Type A risk – one of the biggest wealth destroyers – a deep dive
Updated: Jan 10, 2022
Greetings from Team Carnelian!
“Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital or 2) the risk of inadequate return”
- Charlie Munger
In our previous newsletter, “Who Stole my return: Me or the Market” (https://www.carneliancapital.co.in/post/who-stole-my-returns-me-or-market-a-different-perspective-on-risk), we shared our broader framework to classify risks in 3 broad buckets.
Type A - Risk of permanent loss of capital: Risk of losing ~70-100% of Capital
Type B - Volatility Risk (MTM Loss Risk): Risk of an investment temporarily quoting below the investment price
Type C - Opportunity loss risk: Risk of investing into
sub-optimal stocks/sectors/asset class due to various biases and lack of
knowledge thereby missing superior returns.
Of the above, while one can manage /control Type A and Type C risks, Type B risk is a market phenomenon which is neither predictable, controllable nor manageable. Unfortunately, most investors waste significant efforts in “trying” to manage or worrying about volatility risk (Type B), in the process missing the real point of managing or investing efforts in Type A and Type C risk. This focus or optimization has costed billions to the investors. Once this is understood, an investor’s ability to allocate capital falls in place with the right perspective.
In this letter, we highlight common causes, impact and risk mitigation tools for managing Type A Risk.
We assign 2 major causes of Type A risk:
- Inferior quality of Management
- Inferior quality of Business
Impact Analysis of Type A Risk
Before we get into the details, let us understand a bit about the impact or significance of this risk. Our detail study* conducted on ~8,300 companies suggest some astonishing facts about wealth destroyed over the last 20 years in the Indian Equity Markets due to Type A Risk.
- INR 32 lakh crores have been destroyed by 570 companies in last 20 years
To contextualize, wealth destroyed is
- 12% of ‘current’ equity market capitalisation
- 2x of Total Mutual Fund Equity AUM
- 2x of Market Capitalisation of Reliance Industries (largest listed company by market capitalisation)
Other interesting data points to note:
- 45% of wealth destroyed is by Top 15 wealth destroyers with visible red flags (CLEAR framework helps us to diagnose these risks)
- 22% of wealth destroyed is either by disruption prone businesses, highly regulated businesses or state-controlled units (PIU framework helps us diagnose these risks)
- 1 in 12 companies listed has ended up in this list “till date”
Needless to mention: One needs a multi-bagger to compensate loss caused by investing in a company with Type A risk. This makes investing really a tough job if one ignores Type A Risk
* The above is result of extensive back testing done across listed universe over last 20 years using our proprietary framework – CLEAR (Forensic framework) and PIU (Business & Management analytical framework). For detailed framework please refer Annexure-A.
Now let’s get into diagnosis of Type A Risk
The main sources of this risk are
1. Inferior quality of management
2. Inferior quality of business model
Inferior quality of Management
We have all heard the analogy “Jockey is more important than the horse” innumerous times. It’s the easiest way of understanding how much influence the management teams have on the businesses. Historically we have seen several examples (Enron, Satyam, ADAG group, Manpasand, Jet, Dewan Housing, Yes Bank, etc...) where serious wealth destruction has happened due to poor management of businesses. Below are few red flags to watch out for, which questions the corporate governance of businesses:
1. Oppression of minority shareholders
2. Aggressive accounting policies
3. Poor resource allocation (time/capital)
4. Conflict of interest
5. Poor risk management culture
6. Excessive leverage
7. Gaps in Financial Statements: “Where is my Profit” vs “What is my profit”
Wealth destruction attribution analysis - Type A Risk
To investigate the reasons of such enormous wealth destruction, we deep dived in 118 companies which contribute to ~80% of overall wealth destruction and below are our findings:
Though wealth creation in Indian market is appreciated, wealth destruction is often ignored. There may be several companies with Type A Risk, where there could be wealth destruction which are waiting for a trigger. The above data also demonstrates a very high probability of existence of Type A Risk. Investing while ignoring existence of Type A Risk is sure shot recipe of stepping onto potential land mine leading to wealth destruction over a long run.
At Carnelian, we spend a lot of time managing this risk.
Our CLEAR Framework (focusing on Forensics) which comprises of detailed cash flow analysis, capital allocation, liability analysis – true vs reported debt, earnings analysis, asset quality and related party transactions and governance checks and our PIU framework which comprises of scoring business & management on many parameters including business disruption risk, management IMPRESS score card protects us from getting into a permanent loss risk (Please refer Annexure A for more details.)
