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  • Writer's pictureTeam Carnelian

CONNECTing dots

Updated: Sep 4, 2023

Greetings from Team Carnelian!!

Who would have wondered that the 2-time World champions, West Indies, will fail to qualify for the 2023 cricket world cup? Is it to do only with the skill set of players or other softer aspects?

In cricket, the elemental skills (batting, bowling and fielding) are important, however, the softer aspects like teamwork, leadership, morale, fitness of players, sports culture in the country, etc. also play a vital role. Similarly, in investing merely relying on numbers and history has its limitations that can lead to erroneous conclusions as ground reality at times may be different.

At Carnelian, we have created 2 strong pillars of our forensic framework: CLEAR & Connect. Carnelian forensic framework is built around connecting dots amongst numerous public documents (financial and non-financial) filed by the company (CLEAR framework) as well as connecting information gathered through Connect framework.

We have previously written about how we manage the risk of permanent capital loss (Type A risk*) through our proprietary CLEAR framework (refer here) that helps us avoid companies with financial shenanigans, governance issues & other red flags. In this letter, we will share with you another pillar of our forensic framework – Connect framework.

Our Connect framework focuses on the non-financial parameters of company like promoters/CEO history, organization culture, quality of auditors, board composition, risk management policies, HR policies and employee’s motivation, quality of plant and their ESG practices which are of equal importance to the investors.

What is the need for Connect Framework?

While we do believe that our CLEAR framework is instrumental in avoiding Type A risks* – sometimes the numbers do not fully reflect what is going on within an organization. Even the perpetrators are aware about the checks analysts use to unearth the accounting shenanigans – this along with the inherent limitations across various items in the financials statements and the importance to know about non-financial history of a company make Connect Framework necessary.

*Type A risk - Risk of permanent loss of capital: Risk of losing ~70-100% of Capital

What is Connect Framework and how do we use it in Investing?

(A) Channel Checks

As a part of the beyond desktop research and to better understand the business models, we consistently undertake channel checks for the companies under evaluation to assess quality of management/business, fairness of business practices towards various stakeholders including employees, CSR practices, quality of working condition of labor, environment conscious approach. We corroborate our channel check findings with our CLEAR framework as discussed below:

1. Factory Visits: We make it a point to visit factories/workplace of the companies under evaluation, wherever possible. Not only does it help in understanding the business model, product/service better, but also helps us in engaging with the stakeholders, evaluating the culture of the organization, and looking at the cadre of machinery, facility of an organization, etc.

Further, to corroborate with our CLEAR approach, we try to understand: the factory premise location/area, from which manufacturers the company sources their machinery from, condition of the major P&M items in addition to the process for business understanding purposes. We compare these with the factory visits of peers, and other industry participants.

From ESG assessment, we pay special emphasis on HR practices, working conditions & motivation of workers, plant managers, R&D and quality team, gender ratio etc. We also evaluate aspects like environmental policy (zero discharge plant, carbon neutrality etc.) and the safety norms adopted. Relating this with financials, etc. gives us an edge and a perspective beyond numbers which we believe is crucial.

Case Studies:

  • During the factory visit to an API company, we understood that for a company they had recently acquired – they started medical and travel facilities for the employees which was earlier missing. Further, the old company’s plant had just one floor – they got the approval and extended it to three floors – this shows the scalability and future readiness mindset. Moreover, we got to know that the existing employees are getting skilled and being given the opportunity to move up the ladder. This helped in increasing our conviction on the scalability potential of the company.

  • In our visit to a garments company, we observed that the company mobilizes women from rural villages and empower them with employment as well as higher education. They also provide food and hostel facilities to their workforce. Not only does this help them hire well, but also it helps them in retaining the labour for long and results in higher efficiency vs peers. Labour management is the most vital role in garment companies. This company stood well above others and as a result has been able to outperform the industry consistently.

2. Vendor Feedback – We engage with the vendors of the company. It helps in understanding company’s practices like vendor onboarding process, stringency on quality/timely delivery, timely vendor payments, fair treatment of vendors, company’s treatment vs peers and how that affects terms/service, etc.

To relate with CLEAR, we try to understand any vendor financing deals, the usual credit period for company vs peers, letter of credit norms, cash discounts for faster payment, etc. We correlate these with our financial analysis and checks.

Case Study: Evaluating a vendor supplying products to companies of their new lines/factories, we came to know about the increasing number of enquiries and higher order conversions. This along with the commentaries of companies doing capex helped us build our conviction on the capex cycle and we took adequate exposure to benefit from it.

3. Client/Customer/Distributor feedback – We engage with the clients/customers/distributors who sell their products to understand the company’s capabilities, quality of product/service, where they stand vs peers, quality of management, promptness in delivery, etc.

For CLEAR, we try to understand the credit terms offered by the company, channel financing terms, cash discounts, current/past trend in warranties and any related items, deposits taken by the company, withholding amounts, etc. We relate these with our interaction over the years and with the peer’s metrices.

