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Managers matter, for stock analysis too

LiveMint logoLiveMint 01-03-2017 Lisa Pallavi Barbora

In October last year, industry watchers and market participants were shocked when the ouster of then Tata Sons Chairman Cyrus Mistry was announced. It was sudden, unexpected and uncharacteristic; coming from one of the largest conglomerates and one known for its ethics. Some 3 months later, another public battle in another large Indian company came to the fore. Infosys founder, promoter shareholder and former chairman Narayan Murthy raised governance-quality issues aimed at the company’s board of directors.

Many fund managers maintain that management quality and corporate governance are key in picking stocks for the long term. But a quick look at the stock performance and holding pattern of Infosys and some large Tata Group companies will tell you that investors are not selling in a hurry despite concerns. 

It should matter because the genesis of fundamental analysis lies in identifying good quality management, which has the capability to sustainably drive earnings growth.

According to Sunil Sharma, chief investment officer, Sanctum Wealth Management Pvt. Ltd, “Quality of management and good governance is a prerequisite for long-term stock selection. If governance is not strong, lapses will occur which can potentially lead to a loss of capital. The impact of a gap in corporate governance is often felt over time while the change in perception is swifter.”

At 16 times price to earnings ratio, Infosys is already trading at a valuation that is close to the lower end of its historical average valuations. In case of many of the large Tata group companies, there was a sharp price impact immediately after the announcement of the sudden departure of Cyrus Mistry; it is only after discussion started about the way forward and possibilities of a new chairman for the group, that some confidence returned to these stocks.

According to a senior fund manager with a domestic asset management company (AMC), “Sometimes internal analysis reveals these concerns even before the issue is made public and that impacts stock price and its demand over a period of time.”

Sharma said, investing was first and foremost about risk minimization, anything that raises a doubt needs to be evaluated. There is also an impact on perception and unless that is adequately addressed, the stock tends to remain on watch. 

A quick check shows that out of the 260 diversified open-ended equity and equity-oriented mutual funds that hold Infosys, only four schemes have a portfolio weightage or holding percentage that is greater than the stock’s weight in Sensex and 20 have a portfolio weight higher than the stock’s weight in Nifty50. This shows that most of the schemes are more or less underweight compared to the benchmark position, despite relatively low valuation (which is sometimes seen as a good time to buy). 

Lapses in corporate governance are not new, even for large conglomerates. Not too long ago, there was the Volkswagen controversy about manipulation to get the desired emission data. Often quick and effective action to address the problem alleviates investor worries, to an extent.

A recent update published by Edelweiss India Equity Research on Infosys reiterated a buy/outperform rating. The report summarised that in a call hosted by the management, many of the concerns were adequately addressed. The report said, that the chairman and chief executive officer hosting the call itself exemplified that there was no breach of governance practices and promoters’ concerns were due to differences of opinion of certain shareholders with the company’s board.

The defining line could be the intent of the management around issues of corporate governance. If the intent is to defraud, then the market may take a sharper view on the stock. Let’s take the Volkswagen example again. The stock corrected at least 40% immediately following the finding that the company had intentionally programmed engines to give a biased emission result during testing. Two and a half years on, despite an admission and apology by the management, the stock price is still below the level seen before the event. 

According to Harsha Upadhyaya, chief investment officer, equity, Kotak Asset Management Co. Ltd, “Where the issue affects minority shareholders and can be voted on, investors should use that route to convey their point to the management.”

For mutual funds, investment committee meetings could question some of these issues. 

Then there is also the board of trustees, which can question holding a stock with clear corporate governance issues. However, this process might be unique to each fund house, depending on the composition of the board.

According to a former head of equity with a mid-sized fund house, “In the last 10 years I was questioned only once during presentations made to trustees. Many times trustees aren’t from the industry and the process of counter-questioning is not rigorous.”

This, however, may not be the norm and depends on the AMC’s own governance standards.

No matter how it is approached, the market does evaluate corporate governance. There is an impact on perception, which may take time in translating to stock value. Don’t ignore these issues as the long-term value of a stock is closely interlinked with the quality of management. At the same time, if you already hold the affected stock, don’t be too quick to act; give the management time to present all sides of the issue.

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