!

Recommended Readings



Understanding Quality of Earnings – Part 02

This blog post is the second in a series of blog posts that talk about the quality of earnings for a business. Much of the content in this post takes its inspiration from Thornton L. O’Glove’s book “Quality of Earnings” published first in 1987 and which in my opinion remains a fascinatingly fresh read.   

The way, you can peruse this blog post is as an exposition of the classic text. Alternatively, if you would like to read further about the concepts in the context of modern-day businesses, read up the sister series, “Reflections on Quality of Earnings”, each part in the series roughly running parallel to the other.  

Without much ado, what follows after the following section is the second chapter of the book, Quality of Earnings- Chapter 02– Don’t Trust your Auditor  

It’s Quality That Matters – A continued take 

Think of this section, as a blog post within a blog post. A section in the article that connects to its analogous section in the previous article (“Its Quality that Matters- An Introduction”) and is a predecessor to the next article (“It’s Quality that Matters – Matters of Interest”). While “Reflections on Quality of Earnings” are focussed “meditations” on the crux of the matter, this is a mere discussion on focussing on things that matter – quality. 

It will be a good choice to think about business choices to be divided into four buckets – earning choices/quality, accounting choices/ quality, strategy choices, and corporate governance quality, and dynamics of the industry. Each of these factors influences the exercise of valuation in subtle but impactful ways. Like most things in real life, they are not separate themes but all of them are joined at the hip with the rest.  

Aggressive accounting practices lead to poor quality of earnings. High competitive intensity can lead to unsustainable earning growths. Poor management and strategic choices force a business to compete in unfriendly waters. The relationships are endless. There is no black and white line where does one aspect start and where the other ends. It’s a grey blur at the borders. Force the hand of the management (self-inflicted or not), and he will massage the earnings. To hide it well, he will engage in shady accounting practices, etc.  

Practitioners often engage in numerous “adjustments” to account for poor quality. Heck, market even engages in the same. An industry with an innovative business model (management strategy), experiences value migration (note to self: write about it someday) and a higher multiple. While business with poor management strategy experiences a contraction in earnings multiples. That is also a form of adjustment. But before the market catches onto it, practitioners adjust the valuations to account for these changes. But again what is the adjustment one should make to account for dishonest management? What is the adjustment one should make to account for a total disruption by new technology?  

I do not have all the answers, perhaps because there is no single answer. At the end of the day, it perhaps is just one man’s perception of comfort against another man’s perception of danger.  

Chapter 2: Don’t Trust Your Auditor 

It is usually believed by novices, amateurs as well as professionals, that even if nothing is worth reading in an annual report, surely the auditor’s opinion is a must read. So high is the trust on the auditor and so low is the trust on an average sell-side analyst that while lawsuits for a professional misdemeanor (not amounting to fraud) are brought against auditors, but never against an analyst. Perhaps as a clear indication of the low trust placed on an average sell-side analyst and high premium placed on the auditors. 

Surely, auditors with their unfettered access to the management, the accounting books, the facilities and their high knowledge about accounting must be pronouncing truth and nothing but the truth? In addition, investment books routinely talk up the importance of a clean chit from an auditor and the sacrosanct nature of an auditor’s opinion. 

O’Glove tears apart this perception and largely succeeds in his attempt to do so. On his way, he invokes the economics of the auditing business, the ground truth, pecuniary relationships, and a fascinating mention of wordplay! 

The Ideas  

The Striking Cleanliness of the Opinions 

The chapter out rightly recognises that while most of the investors rely on auditor’s opinions, they make two-fold underlying assumptions:  a- The auditor does his job properly and is well equipped to spot any inconsistency and b, upon spotting any of those inconsistencies and upon not finding any reasonable explanation for the same, will be highlighted in the report. In short, the assumptions are, auditors can spot, and auditors will report.  

