Equity Research – Do Analysts need to be Sleuths? Kolkata

Contributed by: Abhishek Shah

“Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional way”- a quote by Sir Arthur Conan Doyle, sums up the detached thinking process that is to be expected of Financial Analysts as they go through the pain staking and laborious process of analyzing a company and making an investment recommendation.

IAIP Kolkata was delighted to host Anirban Dutta, Director, Jet Age Securities Pvt. Ltd, on October 5, 2013, as the speaker for its monthly speaker event series. The event provided pointers to upcoming analysts on some of the things that they need to be careful about and be suspicious of, while evaluating companies. In his presentation, Anirban discussed six areas that could cause potential shareholder discomfort in future. These are discussed below-

Pledging of shares by promoters

Promoters usually pledge their holdings in order to finance off balance sheet projects in which they are the majority investors. This can lead to significant erosion in market cap in case the financier presses sale below the floor price and the promoter is unable to provide additional margin.

Promoter’s involvement in sunrise sectors (sectors that are in ascendancy) and any media reports on these lines, should immediately arouse suspicion in the analyst’s mind and he / she should start investigating if the promoter has resorted to pledging of shares, and if the percentage of shares pledged is increasing / decreasing.

As an example the promoters of one of the leading Hyderabad based transport, express distribution & supply chain management company invested in new Hydel projects, in personal capacity and financed them by pledging their shares. Pledged shares ratio went up from 64% in Mar ’09 to 95% in Mar ’13 and 5% of promoter’s stake was sold in H2 FY12.

The promoters of yet another listed entity engaged in the fields of SAW pipes, steel plates and textiles decided to develop solar projects under a private company. First pledge of 36% shares was noticed in Q1 FY13 and this went up to 47% in Q2 FY13. Shares collapsed in Q4 FY13 and market cap declined by 50% approximately.

Esoteric / Exotic Financial Instruments

Companies can engage in issuing complex securities in order to take advantage of potential lack of regulatory clarity which can allow them to adopt aggressive techniques to inflate reported profits. One of the reputed housing finance company has issued Zero Coupon Debentures (ZCDs) to raise finances. However, it does not include the proportionate interest on ZCDs in the income statements. On the contrary, they are written off against reserves, a practice that is intuitively controversial given its principal business of lending, and therefore could be inflating the real profit numbers.

Related – Party Transactions

Related parties could be profiting at the expense of share holders. As such, a close look at these transactions is warranted. The promoters of the company manufacturing web offset printing machines have been paying commissions to a Private company of which they are the directors. 85% of total commission paid in FY13 went to the related company and this has been in a range of 81% to 98% in the last four years.

Very  Low Cost Debt in the Balance Sheet

These could signal that the company is perhaps using Interest Rate Swaps or Foreign Currency Loans. Use of such instruments could trigger a knee jerk reaction and alter the cost of debt suddenly, should there be adverse movements in forex rates or unanticipated swings in the price of the underlying. He gave two examples of these.

Capitalisation of Expenses

Sufficient discretion is required to be exercised in various areas by the management, when compiling the financial statements. Whether under pressure to beat estimates and shore up share prices or for the selfish motive of higher managerial compensation, management can resort to earnings management by capitalising certain expenditures, reducing the depreciation rates etc.

As an example a company manufacturing fertilisers & chemicals started an Ammonium Nitrate plant in Q4FY11, but full interest and depreciation was not charged before FY13. So, FY12 profits were likely overstated

Strange Reserves

Companies often resort to Earnings Management by writing off expenses / losses against reserves, instead of charging them to P&L and taking a hit on the bottom line. A company, engaged in the manufacturing of pre-fabricated structures, rotomoulded products & fabrics,  created a strange reserve called ‘International Business Development Reserve’ (IBDR) in FY09 out of Securities Premium Reserve and adjusted expenses of Rs 131 cr in FY09 and further Rs 11 cr in FY10. Long term investments (at cost) in its wholly owned subsidiary in Netherland were written down from a value of Rs 494 cr to Rs 363 cr in FY09. The said treatment was highlighted by the auditors, but they stopped short of qualifying their report.

Price Differential when the input RM for one company is the FG for the other

Sales could be booked at inflated prices in order to manipulate earnings. In cases where the Finished Goods (FG) of one company (seller) becomes the Raw Material for another (buyer), divergence between the selling price and purchase price should immediately trigger suspicion of potential earnings manipulation.

A look at the following table highlights this glaring anomaly and its effect on PAT and market cap in turn.

Product: CTP

   Note: Units in Row 2 & 3 are in Rs/ton and those in Row 4 & 5 is Rs Crores

In the end, the veteran analyst left the young gathering with his final pieces of advice, before throwing the floor open for questions.

• The devil lies in the detail. You have to work hard and be diligent so as to read between the lines
• Read the notes to accounts very carefully and try to connect the dots in your mind just as a sleuth pieces together various evidences
• Allocation of capital should be looked at keenly since that is the principal task of the management. Evaluate all organic and inorganic Capex through the RoCE measure.
• Analyze the motive behind key mgmt decisions – if you are able to read the mind of key players, then you are going to be the Sherlock Holmes of the Investment research profession!

It was an enthralling session that concluded with participants discussing about various other pointers and their implications, in the context of popular Indian companies.

– A S

Disclaimer: The views & opinions are as expressed by the Speaker and reproduced by the author and are not those of IAIP or CFA Institute. Examples about stocks are illustrated to drive key points for equity research and analysis. It should not be construed as an investment advice or recommendation or solicitation to buy or sell.