“All I want to know is where I am going to die, so I’ll never go there”
- Charlie Munger
An investor generally relies on reported financials of a company which form a base for all his investing decisions. We came across numerous cases, where reported financials are distorted to present a rosier picture. Investors who form their decision purely on reported numbers are at a huge risk, hence one requires a CLEAR lens to read beyond reported numbers.
Investing hinges along two vital pillars – Risk & Return. One should pay utmost attention to both while analyzing any investment opportunity.
In our earlier letters to you, we have classified risk of permanent loss of capital as Type A Risk which has resulted in huge wealth destruction in the past.
Type A Risk – risk of permanent loss of capital largely arises when you invest in businesses which are
• Managed by an inferior quality of Management
• Prone to disruption / inferior quality business
At Carnelian, we have created a proprietary framework (CLEAR) to mitigate the above risk. In this letter, we will further delve into showcasing how we are using the CLEAR framework in our everyday research to diagnose forensic risks (potential landmines) along with some live case studies.
Our CLEAR framework is designed to deep dive/analyse the annual reports & financials of companies, which help improve our vision beyond the reported numbers.
C - Cash flow analysis & capital allocation
L - Liability analysis
E - Earning quality analysis
A - Asset quality analysis
R - Related party transaction & governance issues
We have discussed these in detail below:
(A) & (E): Where is my Profit vs What is my Profit???
In an ideal scenario, the journey of reported profits to wealth creation is described below:
Some of us will remember the above as the first lesson of our accounting book …😊
…But ideal cases are rare in the real world and hence, investors need to be watchful of deviations… which can seriously impair the process of wealth creation:
a) Reported Profits > Net worth accretion --- Profits disappearing before making a safe landing to the balance sheet.
b) Net-worth > Actual asset in the balance sheet------ Profits disappearing after making a safe landing to the balance sheet.
c) Value of Assets > Future cash flows (time value adjusted), hence lags shareholder wealth creation – (gap keeps on widening year after year and one final day explosion happens in the form of huge write/off or so-called extraordinary expense)
Note: Consistent write off over years clearly states the habit of reporting fictitious profits.
CARNELIAN CLEAR FRAMEWORK:
(A) - Where is my profit?
We maximise our focus on determining asset quality:
We are extremely watchful of instances where the profits are re-invested into non-core assets like loans and advances, ICDs, dubious investments (overseas funds), etc.
We look for ever increasing receivables, inventory, unbilled revenues, deferred tax assets etc.
We tend to be cautious with the intangible assets present in the balance sheet, increasing other assets, etc.
Case Studies:
For one of the large automobile companies, intangibles accounted for ~40-60% of the net worth. However, during 2019-2021, when the perceived outlook of the product/acquired company changed, the company took large exceptional charges as impairments, asset write off, etc. This resulted in the perceived net-worth declining to almost half with a consequent rise in the D/E ratio (increased from less than 1 time in 2018 to 2.46 in 2021).
For one fashion retailer, we observed that the company was reporting profitability, but its inventory and payable days as calculated on cost of goods sold kept on rising; one fine day it took write offs and announced restructuring of its business. (very important to calculate payable and inventory days as % of raw material cost and not % of sales to get the correct picture).
One dairy company has taken a huge write-off on inventory recently wiping off years of accumulated profits
(E) - What is my profit?
Net-worth reconciliation: We look for gaps between reported profits and net worth accretion to identify any mismatch or direct adjustment to net-worth without routing through income statement/cash flows.
“We like capex in profit and loss, we do not like opex in balance sheet” - we look for instances where company capitalises its forex losses, interest cost, normal operating expenses, etc to show higher profitability.
We compare the company’s depreciation policy across the years and vs peers to detect any change or deviation that could be boosting the profits.
We look for “actual profits” vs “reported profits” of a company by adjusting for one-offs gains/losses, unrealized profits in inventory, etc. Further, some companies try to mask normal recurring expenses as one-offs, etc.
Case Study:
Is it Exceptional or Recurring? For one large pharma company, we observed that the exceptional charges wiped off ~18% of the cumulative PBT of the company over a 10-year period. Consequently, for investors, the normal business profits had become an illusion and looking at this, we decided not to be in that category waiting for normal business profits. We noticed similar issue in one large pesticide company.
In one large media company, we observed that the company used to amortise the content over a longer duration (opex in balance sheet) and used to report higher profits.
A large conglomerate has taken huge inventory write-off (from reserves) during COVID leading to higher reported profits in subsequent quarters.
(C) – Cash flow Analysis – Are reported cashflows real and sustainable?
“Revenue is vanity, profit is sanity, but cash is king.” This is a common perception among the investors and while we do believe that cash flow is one of the most important metrics, the source of cash flow is even more important that the cash flow itself.
We frequently come across cases where reported cash flows are boosted by non-sustainable elements like increase in trade payables/off balance sheet arrangements/ securitisation of receivables etc. Hence, analysis of sources of cash flow helps in the diagnosis of cash flow boosters.
