Investment Blog

Imagine you have been told about an investment opportunity in a business. The numbers look fantastic from all angles. High margins, rapid growth, superb financial ratios like high ROE, low debt/equity & interest coverage ratio, etc. The company is led by charismatic founders telling captivating & convincing business success stories.

You are excited about the opportunity and ready to pay a much higher premium compared to other businesses in the same industry.

However, one fine day people come across some disturbing red flags regarding corporate governance practices in the company. The stock crashes.

Would you consider it a buying opportunity, given the fact that the stock is now available at much lower valuation multiples (PE/PB, etc) compared to a few weeks ago?

You may be tempted to. However, the biggest problem with a company having apparent corporate governance issues is that you can’t rely on the accuracy of the financial numbers anymore. It could all just be fiction, engineered to present a rosy picture.

For example, based on available financial numbers a stock pricing at a 200x earning multiple is now available at a 100x earning multiple after a 50% correction but if earning itself is inflated by 100%, the stock would still be available at a 200x multiple on actual earnings.

The fundamental aspect that is killed on recognizing glaring corporate governance issues is trust in accounting practices. Once, trust is broken, the stocks start trading at even lower valuations (if the business survives) compared to other players in the industry.

There are numerous examples in history where bad corporate governance has destroyed huge amounts of wealth.

Personally, I would filter out the companies that have poor corporate governance before starting to analyze the financials, otherwise, I would just be analyzing the fiction.

You may argue, that many companies have corporate governance concerns in India and then there would be nothing left to invest. I agree. However, degree and intent matter. Some undesirable practices occur out of compulsion to operate in the system. Other practices are just to game the system or willful transgressions to make quick bucks. One needs to understand the motivations.

“You’re looking for three things, generally, in a person,” says Warren Buffett. “Intelligence, energy, and integrity. And if they don’t have the last one, don’t even bother with the first two.”

Remember these words of wisdom and you would seldom make mistakes with hiring the wrong people and investing in a company with unethical management which could cost you a ton of hard-earned money.

Originally posted on LinkedIn: www.linkedin.com/sumitduseja