January 8, 2009

India’s Enron - Satyam

update 9-Jan
When it rains, it pours ! for satyam it is pouring bad news.
I am reminded of buffett's comment - There is never a single cockroach in the kitchen.

There are no suitors coming up. Who wants to be associated with a tainted brand ! The value of an IT company comes from three sources - its brand/ reputation, customer relationship and employees. The brand/ reputation is the foremost and a damage to this asset can destroy the other two.

Satyam, with a new board may be able to rebuild the company (though not to its former glory) partly. However the company is facing a cash crunch and if it is not able to get cash for operations, then it could be in serious trouble. Getting a loan is not going to be easy, if the books have been cooked and the banks cannot trust your accounts.

Once clients feel there is a risk, they may press the panic button too. It is not easy to change a vendor, but i will not be surprised if clients have not started working out a contigency plan.

Finally, this episode will impact Indian IT in the long run. Do you think clients will trust other companies as easily as they have in the past ? With Indian companies vying with IBM and the likes for billion dollar deals, trust and faith is far more important. This episode is going to make life diffcult for all the vendors.


A few days back, I wrote about corporate governance in Indian companies. I hardly expected this – a full fledged fraud at satyam. I was shocked to say the least. Satyam is not a fly by night operator. There were some concerns on the coporate governance (forget the peacock or whatever ‘bird’ award), but what has come out is not some corporate governance lapse, but outright cooking of the books.

Bad intentions
I personally have no idea of the intentions of the management. However from the letter and from what I have seen in the past on such incidents, is that the start of such a fraud is small and not with malice. The management typically is not able to meet the numbers and fudges the numbers a bit to meet the targets with the hope that they will be able to cover the gap in subsequent quarters. However the gap does not get covered and the management resorts to even more manipulation to meet the numbers till finally they hole is too big to cover. This happened with Enron, worldcom and several other companies during the dotcom bubble in the US.

Is satyam headed for bankruptcy ? I don’t think so. This is not a bank where there could be a run on the company. That said, there is more pain ahead and the critical thing to watch over the next few quarters would be how the company manages its customer relationships and employees, which are the bigger assets than the cash on the balance sheet.

Possible to know before hand ?
I received a comment on how to calculate the value of the company if the numbers cannot be trusted ? My response is – you cannot. The entire basis of investing is ‘trust’. When you invest your money in a company, you trust that the management is honest and presenting the true picture. You trust the auditors to be doing their job when they certify the accounts. Clearly both the management and the auditors blew it at satyam.

You can expect articles to come out on how it was evident that something was wrong at satyam. I would say that is complete bullshit. I have not analysed the satyam annual reports till date and plan to do so now to see if it was possible to know the fraud before hand. Most of the times there are red flags on aggressive accounting which would give you a clue that something is not right. You can use these red flags to stay away from the company. However it is very difficult to detect fraud from the public filings such as annual and quarterly reports.

What now?
Such incidents are not unique to India. They have happened in other countries around the world. What is different is the kind of punishment for such a fraud. In the US, the CEO of Enron was sentenced to 24 years in jail. The US law is very strict with white collar crime and gives out harsh punishment for such crime.

In india, I doubt much will happen. We treat white collar crime as no crime. This incident is going to cast a major shadow on all indian companies. If satyam could fudge cash of 5000 crs+, what about all the smaller mid and micro cap companies which have some unknown auditors and a weak to non-existent board.

I hope investors now demand tranparency from companies and vote with their feet (sell !) if the management is not transparent.

Lesson for us
As an investor I can think of two ways to handle such an eventuality – avoid companies where corporate governance is suspect and diversify.

This is a complete tragedy, especially for the 53000+ employees who have worked for years with the company and now face this for no fault of theirs.


Vidyanshu said...

Dear Rohit,

Its a never ending nightmare for people at Satyam. The past one month or so has been a rapid unraveling. At the same time this highlights the need for a thorough understanding of the important dimensions of Value Investing and the way Warren Buffet goes about selecting stocks. People should have exited stocks as soon as there were corporate governance issues raised about Maytas acquisition...something which a Buffet would have done as soon as he felt the Duke guarding the castle cannot be trusted regardless of the width of the moat...(who will protect us from the police?)

To understand the anguish and the volume of people who will be inundated by this tsunami of a tragedy (as also for a good laugh), visit the link below.