CARNELIAN CLEAR FRAMEWORK:
While analysing the cash flow statement, we are always on the watch out for “OCF boosters.” These could be in any form, including but not limited to: (a) Sale of receivables/channel financing (b) High payables with off balance sheet financing arrangement
Analysing the cumulative cash flow generation and deployment of the company for the past years helps ascertain the capital allocation history of the management and helps to decipher true sustainable cash flow of the company, etc.
We look for gaps between the income statement and the cash flows. These could be in the form of taxes, finance cost, exchange losses, etc.
Case Study:
For one of the large consumer durable companies, channel financing provided to its dealer’s basis guarantee from unlisted promoter entities helped bring down its receivables. As the company scales up, this off-balance sheet arrangement needs to scale up at the same time to maintain the current financial economics – thus, it becomes relevant for the investors to be vigilant about it.
Increase in trade payables – a large source of operating cash flow for one of the automobiles major.
In case of one pharma company, we observed that over the last 10-year period, the tax as per income statement trailed the tax as per cash flow by ~30% (cumulatively). This was mainly due to consistent deferred tax creation.
(L) – Liability Analysis – is reported financial debt the only leverage one should worry?
As an owner of business, one should be worried of:
a) Total liabilities (on/off balance sheet) instead of focusing only on reported debt.
b) ALM mismatch – where short term liabilities are utilised to fund long term assets.
We have found cases where true adjusted debt is significantly higher than reported debt mainly contributed by off balance sheet arrangements/ever increasing trade payables (much higher than industry norms)/ channel financing.
CARNELIAN CLEAR FRAMEWORK:
In addition to the financial debt of the company, we look for large liabilities, contingent liabilities, and off-balance sheet arrangements to ascertain the leverage and potential liabilities of the company.
We also categorize the liabilities into operating liability or debt – to get a better picture on the debt profile of the company.
We check for ALM mis-match situations.
Case Studies:
For one large consumer durable company, we observed that company stated to be debt free had acceptances (quasi debt) in the payables having an interest cost attached to it. While working on various assumptions, it becomes necessary to take this into account as debt having interest component.
ALM mismatch – For non-financial companies, ALM mismatch generally happens due to a negative working capital cycle. While this is good from cash flow generation point of view, it needs to be seen along with the overall financial health of company and the stability of cash flows – these assess the ability to repay debt/liabilities. For e.g. airline companies operate with a negative working capital cycle, but due to their inconsistent cash flows, lots of airlines have gone bust as they fell short of cash to repay their debt/current liabilities. We stayed away from many Infra companies owing to ALM mismatch.
(R) – Related party transaction & Governance issues
It is well established that the Quality of Management determines large part of wealth creation, especially when combined with a good quality business.
However, the reverse is also true and when the management starts focusing on creating value for themselves instead of creating value for the stakeholders, the “would-be wealth creators” turn into “wealth destroyers”. Hence, we consider this a very important check as a part of our forensic analysis.
CARNELIAN CLEAR FRAMEWORK:
We tend to be cautious about promoters of listed companies carrying on similar business activities through another unlisted company, unidentified/identified related party transactions, complex corporate structures, etc.
We keep a close check on promoter pledging, his overall assets and the risk thereon.
We prefer to stay away from companies where we come across past instances of unfair treatment with the minority shareholders.
Case Studies/Points:
While evaluating a tyre company, we observed that the listed entity had large, related party transactions with a specific unlisted entity related to the promoter. The listed entity was the single largest source of revenue accounting for 80-90% of the overall revenue for the unlisted entity. When we looked at the overall profitability of that company along with the listed entity’s profits, we observed that it accounted for ~6% of the overall profits. Further, the unlisted company continued to mint money and good ROCEs when the listed company struggled to deliver CoC returns.
In past, there have been numerous instances where global MNC companies have opted to launch newer products/get newer deals through their unlisted entity to keep a larger pool of the share (and not share with the minority shareholders like us). Some of the Indian promoters have also conducted few businesses/deals through their unlisted entities.
While looking at an MNC auto ancillary company, we observed that the promoters of the listed entity were also the shareholders in an unlisted company through which the listed company used to market its products. When we looked at the combined profitability of these entities, we found that the unlisted entity made profits like the listed entity, despite of all manufacturing assets in the listed entity.
Our advise to investors is not to merely focus on the reported numbers, one has to see a holistic picture which involves deep dive into financial statements, connecting dots, weaving different parts of financial statements together and finally marrying the same with peers and business aspects. One poses a serious risk to his hard-earned wealth by merely focusing on reported numbers and building investment hypothesis on top of that. If you find any financial statements too complex, it is always simple to walk away. Making money is not that complex, however losing money always require complexity 😉
We would like to conclude this letter by an interesting quote:
“The task of a man is not to see what lies dimly in the distance, but to do what lies clearly at hand- Thomas Carlyle”
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