How to tell a crooked company from a clean one? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

How to tell a crooked company from a clean one? 

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In this issue:
» Why Stephen Roach believes that China worries are overblown?
» The euro would shave up to 10% off the German economy
» What makes Gujarat different from other states?
» RBI gets support for infra debt fund
» ...and more!

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Regulators, administrators and auditors have for years made the best attempt to make accounting laws iron clad. However, financial statements of even some of the largest companies have been littered with dishonest accounting. 'Satyam' was neither the first nor one of its kind instance. And we will have several more 'Enrons' trying to deceit gullible investors. As a result, it is no longer sufficient for an investor to acquaint oneself with the basics of investing. Playing a detective is as much part of the game. In other words one needs to know where to look for the 'Shenanigans'. Meaning secret or dishonest activity, this term encapsulates the possible ways in which financial statements could take an investor for a ride.

A company's financial statements can be an investor's best friend, or biggest foe. If read carefully, an investor can gain valuable insight into the company. However, not being equipped well enough to spot the gaps in accounting, one could risk the entire investment. There have been regular changes to accounting laws to prevent deceit and outright fraud. However, clever CEOs and CFOs have figured out ways to circumvent these rules. Howard Schilit a leader in forensic accounting has detailed how to catch the tricks fraudulent managements try to pull. His bestseller book "Financial Shenanigans"is one of the best guides for investors unfamiliar with crooked accounting practices.

Recording bogus revenues, inflating them or accounting for them well in advance are some of the most common malpractices. Deferring expenses, booking to a later period or reporting one-time gains as regular income are as popular. As analysts, we regularly come across such practices that are rampant in few sectors. But what could be difficult for even the most discerning investors to spot are the contingent liabilities. Especially when hidden in fine prints or go casually unreported in the annual reports. Off balance sheet items of banks and financial institutions, dues to the Income Tax department and pending litigations are particularly of interest to us.

Each of these and more have been explained by Schilit in a manner that will prompt investors to scan annual reports and earnings releases with a lot more diligence.

We will continue to review more such books, which are a must have in an investor's shelf, over next few days. If you have already read the book let us know your views or post them on our Facebook page / Google+ page.

01:30  Chart of the day
The Indian government's plan to review the double-taxation avoidance agreement (DTAA) with Mauritius was meant to prevent misuse of the treaty and track illicit money allegedly stashed in the African island nation. However, the same is also expected to impact the foreign direct investment (FDI) coming into India. Amongst the sectors that will be adversely impacted could be manufacturing and construction. As data from RBI shows, these two have been the largest recipients of FDI in FY12, followed by financial services and power generation and distribution.

Data source: RBI Annual Report 2012

So far, Jim Rogers was perhaps the only economist who did not see any major problem with China. He is no longer alone though. None other than Stephen Roach has joined him. Roach, also an ex-Morgan Stanley hand, is of the view that worries about China are overblown. He does agree that the economy has slowed. But the slowdown has been contained as per him. Roach further adds that China's export led model is far less threatened than it was three and a half years ago. He also has a very benign view of the overheated property market in the country. As rural to urban migration continues unabated, cities that look like virtually ghost cities today, will quickly become tomorrow's thriving urban areas, he further added.

Well, this is certainly one of the ways in which the China story can pan out. But we are not so sure. There is simply a lot of daylight between the existing ghost cities and their ultimate occupancy. And quite a bit can go wrong here. What if the property prices fall and the loans underlying these cities turn bad? Further, what if interest rates rise from the current low levels? Finally, there is this huge question mark over whether the data that comes out of that country is authentic enough? Taking all these factors into account, we may want to continue being cautious of China.

Woes for the Euro zone just do not seem to end. With the massive debt that has saddled countries like Greece, Spain, Italy and Portugal, talks have abounded whether we are in store for a break-up of the Euro. It certainly seems so. But it goes without saying that all European countries will have a heavy price to pay. This is because the costs associated with such a break-up could be huge.

Take Germany for instance. The Economic Times has pointed out that a complete collapse of the euro would shave up to 10% off the German economy. This is because Germany's gross claims from the euro zone are about 3.5 trillion euros. Thus, when a substantial chunk of the claims go in default, there would be insolvencies in small and medium-sized firms. This would adversely impact the economy. The Eurozone so far is not comfortable with the idea of the Euro breaking up. But its alternative solution of quantitative easing is not helping matters either. Whatever be the case, a new and meaningful line of thinking is certainly what the region needs.

The population of this Indian state accounts for just 5% of India's total. But it accounts for 16% of India's industrial output and 22% of exports. Its GDP (Gross Domestic Product) has grown at a pace much faster than India's income. Even this year, when India's growth is likely to slip below 7%, this state is expected to grow by double digits. Can you guess which state we are referring to? Without any doubt, we are talking about Gujarat.

What is it that makes Gujarat so different from other states? Why are corporates more than willing to set up shop here than any other state? An article in the Economist lays down the answers. For industrial activity to flourish, all you need is a conducive business environment, less onerous labour laws, effective bureaucracy, availability of basic infrastructure such as roads, electricity, etc. On these counts, Gujarat fares much better than any other state. Gujarat could play the role of India's industrial engine, just the way Guangdong province did for China in the 1990s. We strongly believe that the other Indian states have a lot to learn from Gujarat's economic model.

We Indians seem to be losing faith in India's growth story. However, it seems like foreign investors are in no mood to give up on us. In a recent meeting hosted by US India Business Council (USIBC), American industry leaders have assured their support to RBI's Governor Mr. Subbarao to get foreign funds for country's infrastructure development. This will be done through sectoral debt fund and other initiatives. What they hope for in return is more liberal stance. This includes transparency in priority sector lending norms, full ownership of wholly-owned subsidiaries and banking oversight over fund movements.

India has a huge potential to grow. However, the same is getting wasted for the lack of right policies and funds. Forging commercial ties with foreign nations will go a long way in addressing the latter. However, an improvement in investment climate will need a proactive approach to reforms from the Government. Else such support might get limited to just lip service.

The world stock markets ended the week on a negative note. The US stock markets were down 0.5% during the week. The lackluster performance till Thursday was slightly made up on Friday as Federal Reserve Chairman Ben Bernanke endorsed more stimulus action. While there is no formal announcement, chances of quantitative easing are strong. Going further, data regarding employment , manufacturing index , construction activity and job creations will decide the course of markets. The European stock markets rallied on Friday on account of chances of economic stimulus in US and as European Central Bank suggested that it was ready to give relief to European countries struggling with high borrowing costs by buying up their bonds. However, the markets have ended the week in red .The stock markets in France and UK were down by 0.6% and 1.1% respectively during the week.

The Indian equity markets closed the week with 2.3% loss amid concerns on policy paralysis and a controversial CAG report on coal block allocations. This has come after four consecutive weekly gains for the markets. The other markets have also ended the week on a negative note led by Japan (down 2.5%) and Brazil (down 2.3%).

Data source: Yahoo, Kitco

04:50  Weekend Investing Mantra
"The speed at which a business success is recognized is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage as it may give the chance to buy more of a good thing at a bargain price." - Warren Buffett

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    2 Responses to "How to tell a crooked company from a clean one?"

    Ramakant Pareek

    Sep 3, 2012

    I want to see sector wise chart post 1991 after liberalization and pre-liberalization. Also wants to know how much money is received in new technology.
    Great reading some updates, keep the good work.

    Like (1)


    Sep 1, 2012

    bsc-c&c jv

    Like (1)
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