Quality of management: Identifying good and bad companies in same space

One soft skill for long-term investors is judging the quality of management. Vision is a subjective factor -opinions will always differ on management vision. Operational competence can be assessed by benchmarking a firm against other businesses in the same space.
 
Probity and honesty are both decidedly tricky areas. There are two key factors that investors must consider in their judgement calls. One is to judge if the management treats minority shareholders and stakeholders fairly. The other area is making a call on whether the financials present a true picture or are fudged in some way.
 
Honesty and probity are connected of course, but not the same thing. A company may present honest accounts, while treating minority shareholders badly. For example, many government-run companies present honest accounts. However, the majority shareholder (meaning the government) consistently treats minority shareholders badly.

 

Glaring examples of treating minority shareholders badly have occurred in the energy sector, and in banking. When crude oil prices are high, PSU oil marketing companies have often been ordered to sell fuels at below cost of production. Sometimes, PSUs may be ordered to buy cross-holdings in each other, thus transferring money from the company reserves into government coffers. PSU banks are regularly forced to write off farm loans and often ordered to give loans without due diligence. In every such case, the minority shareholder loses out.
 
Whenever a company presents accounts that are misleading, it treats shareholders badly as well. How does an investor check whether the accounts present a true picture? One popular method is the so-called "C-score", which was devised by behavioural expert, James Montier.

 
The C-score is a 6-step set of questions of answers, as presented below.
 
Is there a rising divergence between net profits and operating cash-flow?
 
Cash flow statements are difficult to manipulate. Net profits can be fudged in many ways. If cash-flow is poor or deteriorating, but net is okay, that's a red flag.
 
Are days sales outstanding (DSO) increasing?
 
When a company dumps products on dealers and assumes everything is sales, this increases. Check if Accounts Receivables grow faster than sales.
 
Are days sales of inventory (DSI) increasing?
 
This is another sign of slowing sales.

 
Are other current assets increasing as a percentage of revenues?
 
This item (other current assets) is another one that can be manipulated.
 
Are there declines in the levels of depreciation relative to gross PPE (property, plant and equipment)?
 
By cutting depreciation (and capitalising expenses to keep them off the profit & loss account) a business can push up net income. But, eventually equipment must be replaced.
 
Is total asset growth high?

There is a well-known negative relationship between high asset growth and profitability. Low-asset growth is associated with higher profitability. A company that grows inorganically by constantly buying assets will be punished on this front. The analyst can use a cut-off where for example, asset growth of above 10 per cent per annum, is flagged.

 
The C-Score method answers these questions in turn and scores a point for every “yes”. The lower the score, the better. A firm that has a zero C-score is likely to be well-managed and presenting a true picture of its financial health. There is strong evidence from studies across the European Union and the US that corporates with low C-scores (less than 2) generate higher total returns in capital gains plus dividends.
 
Some value investors use a combination of C-score, plus a valuation ratio such as a high market cap to sales ratio as filters to eliminate underperformers. The really aggressive trader may use a high C-score (above 4) and a high market cap:sales ratio (above 2) to find potential candidates for shorting.