This incident more than anything else highlights the need for a thorough due diligence of the management as well as the numbers. What are the other learnings?


Rohit Chauhan said...

i agree vidyanshu with your comments.
this is a tragedy for employees. i feel more for them. as an investor, unless i have invested blindly into a single company my losses are capped.
however as an employees the stakes are higher. there is personal and emotional involvement with a company. in addition, most employees have a big financial stake via esops.

i think management quality is critical when investing. however that is the most diffcult point to evaluate. there is no fixed criteria to measure. what one can do is avoid companies with weak disclosure and poor governance standards even if the company is doing well and may not have fraud.

i have personally avoided severally such companies in the past. however still some of my current picks, have managements which may not be fraudelent, are nonethless ..not shareholder friendly.

i think going forward most of us are going to focus on management quality more than the past


Kannan said...

That is buffet's formula right...

What struck me was Buffett’s adaptation of Einstein’s equation for the theory of relativity.

e = mc² (squared).

For Buffett, the success of a business can be predicted from this equation, with changes to what the variables stand for:

E = earnings, the lifeblood of a business.
M = management capability.
C = character of the management. Squared.

The emphasis was on “C squared”.

No matter how skilled the management of a company is, the character of the business leaders is even more important for long-term success.

Source: Internet

Sachin Purohit said...

Regards the article and the question you have raised as to whether account books of the likes of Satyam can give any hints regarding their being fudged? Maybe. It would be interesting to read your article once you come up with some interesting findings from Satyam's books. But till then I am really not sure and am confused as well as to how these kinds of companies can be avoided based on quantitative analysis. But I tried to see if there is a qualitative pattern that runs common among these scam companies. At least it turns out in case of Satyam that since 2000 there has been a history of shady things related to it. Taking a cue from Vidyanshu above, I think a Warren Buffet may not have waited till even Maytas' shady transaction. He may have exited around 2001 itself when it became clear that it was a K-10 stock, had dealings with another scam-ridden company - GTB and a numerous other corporate governance controversies against his name.

Mahesh Kshirsagar said...

I really doubt that Satyam will survive this storm. I know that few clients have already cancelled their contracts. Typically consulting company like this is broken into pieces and sold since every account is a valuable piece of business. (This happened with Aurther Anderson and Anderson Consulting after Enron). There will be many individuals involved in this from account manager level to CEO, contrary to Mr. Raju's statement saying that he is the only person involved. Many companies try to avoid professionals who may have spend 10+ years in a corporate culture which promotes such fraud. Satyam may not have enough money to pay next months salaries and most of their assets are worthless.

Sachin Purohit said...

In connection with our discussion above, what do we make of this news that L&T has acquired 4% stakes in Satyam as late as 1st January 2009? A.M Naik says it happened before Raju went public about his fraud. But as we have been discussing from value investing point of view..who would want to buy Satyam's stakes after the Maytas fiasco, World Bank fiasco, etc .. speculators? If speculation is one of the business goals of L&T, then this question need not be asked. But I think it is not. Shouldn't the shareholders of L&T question the wisdom used by the management of L&T in this transaction? Based on shareprice information available for the 1st Jan 2009, I estimate the MTM loss for L&T as on today is about 360 Crores. There are two possibilities .. either Satyam does not go down under, in which case this MTM loss has a chance to become a real profit some time in distant future. But if Satyam declares bankruptcy, who in L&T stands to lose?

Vic said...

Hi Rohit,

Prem had asked you the following question in Dec 2006 and I didn't see your response to it.:
"Thx for replying Rohit.
Sometimes I feel it would be good if I were to go through a bear mkt first. That would help keep my common sense in place.
Though I know long term holding is the key to riches, sometimes I feel compelled to sell when a stock runs away...and u sell and it runs even further.
What I really meant was this..would u sell a fantastic co when it sells at/above fair value..during the lifeterm of a great co, there ought to be times when U feel its too heated to hold it anymore..

I feel peeved when ppl quote HDFC bank and Infosys to showcase the potential of long term holding...how many ppl had the nerves to hold it at sky high PEs in 99-2000..and how many had the guts to hold it through the fall later?

Take Bharti tele..from 35 when it went to 200, ppl cried 'sell', 'overvalued', 'expensive', etc... and it went to 350 and ppl cried very expensive (during some periods before the performance caught up with price)and if u had the nerve to hold it all the way through.. u had a 20 bagger..(my friend did..)