When highlighted explicitly, the assumptions start looking shaky. And here, is the rub. For whatever reasons, the number of reserved opinions invoking “subject to” clauses (everything is good, subject to the conditions being met) is surprisingly low. Further down the ladder, is the “except for” clauses (everything is good, except for this, this and this), which is as rare as a unicorn on a rainbow.  

Undoubtedly, this creates a factual mismatch. The frequency with which accounting misstatements come to light is far higher than what auditors claim in their opinions. Which should and must mean, that auditors are not doing the job they are entrusted with. 

It is no doubt, that auditors, big or small have been exposed to increasingly higher legal liability costs. In the summer of 1985, the author quotes the Big Eight accounting firms have been obliged to pay almost $180MM in settlements and audit-related suits and because of their insurance premiums have increased as much by 200% that year. 

[Even in more recent times, the number of settlements and lawsuit liability haven’t quite abated. So much so that, even one of the auditors itself was fined by the US Government for its own illegal use of tax havens and shelters. So even the auditors themselves are not quite squeaky clean] 

O’ Glove observes that most businesses who were later discovered to have engaged in fictional accounts, misstatements and fraudulent behavior never faced any alarming disclosures from their auditors.  

peculiar, pecuniary relationship 

O’Glove mentions a startling aspect of a client-auditor relationship. 


As has been suggested, the entry of what were once purely accounting firms into other areas may have made those auditors’ statement even more suspect. Syndicated columnist Mark Stevens has written in a penetrating fashion about the evolution of auditors in what he calls “a hybrid: part professional firm, part supermarket. They became – with Peat Marwick, Arthur Andersen, and Coopers and Lybrand leading the way – purveyors of a varied smorgasbord of financial services. The marketers among them saw, quite clearly, that the rich veins to be tapped were in general consulting, taxes, small-business consulting, government work, executive recruiting, feasibility studies and actuarial services. Put simply, whatever clients requested, providing it was remotely related to the CPA’s role, the Big Eight provided it” 

An interesting thumb rule of analysis was spotted by Robert Israeloff, who O’Glove quotes in his book. Israeloff mentions, that any time the revenues for a particular auditing firm exceeds 50% from non-auditing activities, its always the auditing responsibilities which suffers! 

Wordplay, Spinmeister and Perspectives 

It was a stunning revelation for me, to discover that a lot of thought and skill goes in drafting an auditor’s opinion report. Play of words to soften the blow, spin tactics to fudge the seriousness of an issue and intentional misdirection which can be called (generously) perspectives.  

O’Glove mentions the story of how an auditor provided a highly qualified opinion based on the risk mitigation, provisioning and other related practices of a particular bank. So the auditor was fired and a new auditor was hired.  

The new auditor wrote up an opinion, that was less of it and more of an artful demonstration of wordplay. That too, with a prescient timing- the opinion came out just 3 months before the eventual bankruptcy of the bank in the discussion. It wrote “it should be understood that estimates of future loan losses involve an exercise of judgment. It is the judgment of management that the allowance is adequate at  both December 31, 1981, and 1980”

What else is this, other than a washing of hands from the larger responsibility- that of auditing the accounts and the judgment of the management decisions. What else is this, other than a complete mistake in realizing that between misstatements and conservative accounting there lies a great chasm of quality, integrity and critical thought?  


Professor Brilloff who served as the grandmaster of conscientious accounting railed against the abuse of accounting. In hindsight, he was clearly too polite. Accounting and auditing have been reduced to a practice of “give-me-the-fees-make-me-sign-where-you-want-it” profession.  

Unfortunately, the curriculum and focus of accounting courses have focussed less and less on principles, risk analysis, and critical diligence than on memorizing accounting standards and the new-fangled term called “convergence”  

This price is what we are paying today in terms of lackadaisical auditing and low-quality accounts. This serves as both, a problem and an opportunity for an enterprising investor. He can trust nothing, but he can generate significant “alpha” by ferreting out misstatements.  

