January 20, 2009

Cash - good or bad ?

I was recently referred to an article by Prof. Bakshi (read here). Prof bakshi has written about a few companies which seems to be cash bargains (selling less than cash on the books), but are suspect due to their accounting and corporate governance.

Readers of this blog would be aware that I have a bias for companies with low debt and high cash on books. I do not get excited by growth as high growth companies are usually fairly valued or overvalued. However slow to moderately growing companies with a solid business model are frequently undervalued. Excess cash on the book only adds to the attractiveness of these companies.

Low debt and cash on books is usually a good thing, but excess cash holdings for long periods of time are not good for shareholders. It usually signifies that the management is allocating capital poorly and in absence of high return opportunities is letting the cash idle. This is ofcourse better than spending the cash on stupid acquisitions. However a shareholder friendly management should return the cash through dividends or buybacks.

The above holds true if the cash is actually present. After the satyam episode, one cannot be completely sure of that. I have always looked at the management quality and corporate governance of a company in the past, before committing my money to it. It is easy to identify cases of bad (see
aftek here, which the prof has also referred to in his article) or good governance. The problem is identifying managements which are not good, but not overtly bad. The bigger problem is identifying complete frauds, where the !@## (put your choice of expletive) auditors are hand in glove with the management.

There are books, which discuss this topic (of financial fraud) in detail (see
here). There are no clear-cut formulae to identify aggressive or fraudulent accounting. A deep understanding of accounting and experience, will throw up red flags when one is reading and analyzing the annual report of a company. A single red flag may not be a cause for concern, but several of them together should alert you. I will be covering some of these red flags in a future post.

Let me come back to another example in the article –
HTMT global. I have discussed about the company in the past and have a small holding in the company (it is part of my diversified graham styled portfolio). The key reasons for my investment are – cash on books higher than the market cap, decent topline and bottom line growth and ultra cheap valuation. However the negative on the stock is corporate governance. As indicated in the article, the cash is held in a subsidiary in Mauritius.

The CFO indicated in the analyst meet that the cash is being held to avoid the 30% tax and for acquisitions. During the analysis of the company, I read this explanation (I was searching for it) and found it plausible. However on reading, prof bakshi’s article I was disappointed to read this

HTMT has deposited cash in Mauritius. When asked about keeping its money outside India, Anand Vora, CFO, said: “We have been getting a lot of queries, because PwC is our auditors and have a considerable amount of cash on our books. We don’t want to comment till we get a clearance from our legal team. So, while your questions (on overseas accounts and account balance and cash on books) may not be very sensitive issues, we will still like our legal team to go through it.”

There are two red flags in the above statement : PWC and the reluctance of the CFO to give a straight response. If you have cash on the books, why do you need the legal team to go through it?

Does the above mean that the cash does not exist? Should one exit the stock? To be honest, I don’t have an answer for that. If one cannot trust the management and the auditors to tell the truth, then it is not possible to invest in a company. The entire financial system depends on this trust. No one will invest, if the management and auditors cannot be trusted to tell you the truth.

So where do we go from here? For starters I am reviewing all my holding to check their cash holdings closely and tie it with the interest income. I have checked these numbers in the past, but with only a passing interest. I will however be looking at these numbers far more closely now.

In addition, though I have focused on corporate governance in the past and rejected several ideas for my core portfolio, I have been more tolerant in my graham styled portfolio. I plan to give more wieghtage to this factor in my stock picks in the future. I have purchased companies, which are statistically cheap, even if they are not upto the mark in corporate governance. I plan to put more wieghtage on this factor going forward.

I am still thinking about HTMT and have not decided yet. However my comfort levels have dropped a lot with this company and my gut feel is not good (yes, I listen to my
gut feeling ..ignoring it in the past has been costly). I may decide to exit the company even if I have to take a small loss. This may be an over-reaction to the satyam episode as there is still no factual basis to distrust the company. However there should be no tolerance on corporate governance and transparency. In the end i would rather err on the side of caution than repent later.

Added note : I just glanced at Satyam’s annual report. The company reported 3300+ crs of cash with scheduled banks and an interest income of 270 Crs. The scheduled banks seem to be bank of baroda, BNP, citibank, HDFC, HSBC and ICICI bank. How the hell did the auditors certify the cash if the management says all this cash was fictitious ? If this
news report is true, then one could derive comfort that the statements were not fraudulent and the cash was actually siphoned out.

14 comments:

Anonymous said...

Dear Rohit, Again a nice post. It's really a concern for our faith and believe on the publicely available sources about the company financials. Now I am gradually understanding the importantce of accounting experinces to make better investment decisions along with the search for management credentials & integrity before taking any investment decsion for a particular company. Unfortunately I had a small exposure to Satyam and now I am trapped with that. Anyway I have learned a very good lesson the hard way. However it would have better if I could understand the electric fence quote of Munger earlier.

Sachin Purohit said...

Nice and informative post from you as always. Coincidentally, Aftek was in my radar at about the same time, it was in yours. My reasons for rejecting it was purely instinctive. I felt there was something very wrong about this company but was not able to pinpoint. I followed your link to your earlier Aftek post and found a lot of valuable analysis out there by you as well as one of the comments (RaviAranke) to that post.