Seeing ur holding.. u have managed to hold the few stocks u mentioned all through the bull run so far without selling...didnt u feel that at some periods, the stocks were overpriced and time to sell?"
I think it is a good question. Can you please answer this?



Rohit Chauhan said...

Hi kannan
i have read that too about buffett. unfortunately it is not easy (at least for me) for me to judge the character of the management.
however if there are red flags it makes sense to stay away from the company


Rohit Chauhan said...

hi sachin
management character and integrity is generally not quantitative. it is a subjective analysis.

i am reminded of buffett statement - there is never one cockroach in the kitchen.

if there is doubt about the management, stay away. only if the management has a history of integrity should one proceed.

satyam had corporate governance issues in past. that should be a tip off.

well these kind of issues are not limited to satyam ..there are several other companies with similar stinks


senty said...


Is there any way to identify a company which is not correctly valued(i mean low value - which gives an opportunity for the value investor to invest in it) and devalued (devalued and carries low PE for its corporate governance issues)? I ask this because I have seen few articles after the Satyam mayhem that stocks like Videocon are of low PE(relatively compared with peers) solely because of corporate governance issues.

So, how do you manage to distinguish between a real gem from the others?

PK said...

I have some points to make on the basis of my experience in business and IT sector:

- IT companies have Income Tax holidays. This can be precise reasons why they would like to overstate profits to win investors. Also investor's profit expectations are high from IT companies. Combine the both and you have enough reason for management to consider this fraud.

- In addition they have lot of forex/exim relaxations, they work thru multiple countries with multiple subsidiaries. All this is enough material to cook books

I am pretty sure that all IT companies have overstated profits including Infosys, it is the question as how much over stated by whom and since when?

Secondly in every bear market there is some big frauds detected First it was harshad mehta, then ketan parekh and now Raju... But as last bull run was quite substantial, i expect more frauds..

Sujith Marar said...

Hello Rohit ,

I agree with your comments .But , the point i am trying to make is that most likey investors that have suffered heavily is recent investment made after maytas fiasco or the investors who had invested after the payment of dividend in the year of 2008 and if it is their sole holding . I would think long term investors who had kept this stock and who had not sold till now will still benefit from some amount of gain through dividends rather than losing everything .

Diversify is the only solution

Rohit Chauhan said...

hi senty
there is no quick or clean way of identifying companies with bad management. one has to read through the annual report, analyst meet and general news to get a 'feel' of the management. they are some key points one can look for - will be making a post on that - but overall it is a very subjective process.
this is where skill and experience comes in play


Rohit Chauhan said...

accounting rules give a lot of leeway in fudging the books. i would not single out IT companies alone.
actually IT companies have the one of the highest level of disclosure. try the annual reports of some midcaps and MNCs ..you will be horrified.
tax holiday and other benefits can be misused and i dont think are the root of the problem
fudging or managing earnings is prevalent in india and in all developed markets. outright fraud is much smaller ..what distinguishes india is the lack of enforcing the law.

i will not go the extent of saying all IT companies have some or the other fraud. you cannot pronounce 'guilty' unless proven otherwise just because a satyam commited fraud. that would be a knee jerk reaction ..that is what the market is doing now.

it is now that everyone is concerned about corporate governance ..during the bull most investors did not care about it.

i agree that some scam always comes out after a bull market ..mainly because most people are prepared to close their eyes to a fraud as long as everyone is making money

Ninad Kunder said...

Hi Rohit

Your point that "most ppl are willing to close their eyes to a fraud as long as everyone is making money" is very apt.

There are lot of Satyams in the making though not in a similar scale and most of us know it but we choose to be blinded.



Rohit Chauhan said...

hi ninad
yes ..as long as people were making money ..everyone was ready to keep their eyes closed. i would say the % of ethical and good companies is lesser than the other type

now the reverse is happening and everyone is now questioning the management. atleast the satyam episode has shocked people out of their slumber


Sachin Purohit said...

Hi Rohit,
Just thought this would be of interest to you regards trying to look for symptoms in a Satyam-like scammed annual reports:

It mentions one Mr. Saluja had indeed asked some uncomfortable questions to Satyam's CFO during a Conference Call after one of the financial results, regarding suspiciously high amount of money in low-interest Current accounts instead of high-interest paying Fixed Deposits.