Reflections on Quality of Earnings – Part 01

Introduction to the Series

This series intends to be a personal journal of my ideas/insights that I happened to have when reading Thornton O’Glove’s spectacular book “Quality of Earnings”. In this series, I will attempt to “port” the lessons, teachings, and ideas of the book, to India. This project is challenging at two levels. Firstly, the book was written at least 3 decades back and the ideas that are discussed in this book will have to be revisited in the context of today’s business and accounting developments. Secondly, the ideas that were fit for a matured, developed market like the US, may not find their rightful home in India.  Be that as it may, it will serve a useful exercise for any investor worth his salt to try to incorporate the lessons of this book into his practice.

Introduction to the Blog

This blog post is an exposition of the ideas elucidated in the first post of its sister series “Understanding Quality of Earnings”. In that chapter, the author warned a lay investor against trusting his stock analyst. He provides solid reasons to explain his stance, rooted in the economics of the business, ground realities of the industry and incentives of an individual analyst.

This is an attempt to “reflect” on those reasons from the “lens” of an ordinary Indian investor.

Why you must not trust anyone peddling stocks…

In India, the most common way of gaining knowledge about upcoming investments are three folds – financial news channels, broker recommendations, and friendly advice in the descending order of importance.

But it is important to understand what kind of forces drive each of them and why it is a bad idea to invest based on their recommendations. For one, the incentives and an institutional imperative of the financial news channels are markedly different. There are some advantages inherently going on for a financial news channel. The “stickiness” of programming (the ability to hold an audience) is unparalleled for financial electronic media during the market hours. The constant illusion of activity, the rolling of ticker tapes at the bottom of the screen, the commentary – all try to convey a sense of uncertainty for an investor.

Every development is a piece of breaking news, every rate hike is a policy surprise and every downtick is signal of a larger development. Ensconced in this packaging, are technical and fundamental “experts” who offer tips of the newest stock ideas.

Why is that so? Why does an expert choose to “rent” his expertise on a common platform like this? The idea is simple. For an expert, this act of offering “free advice” is an exercise in building credibility, reinforcing image and a medium of outreach. Most, if not all experts run their workshops teaching scores of people every year to time the markets.

So, an audience of these news channels is “free fodder” for these analysts. But what do the news channels gain out of it? Three things- a, they are able to fill their programming with believable noise, b- they have found that for most members of audience this is the only thing that keeps them hooked. All the other discussions on macroeconomics and management discussion are merely sprinkling over the cake. But most importantly, it helps them to trade on “favors”. They know that facetime on premier channels has the ability to be a good “sales pitch” for any upcoming analyst. In turn, they “buy” the option of using them in the future if an analyst succeeds in capturing the attention of the larger media and audience.

So, where do we all figure out? Nowhere.

No one is paid to offer accurate stock tips, no one is paid to have our interests in their hearts. No one has any accountability.

But if financial media is the culprit, the biggest sinner will be the brokerage industry. Today’s brokerage reports have reduced to “journalism” and mere parroting of facts, without any analysis. The reports have reduced to serve as mere public relations material for management.

Take a look at this snapshot. This is extracted from a brokerage report on CaptureONGC’s Dahej plant of its subsidiary OPAL. The analyst visited the plant, came away extremely pleased and built this projection. Do note, the 2019 estimated sales. Now compare it with 31st March 2018 year-end sales of ONGC (consolidated) of 3622bilion. This marks a stunning growth of 27%. For ONGC to register a 27% growth in its top line, OPAL will have to log the 981b in revenues. This is so because all other subsidiaries and joint ventures of ONGC are recording flat growth.  Now compare this figure with FY18 full-year revenue of OPAL: INR 55B. The subsidiary will have to turn in a miracle based on its current performance. But what’s worse is as follows. Even the internal estimates of growth are not consistent with the projections. Consider this: with a projected retention ratio of 60%, a return on equity of 16.3%, the estimated growth comes to be around 9-10% only. Any investor going through this projection will certainly understand not only the quality of recommendation but also the quality of the analyst.