Case Studies:

  • In case of a chemical company, instead of selling a by-product from the manufacturing process of their key chemicals, the company decided a project on the downstream expansion of a product which had very few suppliers – namely large European & Chinese companies. This product as per the company even if sold at ~10-20% discount to major players would have earned >45% margins (based on prices of product at that time). If executed, this might have led to re-rating in the stock. We checked the prices of the said product with a dealer and understood that the price of the product had already declined (~40-50%) even before the company’s capacity came on stream. This helped us in avoiding the above stock.

  • We were invested in a paper company, and it benefited from the increase in pulp prices which started towards the latter half of CY 2021. We were in continuous touch with a distributor to understand the pass on of paper prices by companies. Towards the mid of CY 2022, based on our interaction with distributors, we understood that due to fixed price contracts with clients from industries like pharma, FMCG, etc. - any more price hikes from the paper companies could not be absorbed by the market. The company had reached peak utilization and was not planning any new capex. Thus, we believed that the optimism for the sector was near its peak and being a cyclical sector - we decided to exit the position. With hindsight benefit, we can say that it helped us exit near the top of the sector – the stock has declined by ~25%+ since then.

  • In case of a laminates company working to introduce a new product in the Indian market for import replacement opportunity, we observed that the company was trying to perfect the product over the last 1-2 years, but quality of the product was nowhere near the competitors. However, in the previous 3-4 months of our channel check, the company had rolled out an improved version of the product in its nearby regions only – the distributor’s feedback on this product was good. The company was yet to launch in other markets but using the experience of the dealer with the company’s product over the years and with the competitor’s product, we established confidence that the company might be able to scale this product.

4. Interaction with Employees – During our site visits, we engage with the employees of the company to comprehend about the quality of the company’s products, feedback about management, what existing and prospective clients are impressed with or look for when they come for factory visits, company’s USP, positioning vs peers for product quality, pricing, other terms, etc.

For CLEAR, we look for the pricing, quality, terms of company vs peers, their treatment of employees and culture (covered more in detail later), any feedback on accounting/promoters, indication of any wrongdoings in the organization, etc.

Case Study: During a walk on the plant floor of a pipes and tubes company, we learnt that promoters entrusted the employees with complete freedom along with responsibility & accountability. We were intrigued to see the longevity of employees and observed that most of the employees were working there for decades, few since inception as well. The above are key reasons for superior ROE, FCF and sustainable growth in an otherwise commoditized/cyclical sector. The stock has delivered ~35%+ CAGR and ~28%+ CAGR over the last 10 years and 5 years, respectively.

5. Peer and industry circle feedback – For our business analytics, we consider this a particularly important metric – how the competition is talking about the company’s capabilities, its product, management quality, stakeholder relationships, etc.

To relate with CLEAR, we try to correlate the discussion with our peer analysis and common size financials, feedback on practices used by company, clarify any potential adverse observation we have regarding the company/management, etc.

Case Study: In the case of a financial services company, despite the strong promoter group and liability side of the franchisee, the company was unable to execute on these strengths. In 2022, they appointed a new CEO – understanding that this could lead to better execution, we interacted with top people from the past organization of the CEO and got particularly good feedback. A few months after the CEO joined, we did checks with distributors and connected with a few branches - we were positively surprised to see the new actions being implemented, heard about CEO visiting branches & taking feedback, etc. – this was a material change from earlier. Results could be seen with higher growth and ROE improvement in their key NBFC and Housing finance businesses. – we believe that our on the ground connect along with our business analytics helped us to capitalize on this opportunity.

(B) Culture

At Carnelian, we spend a considerable time finding companies and teams having the right culture. Often, we are asked the question – which managements/companies will you bet on for the next 10 years who will create value for shareholders? For this, we have created our own little framework – “IMPRESS” encompassing numerous qualitative and quantitative checks to assess managements and culture of companies on different parameters.

What do we look for in a company’s culture?

Simply put, culture is how you do what you want to do. It is the sum of your formal and informal systems, behaviors, and values, all of which create an experience for your employees and customers.

We have seen that companies with poor culture and HR practices find it difficult to scale the business and usually command lower multiples vs their peers.

We have covered in detail about how culture plays a vital role in the success/failure of any organization along with case studies – here.


Connecting dots, weaving various parts of financial statements together and finally marrying the same with peers, business aspects, and information gathered through beyond desktop research gives a holistic picture and goes a long way in overall wealth creation journey by assisting in building conviction on investments and avoiding permanent capital loss.

Disclaimer: The purpose of forensic analysis is to be aware of these kinds of events concerning the company. The materiality of these observations is key and the investment team on a case-to-case basis evaluates the merit of such past incidences while taking a call regarding the investment.

During the life cycle of a company, the earlier management might have been involved in some of these activities but with new owners/management or a new approach – such observations may not be relevant anymore. Thus, we approach forensics with a view to be aware of these events – so that we do not find ourselves at the wrong end of a Type A risk.

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