The Most Important and Most Ignored Step in Investing

In this issue:
» How did the sectors perform in the July-Sep quarter?
» Economic recovery still elusive. Focus on bottom-up investing...
» ...and more!

00:00

Enron, NSEL, Satyam... Names synonymous with corporate scam. Each highlights how quantitative information can mislead...and how management can make or break a common investor's portfolio.

Unfortunately, the most crucial factor is Qualitative in nature, difficult to measure. While return ratios, debt levels, dividends, and cash flows can give some insight into the fundamentals of a business, they won't always give you a real taste of management quality, integrity, and efficiency.

This is truer for less-tracked small cap stocks. And it's why meeting the management is an essential step for all our small cap recommendations.

Before we recommend a stock, here are some of the most important management questions we address:

• Is the management cost conscious?
• Does it reward itself more than warranted?
• Does the management focus on long-term value creation? Or is management opportunistic and likely to jeopardise the business stability in the long term?
• Is their focus on stock price movement or business?
• Has the management any succession plan in place?
• What kind of value creation is it working towards five years from now?
• Is the management honest and transparent?

Unfortunately, you aren't likely to find answers to these questions in financials or annual reports. Take cost consciousness for example. While all managements claim to work towards cost efficiencies, very few do so in practice.

Some of our best recommendations were in managements whose simplicity was evident from the moment we entered their modest company premises. Everything about their simple office and efficient work culture suggested that cost consciousness was deep in the company DNA.

Interactions with managements from different companies in the same industry can give insights that no comparative financials and valuations ever could.

For example, it was our meeting with a shoe company that vouched for its leather supplier and was ready to pay a premium for its quality that gave us the idea for our next recommendation.

However, qualitative research is not limited to management meetings. Taking management's word as gospel truth can be a huge mistake. What they say must be cross-checked. Claims that cannot be confirmed by suppliers, customers, and competitors must be dismissed. We meet with many managements, and we reject far more than we recommend.

Philip Fisher was famous for this kind of vetting of management. And this 'scuttlebutt', as it became known as, led to some of his greatest stock ideas.

Common investors can learn many lessons from this. Successful investing is not just about identifying a good business. Especially for small and growing companies, a bad management of an otherwise good business can lead to unrecoverable losses. Make sure you have enough qualitative information before betting on a stock.

How do you judge a company on qualitative aspects? Let us know your comments or share your views in the Equitymaster Club.

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02:00		Chart of the day

The Indian stock markets have been slipping lower in recent weeks. A mix of domestic and global factors is responsible for this. BJP's debacle in the Bihar elections was seen as a dampener to market sentiment. On the global front, the likely hike in interest rates by the US Fed next month is another concern that is forcing investors to take a cautious approach. But another key factor that is indeed at the heart of the recent underperformance of stocks is the poor show in the July-September 2015 quarter results.

As per an article in The Economic Times, a sample of 1,822 listed companies witnessed a meagre 1.5% YoY aggregate growth in revenue during the quarter ended September 2015 (the sample excluded banks and oil firms).

Now, you may say that such a large sample may not be an appropriate representative of the fundamentally sound companies that may be of interest to investors. Here is another set of data that we came across in Business Standard. Today's chart shows the sector-wise revenue performance during the quarter ended September 2015. But the sample taken is slightly different. Performance of the top 25 performers from some major sectors has been taken into account, excluding banking and finance.

So, how has the performance been? Realty, power and IT sectors reported the highest topline growth at about 14% YoY. The steel sector has been the worst hit. Capital goods have also fared poorly. The FMCG sector, a good indicator of consumer demand, has slowed down to 2.2% YoY growth. It is clear that the Indian economy is not out of the woods yet. The macroeconomy is in a much better state than it was two years ago. But the economic revival still remains elusive.

Sales Growth in 2QFY16: How Did The Sectors Perform?

03:30

A year and half ago, Indian economy seemed to be at an inflection point. The incumbent Government, blamed for economic slowdown and scams, was getting replaced with reform-oriented Modi Government. Be it economists or investors, all were confident that with clear majority, Modi Government will fulfill the promise of 'acche din'. Everyone bought the story, including the stock markets that touched all-time high levels.

One and a half year later, the recovery that seemed so close remains a mirage. Corporate profits and business confidence index paint a sorry picture. While there are some good indicators as well, such as growth in industrial production, low inflation and deficits in control, it has more to do with global factors such as low crude prices, than positive domestic developments. In such an uncertain scenario, one would do well to keep realistic expectations regarding growth and follow a bottom up approach for investing in equities.

04:15

After opening the day on a weak note, Indian stocks inched their way into the green. At the time of writing, the Sensex was trading higher by around 224 points (0.88%). Barring IT, all major sectoral indices are trading in the green with banking and capital goods leading the gainers' pack.

04:45

Today's investing mantra

"A lot of people with high IQs are terrible investors because they've got terrible temperaments." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst).