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.



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!

The paradox of holding companies

Holding companies in the world of investing stand for a mirage. Many a novice have sharpened their horns by ramming against them. Looking from a strict Benjamin Graham style of play(where market capitalisation is compared against tangible assets) has resulted in many a tears and heartburns. They are numerously termed value traps, the final frontier where valuation fails and even a quicksand of the novice investor.

It is not that, they have not made money for investors but more often than not, the discount they were hoping to be closed never materializes. An extremely cheap stock of holding company just corrects 25% upwards instead of the expected 250% and penalises the investor with a decent opportunity cost. As a result this is an interesting puzzle in the equity markets- why doesn’t markets correct the severe undervaluation?

Numerous reasons have also been forwarded- holding company discount, conglomerate discount and so on which are often the different names for the same phenomena. However blaming conglomerate discount for 40-50% discount either implies that it not merely a discount but a wholesale writeoff. In facing such beasts , it is important to remember the customary honourable solution. Gently take a step back, ever so silently without disturbing the sleeping beast.

However instead of a strategic and brave retreat, just shuffle and observe it from a different perspective.

Look through Earnings

Throughout the 1980s Warren Buffett keeps etching, fleshing and time and again repeating the concept of look through earnings. In 1982 annual report he mentions( apparently, the then accounting rules don’t allow reporting of earnings where ownership is less than 20%)

“We prefer a concept of “Economic” earnings that includes all undistributed earnings regardless of ownership percentage. In our view the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used”

Finally in 1993 Warren goes to define it:
“Look through earnings consist of : (1) the operating earnings reported in the previous section, plus; (2) the retained operating earnings of major investees that, under GAAP accounting are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.”

In many ways, it reflects the difference between Berkshire Hathaway- a holding company and the other holding companies which never “come close to getting rightly valued.”

I believe Look Through Earnings is the correct lens to look through this problem. The entire ecosystem of Indian holding companies which I went through squarely looked costly to me rather than cheaply valued.

Economic Fortunes are enmeshed

The paradox gets resolved if we think in these terms: Whenever an investor buys a business from the market, he links his fortune inextricably with the economic fortune of the business adjusted suitably by his own buying price. Post that step, any and all fluctuations, gyrations and information thrown by the market ceases to matter materially to the owner-investor as far as the economic fortune is concerned. This implies that for the holding company the ultimate benefit comes from the economic earnings of the investee firm, implying free cash flow.

If in this lens, we try to analyse a few holding companies, they look inextricably costly. While a vast majority of the holding companies have their precious capital parked in businesses with questionable economics, the free cash flow (or rather the free cash sink) these businesses appear to throw, adjusted for the stake the holding company owns is materially reducing its book value.

In light of such facts, it is not a surprise that holding companies trade at a material discount to the book value. Consider for example a holding company which in its quoted investments owns the steel, power and other energy companies from the same stable. In essence it is investing in sister concerns. Though creates unwieldy holding patterns but not a crime definitely. However what makes it an economic sin is that the biggest holding- the sister steel company is the fact that, if it would have in its utmost graciousness returned the entire free cash generated by its operations- it would have wiped the book value of the holding company.

Capital Allocation

This problem can be described in only one way- capital allocation. Why allocate capital to a company which is a perennial cash guzzler rather than a cash thrower? But then the managers of these holding companies have precious little to do other than take a chunk of the stake away from the promoter’s names. Their decision making is zilch and capital allocation has nothing to do with it.

One holding company I came across, which also buys stocks of companies outside its parental stable is Bombay Burmah Trading Ltd. Not a pure holding company by itself, because it has its own operations of tea and coffee.However the proactive decisions (not necessarily the best) its management has taken has forced markets hand at valuing it at a premium to the book value. I consider the presence of an independent operation inside Bombay Burmah Trading Ltd to be an unintended advantage its owners , the Wadia group bestowed on it. Since a management which has some latitude in managing its operations will also be slightly more awake in picking and selecting the investee companies.

Before you go out and buy it, there are two factors worth knowing out here- one, it doesn’t imply that the aforementioned company doesn’t own its sister shares. At best its portfolio can be described a sister concern plus, implying sister concern stake and stake in other businesses(not necessarily the best ones), secondly the valuation of the same is too costly, perhaps only for my own taste.

There exists one holding company out there which breaks all these patterns and for breaking all of it, the market has rewarded it handsomely. That name is without doubt Berkshire Hathaway. But to be sure, that is not the only holding company out there which is charting a lone wolf story. There is Markel Inc and then there is Fairfax Holdings. All of them follow the best practice and praxis of capital allocation strictly.

Lorimer,MCX,Buffett and China

Of late, I have been caught up with certain things and posting frequency has dropped accordingly. However I started reading this book called “Letters from a Self Made Merchant to his Son” by one pig meat trader named George Horace Lorimer. Its comes widely recommended by Shane Parrish of Farnam Street blog and the partner of the most famous business of Farnam Street- Charlie Munger.

