The Hindu Business Line : Simpler checklist

Pore over annual reports, read cash flow statements, check out auditor’s qualifications…. Isn’t all this too difficult for a lay investor to practise? Here is a simpler checklist to filter out stocks that may carry “governance issues” before you buy them:

Promoter Disinterest

A promoter stake of less than 10 per cent may be the sign of a professionally managed company, influenced by no single family or group. But the Satyam episode has proved that it can also show complete promoter disinterest in preserving shareholder value.

Would a promoter who is part of a company’s top management indulge in massive falsification of numbers, if his own personal wealth hinged on the stock’s fortunes? Not if he can help it!

Where’s the Tax?

You cannot avoid death and taxes. So if a company is getting away with skimping on taxes, should you take its reported profits at face value? Maybe not. Measuring a company’s tax incidence against that of its peers in a sector may serve as a check that is as good as poring over its cash-flow statement.

Value Trap

You’ve uncovered this company which has been delivering scorching growth rates quarter after quarter, but its PE multiple remains at a dismal 3. So, have you stumbled upon an undervalued gem which everyone else has missed? Probably not.

When a stock consistently trades at a dismal PE compared to its sector peers it means that the market doesn’t quite take its reported numbers at face value. Or that it perceives risks to the business that will slow down reported growth.

Beware the Outlier

Are a company’s profit margins or growth rates way out of sync with the norm for a sector? That could be the sign of a great business model, an ultra-efficient operation, or… creative accounting.

When you see a company reporting exceptionally high operating profit margins year after year it could be a sign that the company has discovered a business opportunity that others can’t replicate or that it operates in a niche, which rivals can’t easily enter. If you can find evidence of neither… ... treat it with a healthy dose of suspicion.

It’s all in the family

Related party transactions, or a company’s dealings with its promoters, top management, group companies and associate companies are often a clear giveaway on governance issues. Consistent transactions with key management personnel (or their relatives) may indicate that the management is using its position in the company to undue personal benefit.

Sales or income originating from related parties and large loans and advances to group entities may be warning signals on diversion of funds. Collateral and guarantees extended to related parties may turn out to be liabilities at a later date. Interpret these by looking at their size and materiality.

AARATI KRISHNAN

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