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Throw out such poison stocks from your portfolio!

Apr 11, 2015

In this issue:
» Is your money lying in banks safe?
» PM Modi thinks of a novel plan to put idle gold into productive use
» Round up on global markets
» ....and more!

00:00
With the court sentencing Ramalinga Raju seven years of rigorous imprisonment for perpetrating financial fraud, India's largest corporate scandal witnessed a closure of sorts. However, if a report by ratings agency India Ratings is to go by there are many more Satyam's mushrooming in India Inc.

As per the report, one third of India's top 500 companies are managing/window dressing their accounts. To everyone's surprise the percentage of black sheep's in BSE 100 list is in excess of 15%! Imagine financial statements which are the essence for making investing decisions are being fudged by corporates at will to show a rosy picture. This raises a big question over the health of financial reporting quality in India Inc.

However, the bigger question is what are the auditors and ratings agencies who are assigned the job to bring such issues to light doing about it? If corporates are able to modify financials in such a large scale it is an indirect failure of audit firms who are verifying the numbers. This also raises question on the objectivity of having independent directors on board.

Knowing that camouflaging is recurrent and intermediaries are not doing enough what should investors do in order to identify such mischievous companies?

Well, one strategy is to focus on the cash flow metrics. It is easy to manipulate earnings but not cash flows. As an example, a company by employing aggressive revenue recognition technique can boost its revenues. However, if a glance at the cash flow statement reflects continuous build up in debtors it is a sign of red flag. Inability to liquidate debtors and collect money is a sign that the revenues were booked beforehand to build a rosy picture.

Rising instances of earnings manipulation makes investing based purely on financial strength a dangerous approach. It indicates why meeting management is such a critical aspect to investing. Not that by meeting management you would get to know of earnings manipulation. However, a conversation helps one understand the mindset and thought process of the management. It also gives subtle hints as to how management thinks and acts. This is one area where we at Equitymaster pay utmost importance.

Let us highlight an instance we encountered recently to help you understand why a meeting exercise is so important to us. We wrote about it in a recent edition of The 5 Minute Premium sometime back. However, we would like to share it again as the occasion is apt.

It is not that the company we met managed earnings or tried to create a rosy picture. It is just that the facts that it stated made us ponder a bit and so we decided to take steps to validate them. Since the company was into manufacturing stainless steel (SS) pumps it highlighted various benefits that these pumps had. Few of them were substantial power savings, durability, higher output etc.

We thought of doing some market research in order to confirm the figures given to us as they appeared quite optimistic. We were lucky enough to get through a couple of vendors who were ready to speak to us on this matter. And to our surprise most of the claims made by the SS pump manufacturer were refuted by the vendors that we spoke to.

So, now we had two conflicting opinions in place and we did not knew who was right or wrong.

In fact, to be honest, our aim in conducting this exercise was not to know who is right or wrong as we knew both parties would have good things to say about their products and knowing their true intentions would be difficult. But the whole idea was to get an outside view that would help us think a bit more about the business and its dynamics. This would not have been possible if we had solely relied on financials and recommended the company outright.

The bottom line is that investing based solely on financials is tricky considering the quality of financials of India Inc are below par. What is further discomforting is the inability of mediators (auditors, board members) to bring this to light. Hence, one should always assess the quality of management before making any investment decision. And not go solely by the reported financials. Wherever you find that the quality of cash flows and the management do not seem comforting from long term perspective, it would be better to throw out such poison stocks from your portfolio at the earliest.

How do you check whether you have any poison stocks in your portfolio? Let us know your comments or share your views in the Equitymaster Club.

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02:45
  Chart of the day
Talking about frauds here is one which is brewing in the banking system and could be more endemic than the NPA problem that banks face. It is so grave that besides impacting the shareholders of these entities, even the depositors need to exercise enough caution to guard against it. Well, it relates to billions of money that get siphoned due to fraudulent transactions!

The PSU and private sector banks together have lost Rs 270 bn cumulatively in the last five years to such frauds. Not just that. More than 11,500 cases of cheating and forgery of amounts involving Rs.1 lakh and above were reported by banks to RBI. SBI (as seen in today's chart) and ICICI Bank lead the pack of entities in PSU and private sector respectively being the victim of such frauds. The frauds not just pertain to electronic transactions but also forgery of documents for loans. Needless to say the banks that are constantly hit by rising NPAs are a drag for not just their shareholders but a worry for depositors too. And we do believe that the RBI has not done enough to cleanse the NPA malaise in the sector. Unless dealt with urgency the frauds and NPAs will become a recurrent problem for the sector. Something that could deal a heavy blow to India's economic potential.

Is your money safe in these banks?

