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Role of Corporate Governance in Investing

Much has been written about the importance of competence and integrity of management when it comes to investing in a company. I find it difficult to write any more on the subject. Assessing management integrity and background prior to investing is no doubt the best investment advice anyone could give to a serious investor. However, when it comes to the role of corporate governance in investing decisions, the trouble is with finding the correct resources. We don’t meet the top management frequently enough to know if they are competent or honest, do we?

But do we have to? Where do you find the answers?

I will try to list down a few things which you ‘Must’ do as an investor before including any more shares in your portfolio. Bear in mind that there are two very distinct points on the role of corporate governance which I am trying to cover, though the variation is often subtle:

FirstlyIntegrity: Is the management honest? Is it frank in disclosing things to the shareholders?

SecondCompetence: Is the management rational?

While it may not appear so but oftentimes it is easier to assess integrity than competence. 

6 points on a company’s corporate governance to check before investing:

1.      Who are they?

These days it is easy to find out a lot about the management on the internet. Read about the management on their website. Look for what shows up when you Google search their name. Try to find out about their professional and business history.

Remember: when you want to do business with someone, it is important to do some groundwork on them before.

2.      What promises did they make?

Pick up the annual report for the last 5 years for the company under investigation. Pay special attention to the chapters on corporate governance and management discussion and analysis and look for other places where the management has made a promise. Try to make a list of every promise which the management made in past.

3.      What efforts have they made to fulfill those promises?

For each promise, find out if the management has taken any steps in the direction of fulfilling that promise. Did they repeatedly talk about their plans in interviews, future annual reports etc?

4.      Everyone makes mistake, but do they admit them?

It is easy to do a cover up job on plans gone badly. These days, there is a whole army of accountants which can use creative accounting principles to cover up inefficiencies. One of the most refreshing things to read is when the manager of a company admits mistakes in an interview or on a report. This is surely a positive sign.

5.      Do they buy and sell shares in their own company? Are they always busy trying to justify share price movements? Do they excessively subscribe to share warrants/ stock options?

6.      Have you checked for financial irregularities? SEBI investigations?

When reviewing financial statements, it is easy to be inclined only to look at PE multiples, net profit, expenses etc and compare those line items to peer companies. Attention should also be drawn on aspects such as:

►      What happens to the profits: Does the managements return most of the profit it generates in a year to the shareholders (as dividends) or, does it keep most of it in Reserve and Surplus account. In either case, one must question management rational. If most of what the company makes is being returned as dividend, is it because the company has accomplished as much growth as is possible, or does the management believe that there is no possibility of re-investing the money in order to make a higher return in future.

On the other hand, too much of a reserve build up should raise a question about management’s future plans and what it plans to do with large reserves.

►      Break up of expenses: get a sense of where the company spends most of its money and compare this figure with its peer group. It is great tool when you are trying to understand the efficiency of management.

►      Extraordinary items: Look for companies where extraordinary and exceptional items are consistently high – avoid them.

►    Finally, look at the attached schedules and notes. Do they answer your questions when you go to them from the main sections of the annual report? If not, don’t buy a single share in the company.

There could be several more ways to analyze the management. For example if you know those working in the organization, who work closely with the management, that should help. Mostly, even if the employees can’t tell about issues of integrity, they can give an insight about the general behavior and approach of the management towards everyday issues which can serve as a great analysis tool.

As I had mentioned at the beginning; Integrity, competence and rationality are mutually exclusive concepts. It is far too common to find honest management which is not competent enough as it is to find extremely competent set of fraudsters.

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