When Auditors Are Paid 100 Times the CEO...

Every market crash finds a scapegoat.

And it is typically not the traders, speculators or the management of the companies.

The real culprits go scot free. The blame rests on few individuals or entities who are supposed to raise the red flag.

Think about it. When did you first see credit rating agencies grab newspaper headlines?

Many of you may have read about them for the first time during 2008 market crash. They generally keep a low profile.

But they got into the limelight like never before exactly a decade back. In the US, they were blamed for not warning about Lehman's possible bankruptcy. And for offering AAA ratings to Wall Street firms that were not financially sound.

In India, in January 2009, Satyam's Ramalinga Raju confessed he had cooked the company's financial books for years. This time it was not the credit rating agency but the auditor, PwC, which was in limelight.

It took the courts a decade to penalise PwC for this fraud.

And in 2018, it took the resignations of more than 30 auditors in the last six months, for the market to take note.

You see dear reader, you face a big problem when such rating and accounting frauds come to light. It's typically too late to act. No one warns you when the fraud is happening. Only after it has happened.

The stock crashes and you are left with huge losses.

Even the exchanges and regulators know little.

Else, why would Vakrangee find a place in the BSE 100 Index just two months before its corporate governance issues became known? Did you know that it even made it to the BSE Quality Index for a while? How did that happen?

So the only recourse, dear reader, is to look for data points that are usually not part of financial reporting.

For instance, take the ratio of auditor remuneration to CEO remuneration.

Why should the compensation to people auditing the accounts of a business, be more than that of the person running the business?

There can be anomalies in some cases.

The Chairman of SBI is grossly underpaid compared to the CEO of a comparable private sector bank. This is why the ratio of auditor pay to CEO remuneration at SBI at 98.8 times looks obnoxious. See the table below.

But ask yourself dear reader, should any company really be paying its auditors almost 100 times their CEO?

In the case of PNB, where the role of auditors in the Nirav Modi fraud, is already established, the ratio is 25 times!

I took a random sample of companies from the Sensex. You can see a huge variance in the auditor pay to CEO pay ratio.

Of course, this ratio is not foolproof. It cannot tell you with certainty if the auditors are being overpaid to camouflage some wrongdoing.

Companies like Kitex Garments and Manpasand Beverages, which recently had auditors resigning, do not seem to have paid them excessively.

Nor is that the case with Sintex, which is the latest to join the queue of auditor resignations.

Nevertheless, tracking this data over a period of time is important.

Auditor Pay to CEO Compensation (times)*

SBI	98.8
PNB	25.2
ICICI Bank	4.1
Kotak Bank	3.2
RIL	2.0
TCS	1.1
Maruti Suzuki	0.7
Asian Paints	0.5
Infosys	0.4
IndusInd Bank	0.4
HDFC Bank	0.3
Kitex Garments	0.3
Manpasand Beverages	0.2
HUL	0.2
Bajaj Auto	0.1
Hero MotoCorp	0.1

Source: Annual Reports, Ace Equity
Economic Times
*FY17 data where FY18 data not available

In a scenario where markets are punishing businesses with poor quality of corporate governance, it helps to look beyond the obvious.

Chart of the Day

This is the third time I'm warning you about the risk that the Sensex dominoes pose. But I must.

I talked about the Sensex dominoes for the first time in November 2017. Well before the markets started showing any signs of correction. And my view that these stocks could take the Sensex to 23,000 levels hasn't changed.

I talked about them again in June 2018, citing the risk to them from macro variables like oil prices, exchange rates, and interest rates.

But it is funny that the mutual funds being aggressively endorsed as 'sahi hai' see no risk in being over exposed to these stocks.

Even as the money coming into mutual funds almost tripled over past four years, they allocated more

to the same big Sensex stocks. An overall allocation of 1-2% of the entire industry's AUM may not seem large.

But, specific large cap funds have as much as 5% of AUM allocated to each of these stocks.

The recent regulatory reclassification of funds, based on market cap, also had a big role to play.

Mutual Funds Sahi Hai? With Big Exposure to Sensex Dominoes?

This reminds me of what Howard Marks wrote in his recent memo about the blue chip bubble in the US funds. The scenario in India isn't any different. Be warned dear reader.

• The large positions occupied by the top recent performers - with their swollen market caps - mean that as funds attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don't have the option to refrain from buying a stock just because its overpriced.

Warm regards,

Tanushree Banerjee (Research Analyst)
Editor, The 5 Minute WrapUp

PS: Tanushree Banerjee is the editor of StockSelect, the safe stock recommendation service. For over 16 years, tens of thousands of members of StockSelect have received safe stock recommendations that generated double and triple digit returns...with a success rate of 74%. You too can receive these safe stock recommendations. StockSelect is currently accepting new members. You can sign up right away here...