It is equally offensive to a person’s good taste to assume that the earnings multiple will magically grow by 33% over the course of a year. Since the going earning multiple is hovering around 6 and the standalone earnings multiple is estimated to be 8 (a full 30%

SOTP increase). It so happens that the entire increase in projected valuation is flowing from this assumption.

But then, lest I be accused of cherry picking. Allow me to venture to another broking house- a very famous one at that.

The case in discussion is Vodafone-Idea. The overall brokerage report is undoubtedly VodaFone-Ideanegative (thank god!) and circumspect about its ability to survive. But then, the numbers speak a completely different story. Yet, even after such unabashed optimism, all they could come up with was a 1 rupee decline in the target price. Imagine, the mayhem to the valuations that will be caused if numbers start talking to the story.  So what’s wrong, really with this valuation? For one, take a look at the magical number of 10.2%, which is masquerading as a discount rate for the business. Mind you, this business is a commodity business, with minimal pricing power, minimal volume growth visible in the future and increasingly facing obsolescence of technology(3G and 4G in a few years), with high fixed costs (license costs), etc. Oh yes, did I forget to say, it has a debt 2.2x its equity?

Just recently it attempted to raise $3.6b via an astounding 229% increase in shares outstanding. Make a guess, as to the “cost of equity” that is being conveyed by the market to the company. Surely not 10.2%, even if I assume there is no debt. Add 2.2x debt to the mix and the DCF party cocktail turns into a Molotov.  

But the massive violence to common sense happens just below this line. The report assumes growth of 12% for the next 5 years. Growth in this business can only flow via, an uptick in average revenue per user (ARPU) and/or a growth of customers. While Reliance Jio plays a spoilsport by attempting to corner the market with cut-throat pricing, it appears nigh impossible for this merger to clock 12%.

Do the math, and you will quickly find out that “HOLD” (which was the recommendation of this report) is really a euphemism for “get the hell out of this one!” 

This is just one of the few examples of how lay investor is bilked into buying stocks when he doesn’t need them, holding stocks when he needs to get out of them. All of this is done to curry favors with the management of a company and milking those last dollars out of the investor.

I cannot reproduce the reports verbatim, but in India, brokerage reports have degenerated into journals. A mere replication of management spiel, rosy projections, and unbeatable optimism.

When the idea of such reports is merely to ensure the gravy train of commissions stays intact, is there a reason why we should trust them?

But why is that so? Is it because the analysts are inherently malicious? I would like to say, never blame malice when incentives explain it all. The complex incentives at play are too many to list, but for the starters consider this.

Every brokerage institution tries to target the “volume business” of generating brokerage reports, no matter how non-sensical and poor in quality they might be because everyone is else is doing them. I suspect clients seldom read them, but because it is offered like trinkets, clients expect to receive them.

A sell-side analyst, like those in our brokerage houses, is as much as a victim as he is a perpetrator. Institutions seldom ask for an independent opinion, too scared to lose access to management who might even be trading through them. Beaten by constant discouragements, an analyst often concedes and starts fitting the facts to his story. It takes a special kind of environment to have people ask penetrative questions and call a spade, a spade. Well, sell-side ain’t one.

O’ Glove talked at length about how analysts are not to be trusted when it comes to investing. Stories abound at the level of hustling that happens to rope people in for all bad, no good advisory services. In independent investing circles, “Indore Call Centres” have assumed their own place of infamy. That is our own version of boiler rooms! Engage in a chat, sometimes with one of those cold callers and ask them about simple metrics like what their IRR is, and their investing methodology is- all one will get is flim-flam ideas of proprietary trading techniques.

An investor has no friends. He doesn’t have any well-wishers. He doesn’t have a guardian angel. He also doesn’t have help. It is foolish to believe otherwise. One must cook his own broth, boil his own egg. This is a grassland of “hunt-or-be-hunted” philosophy. Whenever someone approaches you to help you in your hunting, be very cautious- they might be silently preparing the broth to cook you in!