Mid Cap Mania

Mid Cap Mania

With the market inching towards the 20,000 mark after the uncertainty  faced by most industries in early November, there has been a run up in blue chip as well as mid cap companies. With the initial set of results coming in on the positive side, a lot of market participants are looking at investing in mid cap companies in order to find the next multi bagger. As the saying goes buyer beware, it is extremely important to study the mid cap and small cap companies specially on the corporate governance angle.

Retail investors listen to the term corporate governance lot of times but are not able to understand corporate governance in depth. One of the most important documents that an investor must study and analyses is the annual report of the company. When you read the annual report of any company there is a report on corporate governance which in most cases mentions that highest level of corporate governance is followed by the company and gives no adverse remarks. However as an investor corporate governance, must be checked first and then one must evaluate the investment decision based on the valuation parameters.

As the saying goes that there is no good company or bad company the investment decision must be based valuation and an average stock bought at a throw away valuation is better than a very good stock bought at a very high valuation. However in order to apply this logic the corporate governance standards must be good so that a fair investment decision can be made.

In the Indian market we have seen small caps and mid cap company stocks make over 100% returns within a very short period of time and then fall like nine pins and most retail investors who enter the stock at the wrong time are stuck with almost all of their invest wiped out.

How does this really happen when at the surface the company looks good in terms of valuations and fundamentals then how do companies and promoters really cheat the investors. In order to analyses this, some common symptoms are present in one form or another in these companies and it is very essential to evaluate these before making an investment in any of the mid-size companies.

A.     Camouflaging of Profits:

When you analyses the financial numbers the company is showing a good track record of profit and growth in profit year on year (YOY) when you deep dive you realize that the profit after tax (PAT) is generated without actual cash generated by the company.

We can identify this by analysing the cash flow statement with Profit and Loss (P&L) statement. . If a company shows a good PAT number but the same is not translated in cash flow from operations this is an alarming sign. Negative cash flow from operations is not always bad but in most cases especially with companies listed on the Indian stock markets it would be an alarm bell.

There is a cash flow statement in every annual report where cash flow from operating activities is arrived from adjustment in PAT figure e.g. Depreciation, Inventories, Receivables etc... One should try and identify the source of cash leakage then come to conclusions.

B.    Camouflaging of Profits: Second way:

In this case the company is showing a good PAT and YOY growth in PAT with positive cash flow.

Since there is a good growth in PAT and a positive cash flow is positive it would skip the first test mentioned above. However in this category you will see low Debtors’ Turnover Ratio. If the debtors’ turnover ratio is low you can smell that something is wrong. Sundry Debtors is the field in the balance sheet which indicates how much amount is due from the customer and other parties (Receivables) most fraud companies show growth in PAT, because of the increased Sundry Debtors. It is not difficult to manipulate PAT by Sundry Debtors. These companies increase Sundry Debtor amounts each and every year and after a few years write them off. One should not conclude that Sundry Debtors is bad for every company or industry as every sector would have its own payment patter as the company you are analysing should be compared to the other companies in that sector before drawing any conclusion. Hence if the company has a very low debtor turnover ratio compared to its peers in the sector it does indicate low quality of profits.

C. Share Holding Patter:

Every listed company provides the share holding pattern every quarter, a lot of investors just looking at the shareholding under the category of Promoter & Promoter group, in case the shareholding under this category goes up it is considered as a positive as the promoters have faith in the company and have increased their holding at the current prices where they find value at the price at which it is trading, in case the promoter reduces the stake in the company it is taken otherwise.

However one needs to deep dive and also look at shareholding under the category of Public shareholding both under institutional as well as non- institutional. Under the institutional category the quality of institutional holding the shares is very important and gives a lot of confidence to the new investors and under the non-institutional category if there are known good value investors that are known in the market for their long term investment ideas it should be taken as a big positive.  In case there is a lot of movement in terms of shareholding quarter after quarter, with unknown names as such, it should be taken as a sign that large quantities of shares are sold from one investor to other there by parking of the shares in proxy names and this should raise the red flag immediately.

D.   Turn over Generated by showing sales booked by Subsidiaries abroad:

This is very difficult for a retail investor to really identify and many a time’s even professional investors are unable to really spot this kind of pattern. This normally happens in mid and small size IT companies who are not even having proper infrastructure or the requisite personnel requirements run a software company forget executing high tech export orders. What is really done is the Indian company that is listed on the stock exchange executes the order that is received by its subsidiary abroad. The Subsidiary abroad is setup a small company incorporated having no real staff or setup; this subsidiary abroad claims to have won a contract or order from overseas clients that are relatively unknown as such and gives the work to the India Company. Most of the subsidiaries are setup in free ports like Hong Kong, Dubai or Singapore or certain tax heavens in the world where money can be remitted back and forth with ease.

The Indian promoter sends money abroad to these subsidiaries setup in relatively friendly tax jurisdictions via unofficial means and then these subsidiaries pay the Indian company as per the contract executed in dollars here in India there by increasing the turnover of the company. With decent growth in the sales the company increases its fundamentals and there by showing decent profits where the tax rate would be relatively less as all the income is shown as export income and in case it operates out of an IT park or Special Economic Zone (SEZ) where in lower tax rates are applicable the relative tax outgo that the company needs to pay is lower than normal.

After this exercise the stock price is managed by a stock market operator/manipulator that artificially increases the trading volume and price of the share and is being supported by the company with increase in sales and profitability.  When there is a substantial rise in value of the share the operator and company sell large amounts of shares at that price and retail investor start believing in the companies story as the stock price kept rising and then post the exit of the operator the share price falls like nine pins and investors are stuck with the ill liquid shares almost having no value. This is popularly known as Pump and Dump in the stock market context.

In order to create long term wealth in these stock market never depend on buy on the rumour and sell on the news as it may work once in a while as a part of trading strategy but as a long term investment in most times the genuine investors would lose their money.

Needless to mention that there are many Mid-Size companies in India that have the potential to make it very big and investing in those companies would result in multi baggers but when making the investment decision a check on Corporate Governance along with fundamentals must be carried out by the investor.

_Farzan Ghadially