03:30
Given the roadmap that the FM has laid out for reducing the fiscal and current account deficit (CAD), the Modi government is looking at novel ways to bridge this gap. One of the biggest factors that has put pressure on CAD has been the import of gold. Placing curbs on gold imports did not really do the trick. And now it seems that the government is literally turning to the Gods to help it out. Indeed, as per an article on Firstpost, the government is looking to tap gold lying idle at places of worship most notably temples. It is quite well known that India is the world's biggest consumer of gold. But what is also interesting is that the country's ancient temples have collected billions of dollars in jewellery, bars and coins over the centuries. These have been hidden securely in vaults, some ancient and some modern.

Now the Modi government is looking to launch a scheme that would encourage temples to deposit their gold in banks. For this they would get interest payments. Moreover, this gold will be melted and loaned to jewellers. As a result of which the need for the latter to import gold will reduce. And this could help bring down the deficit. The idea is certainly interesting. But will it work? That will depend on two things. First, the kind of interest that will be offered by banks for depositing this gold. And second, the willingness to break away from tradition and allow the gold, which was given as on offering to the Gods, to be melted down.

04:15
All the major global stock markets witnessed gains during the week with stock markets in China and Hong Kong leading the gains.

As the European Central Bank's €1.1 trillion quantitative easing policy suppresses borrowing costs and cheapens the currency, record amounts of money have been poured into euro -zone equities over recent months. The stock markets in France and Germany were up by around 3.5% and 3.1% respectively during the week.

Despite not so strong employment report data, US stock markets inched higher (up by around 2%) during the week. Further, statements by Fed officials to the effect that a rate cut is not totally out of question if economic reports are strong supported the positive sentiments.

The stock markets in China (up by around 6% during the week) seem to be following the movements in the leading global markets. Apart from that, the positive sentiments in the markets could be attributed to national policies such as China's "Belt and Road" initiative that favors infrastructure-oriented stocks and other factors such as loose global monetary policies, low crude prices and privatization of state owned companies. However, at a time when China is facing pressure from slowdown in the GDP growth and lacklustre economic data, these gains could suggest creation of a bubble.

Back home, the Indian markets ended higher, up by around 2.2% during the week. The rise was supported by a rating upgrade by Moody's .However, gains were restricted on account of profit taking especially in the banking and capital goods stocks ahead of the release of IIP data. The gains in the small cap and mid cap stocks outpaced the gains in the Sensex during the week. Going forward, the fourth quarter (4QFY15) corporate earnings are likely to influence investors' sentiments. Among the sectoral indices, metal and realty were the top gainers.

Performance during the week ended April 10, 2015
Data Source: Yahoo Finance & Equitymaster
Note: Since the Indian markets were shut on 2nd and 3rd April in the last week we have taken the start date as 1st April for all the markets to enable a like to like weekly comparison.

04:50
 Weekend investing mantra
"The great personal fortunes in this country weren't built on a portfolio of fifty companies. They were built by someone who identified one wonderful business". - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi.

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5 Responses to "Throw out such poison stocks from your portfolio!"

Pradeep

Apr 13, 2015

Vendors/Competitive source are one source of information. I would say the usage of SS is niche and suitable to certain conditions and they may or may not be worth while. From a scientific point of view, SS is more corrosion restive, and would wear less in certain environments. Also they could be mirror polished and be more energy efficient, Besides food automation would be more hygienic. Ultimately this depends on the quality of the SS and the hardening and if they are the 400 or 300 Series. For more details 304 steel would actually be really bad for food cleaners and would corrode much faster. 316 the marine grade steel is used in pharma sector and other common sensitive liquid applications. For food normally 420/440 is used. for most normal house hold and water pumping regular pumps are just fine. Also for very high stress environment if presses SS is used they will have a tendency to crack. So the ? is is the co going after a niche industrial or mass market strategy?

Like (1)

Sarat Palat

Apr 12, 2015

In order to reduce CAD taking the gold from the temples is not a good idea. What about the assets of other religions ? Why only from temples ?

Like (2)

b.s.waghela

Apr 11, 2015

Black list some CA firms and debar them from practice. Obtain from them a Certificate about the accuracy of the accounts and if some thing fishy is found later, arrest those CAs. and try them for abetment of offcences.

Like (2)

SAURABH

Apr 11, 2015

one easy way to know poison stock is default on payment of statutory and employees dues. this is so because, defaults of such nature entails prosecution

Like (1)

shankar Dev

Apr 11, 2015

It is interesting, first topic says even investing in bank deposits is risky considering the mounting NPA of banks, and second one says, the govt is encouraging people to place their gold in bank, and bank will offer interest. This again exposes to risk of NPA.

In short people continue to invet in gold and keep the gold with you!!!

Like (1)
  
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