It is a a highly enjoyable book and I find it far better than all those books on aphorisms. It is almost a modern day “Letters from a Stoic” ( I highly recommend that one as well). And at times I felt that Lorimer is rebuking me for the countless mistakes I have done in my past just like his son Pierrepoint.

Sample this:

“You’ll find that education’s about the only thing lying around loose in this world, and that it’s about the only thing a fellow can have as much of as he’s willing to haul away. Everything else is screwed down tight and the screw-driver lost.”

Or the idea that the essence of capitalism is postponement of self-gratification.

It’s the man who keeps saving up and expenses down that buys an interest in the concern.

Or the most important mental model to success in the public markets:

If you find your crowd following him, keep away from it. There are times when it’s safest to be lonesome. Use a little common-sense, caution and conscience. You can stock a store with those three commodities, when you get enough of them. But you’ve got to begin getting them young. They ain’t catching after you toughen up a bit.

Please do buy and read it. It sits on my bookshelf between Letters from a Stoic by Seneca and the Autobiography of Benjamin Franklin.

They say that never push a good thing too far (and never get pushed by a bad thing in the tiniest). FTIL the erstwhile anchor entity of MCX, India’s largest commodity bourse and once of the world’s biggest had been taking the goodwill of authorities a tad too easily.
It adopted worlds oldest tactic for avoiding a decision.

While as early as September it lost the status of fit and proper entity it kept dragging its feet on the stake sale. [For those who are not very much familiar with it these links will get you upto speed-

1. Deepak Shenoy on Original Fallout of NSEL.

2. As early as July 30th market bloodhounds sniff problems in FT & MCX

A side note- whenever the CEO comes on record blaming bear cartels short the stock. Lehmann, Bears and Stern and even Satyam at one point of time blamed the infamous bear cartels.

3. And the whammy of CTT also strikes MCX killing the volumes off and attracting a Morgan Stanley downgrade

4. MCX hits an all time low of 212

5. FTIL gets “fit and proper” notice and Shah and Massey step down.

For valuations this will help, for my thesis this set of posts will help.

1. A tale of two kids- Part 1,  2, 3, 4 ]

So post two management changes , the new management has decided to take a very radical step. It has decided to keep the stake of 24% in an escrow account for MCX to sell it all by itself.

Now will the money go to MCX? No.
It will be just like the auctioning of a collateral by a lender. Over and above the amount liable i.e the sum of principal and interest, a lender returns the entire surplus to the original owner.
In this case FTIL doesn’t owe anything to MCX. Hence MCX will return the entire money to FTIL. Which is a good thing for MCX!

Why? Well simply because even the remotest association with a scrupulous man is costly. Hence that FTIL and MCX will go its own way is a very positive step.

For this to happen- MCX has to seek a shareholder nod for the change in its article of association. I am in favour of it and will vote my yes. However, is there a guarantee that this will not be used against anyone else?

I recommend to the directors to have a sunset clause associated with this proposal, where after a stated date without the shareholder’s nod the article association will revert to the present form.

On other ideas I am reading these days is where Tren Griffin echoes Buffett’s idea of mispriced optionality and his idea of portfolio of such bets-

“you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.”

This is at the core of probabilistic thinking. To weigh the final material gains and losses by their respective probabilities makes many decisions easier to make.

A higher application of such a mental model is a decision tree, where diverse alternatives are presented in an intuitive way. This kind of mental model is highly beneficial to assess special situation opportunities.

Which brings me to the special situation building up in the China seas. I am no Foreign Policy expert but the recent muscle flexing of China in the East and South China Sea is a cause of concern for India. It has huge conflicting claims with Japan, with South Korea (East China Sea – Diayou/Senkaku Islands and Goguryeo, Gojoseon problem).

Parallely it has problems with Vietnam and Phillipines in contradictory claims on Paracel Islands and Scarborough Shoal. If that was not enough, China went ahead and claimed one of Vietnam’s island (which is incidentally a very good fishing ground) as its own. In April this year, a Chinese fishing vessel uncermoniously crushed a Vietnamese counterpart. And it dragged a deep sea drilling platform into Vietnamese claimed waters.

In this light, what is India to do? Of note is in 2013 India unceremoniously dumped a joint sea exploration project with Vietnam, for fears of ruffling Chinese feathers. So what is India to do?

Or rather what is the cost of inaction?

The essence of value investing

The thoughts of others

                                   Were light and fleeting,

                        Of lovers meeting,

                   Or luck or fame.

Mine were of trouble,

And mine were steady,

So I was ready

                      When trouble came.

-A.E.Housman (1859-1936)
A Shropshire Lad