The RCom Bankruptcy: 5 Lessons for Smallcap Investors - Profit Hunter by Equitymaster
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The RCom Bankruptcy: 5 Lessons for Smallcap Investors

Feb 7, 2019

Richa Agarwal, Research analyst

When Anil Ambani-led Reliance Communications (RCom) filed for bankruptcy through the National Company Law Tribunal to resolve its high debt burden earlier this week, I'm sure one thought was running through a lot of minds: If even an Ambani can be reduced to filing for bankruptcy, who out there is actually safe?

An Ambani-led company filing for bankruptcy is something unheard of, considering the 'Reliance' brand has over time become synonymous with success.

Unfortunately, with RCom, many investors took a dive as well. Small shareholders who clung on to the stock believing it to be on the brink of a turnaround at every step simply because it had the backing of the Reliance brand were in for a rude shock...

Because brand value did not stop the debt-laden RCom from filing for voluntary bankruptcy after its debt became too much to handle.

A company's brand can only work for it so much.

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It is the management's actions that matter.

According to media reports, in December 2017 RCom's management announced a debt resolution plan, and said that there would be no write-offs or equity conversion for lenders and bond holders as the company was nearing sales of assets that could provide the cash needed to pay debt.

But none of it came to fruition.

And the company, which was the second biggest telecom player in India less than a decade ago, is now filing for voluntary bankruptcy.


If people were paying attention beyond the brand name they would have realized that the management of the company did not walk the talk, and all the signs were there.

When it comes to assessing the wealth creating potential of a company, the management can be a make or break factor.

As you know, I am always harping on about meeting managements, understanding them, making sure they are capable and ethical, and so on, before I ever recommend a company. I travel the length and breadth of the country - going even to remote locations, to meet managements.

Why? Because this is what happens when managements make bad decisions - loss of shareholder wealth.

The importance of assessing management quality cannot be emphasized enough. After all, it is their decision making in the various areas of the business that will eventually decide whether the business is a long-term compounding machine for shareholders.

But it has to be noted that betting on a good quality management is not the only thing to consider in a business you want to invest in. It is also important to judge the quality of the business they are running.

And the odds are really in our favour when a management with a good reputation tackles a good quality business.

Try having one without the other and you are not quite on a fertile field.

That said, management quality is one of the most overlooked factors when evaluating small-cap stocks.

5 things to pay attention to before you dive head-first into a small-cap stock:

  1. Make sure the management walks the talk. It doesn't matter what they say, it matters what they do.
  2. Is the company taking on too much debt?
  3. Is the management honest and transparent in its communications?
  4. What's their focus? Is the management focused on stock price performance or business growth?
  5. Is the management aware of the trends?

It is important you ask these questions to all managements, but more so to ones that run smaller companies, because small-cap companies seldom undergo the scrutiny their larger peers go through in terms of disclosures and corporate governance.

Since most of them are young and growing companies, managements find it hard to resist skirting on a few issues and window-dressing their numbers to attract interest from potential investors.

That's why I don't even think about recommending a company in Hidden Treasure, without meeting its management first and getting the facts, straight from the horse's mouth.

Big brand names or otherwise, 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.

Talking to a company's management helps understand businesses and their vision better.

There have been countless instances where I have liked the business of a company, its numbers look encouraging, but the management seems to be blind to changing trends, or just not prepared for the road ahead.

Like how one management claimed to have filed multiple patents over the world. But after meeting them I found that it was able to monetize only a fraction of them, without any explanation about the earnings potential of the rest.

This gave us conviction to not recommend the stock in Hidden Treasure.

My team and I meet with many managements, and we reject far more than we recommend.

While this approach led us to miss out on a few opportunities, Hidden Treasure subscribers are not complaining.

Hidden Treasure recommendations have beaten the Sensex nearly three to one since inception (based on internal rates of return).

Successful small cap 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.

Similarly, a change from a bad to a visionary management, can bring out the best in the company.

Make sure you have enough qualitative information before betting on a stock, irrespective of whether it is backed by a big brand name or not.

Regards,

Richa Agarwal
Richa Agarwal (Research Analyst)
Editor, Hidden Treasure

PS: You can also get Richa's thoroughly researched recommendations and replicate her success of beating the Sensex nearly 3X by subscribing to her recommendation service here.

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