Returning back to Satyam, assuming there actually was cash lying out there in those banks, siphoning off that cash would leave a lot of dirty debit entries in those accounts. It would leave Raju's "confession" as a bigger fraud than the story of fictitious cash in balance sheet. Wouldn't he rather go absconding before making this false confession?

Clearly, the mystery is just beginning to unfold but in a non-transparent environment, I am really not sure whether the suspense will ever get revealed. With so many politician and respected people's involvements, I think there is too much at stake. So it might turn out like a Hitchcock thriller seen only uptil the intermission.

Anonymous said...

Dear Rohit,

There are several editions of Security Analysis. First of all is it an important book to read? Second, which edition would be worthwhile? I cannot afford to buy all of them :)

Rohit Chauhan said...

hi anonymous
agree with you point. i have always looked at managment quality and accounting details in the past. i have always paid attention to the 'notes to the account' and other footnotes. however i have not looked at the accounts with a critical eye, trying to tie the numbers and see if something is fishy. plan to do that in more depth.
although we can learn from the experience of others, nothing beats your experience. you remember for a long time.
finally fraud like that of satyam is very diffcult to figure from the statement where the cash itself is falsified.
the only clue were news items and rumors around the management and their past actions. i have not paid too much attention to that in the past, but have kind of avoided stock with such 'rumors'. reason was my experience with ssi and not listening to these rumors

regards
rohit

Rohit Chauhan said...

hi sachin
aftek case is stark ..and i can tell you there are several more such cases. A lot of these cases are not so blatant, but a reading of the AR can reveal that. satyam's case is more complex ..the accounts do not show outright fraud ..atleast not to the extent which came out.
there is definitely more than meets the eye. there could be fudging and siphoning of the funds too

regards
rohit

Rohit Chauhan said...

Hi anon2
you are asking someone who is a complete devotee of graham and buffett :)
i bought the first edition 9 years ago and have read it 3-4 times till date..and plan to do every alternate year
i think the later editions are equally good and you can pick any ..i have not seen them personally

regards
rohit

Anonymous said...

hi rohit,
nice post, any thoughts on Denso India and where the company's cash is parked. The antecedents of the company are exceptional - with stakes by Maruti and Denso Japan - but it does trade below cash levels and the whole satyam episode makes me nervous
regards
domink

Anon2 said...

Hi Rohit,

Thanks. I have bought a copy of the Intelligent Investor and found it a very good read. Now, I am wondering whether I should pick up the book on security analysis too and which is why the question. I scouted around in the internet and found people saying the 1951 edition is the best. There is one edition which is 2008, but people do not seem to be favorably disposed towards it. I see your blog and understand you are a big follower of Graham/Buffet..I will go by your recommendation and pick up a copy of 1951. Hopefully, it will turn out worth the spend. Bon Apetit.

Regards.

Tarkeshwar said...

Re: HTMT CFO statement.
Maybe the guy is talking about consulting legal team on PwC issue, not on specifics of cash. He is talking about two things in that line.

And HTMT's money was from sale of stake in Hutch, not from profit (which was fudged as in case of satyam). Does not that make it less likely that the amount is fake.

There is a possibility that the cash could be siphoned off. That brings back the qus of trust in management, without which no investment is safe.

Re: Prof Bakshi that most of the idle cash in books should be distributed as dividend to shareholders. That's a Grahamites' delight scenario but far from reality. No company has that good corp governance to do that, at least in India.

Rohit Chauhan said...

hi domnik
almost all investors are suffering from the 'cat on hot tin roof' syndrome. we are now scared of cold tin roof too.
one cannot pronounce a company guilty unless proven otherwise
In the AR the cash seems to be held with scheduled banks, this cash is tying up with the interest income. In addition the management (CEO and others) does not own the company and are mostly employees ..so they do not have a strong incentive to commit such a fraud.
we also have to look at the incentive to commit a multi-year fraud. that may not be the case here

regards
rohit

Rohit Chauhan said...

Hi tarkeshwar
you highlighted exactly the dilemma i am facing. there is no 'proof' that there is fraud in the company.
however it is not a comfortable position till we get a more disclosure.
in case of management, one has to go by a subjective analysis and gut feel. as a result i am looking at reducing my holding and percieved risk if not exiting completely.
regarding returning cash - i agree it would too much to expect with any company in india to return.
in addition HTMT is growing well and can use the cash to do some decent accquisition.

Rohit Chauhan said...

anon2
it is a fairly dry book ..not entertaining ..but a great book to learn value investing from the master himself

regards
rohit

Vic said...

Hi Rohit,

Great post and thanks for the article from Prof Bakshi, I read it with a great interest.

All the "details of these foreign banks" where the cash is held for some of the companies like HTMT Global etc, is this info mentioned in the ARs or balancesheets?

Thanks,

Vikas

Rohit Chauhan said...

hi vic
i read in the AR that cash was held in mauritius with a foriegn bank ..though i dont remember the name of the bank
regards
rohit