We have a clear NO GO when we find the business bears disruption risk even if rest of the parameters are fine.
Inferior quality of business model
Businesses operate in a dynamic world. Constant changes in the environment in which businesses operate may sometime create a threat on the existence of the company. These disruptions challenge these businesses to keep evolving to stay ahead of the curve or even survive depending on the level of disruption. Failure to evolve and cope up with the changing dynamics eventually leads to the companies going out of business. Disruption can come from various directions but more prominently from the below factors.
1. Innovation/Technology obsolescence
2. Product substitution
3. Increase in competitive intensity from new entrant or incumbents
4. Structural political/geo-political issues
5. Regulatory changes
Since markets are always forward-looking, investors lose money much before the actual disruption. Also, the impact of disruption also has a lot to do with the DNA of the management team since it requires substantial investments in terms of time and cost to prepare themselves for foreseen as well as unforeseen business disruptions.
Finding moats is essential in doing business analysis. We like businesses which have a high sustainable moat and avoid businesses which have potential disruption risk. Businesses which do not have high moat or have high disruption risks are more prone to destruction in value. Investing in cyclicals businesses requires a very different mindset. Sustainable long-term wealth is created by businesses with high moat and good management team, often cause and effect for each other.
We are happy to share the process we follow at Carnelian to manage Type A risk in the following Annexure. Happy to receive your suggestions and feedback.
Annexure -1: An Insight into Carnelian risk mitigation tools to manage Type A risk
How do we manage this risk at Carnelian?
At Carnelian, we channelize most of our time and attention towards understanding Type A risk while evaluating investment opportunities and continue to monitor them regularly. We have chosen to stay away from companies and even exited companies from our portfolio which did not qualify or stopped qualifying as per our framework despite short time upside potential.
Forensic deep dive (connecting the dots)
In Carnelian world, forensic analysis starts with “marrying” the financial statements to find the obvious gaps which are as complicated as the jig saw puzzles.
We follow a two-step forensic deep dive while evaluating a company
Step 1: Automated quality checks
We have developed a proprietary automated template, screening last 10 years of historical data, highlighting potential red flags, basis which we decide whether we should devote any additional bandwidth for the company under consideration.
Step 2: CLEAR Framework
Our unique forensic framework deep dives into the following before investing, what we call “CLEAR” framework.
C Cash flow Analysis & Capital allocation
L Liability Analysis
E Earning Quality Analysis
A Asset Quality Analysis
R Related party transaction & Governance issues
The above framework requires in-depth analysis of the annual reports of the companies. To put things in simple words, we are extremely cautious and avoid companies where we find evidence of:
1. Profits disappearing ‘before’ landing to balance sheet,
2. Profits/Assets disappearing ‘after’ reaching the balance sheet
3. Profits/Assets landing in the balance sheet and remaining there forever
An insight into Carnelian CLEAR framework:
1. Analyse the quality of assets specially intangibles; deferred expenses; Investments in non-core assets like loans and advances, intercorporate deposits, dubious investments
2. Assess asset-liability mismatch (ALM) risks
3. Net-worth reconciliation: movement not explained by P&L
4. Ever-increasing receivables, inventory, unbilled revenues, intangibles assets
5. Categorization of liabilities – is it an operating liability or debt?
6. Look for off-balance sheet arrangements/ derivative book.
Cash flow Statement
1. Source of OCF is more important than OCF; watch out for “OCF boosters”
a. Sale of receivables;
b. “Non-recourse “channel financing
c. High payables with off BS financing arrangements
2. Gaps between Income statement and Cash Flow
a. Taxes, Interest & Exchange losses
b. Question the Non-cash adjustments
1. “We like capex in profit and loss, we do not like opex in balance sheet”. Capitalization of forex losses & interest cost, revenue expenses.
2. Whether exceptional items are one-offs or recurring?
3. Are profits contributed by inventory gains?
4. ESOP/pension accounting policy & future obligations.
5. Low rate of depreciation, delayed depreciation through delayed capitalization
Look out for other hidden/off-balance sheet issues
1. Business consolidation leading to unexplained net worth creation ---1+1=3 which is disguised revaluation
2. Complex corporate structures
3. Unidentified/identified related party transactions
4. Derivative book and unhedged forex exposures (Time Bomb without timer)
5. High contingent considerations
6. Promoter pledging
Refer www.carneliancapital.co.in/forensicanalysis for detailed reports/case studies.
PIU framework is a proprietary framework specifically designed to score companies under 3 elements: Business, Management and Risk Reward tradeoff. Apart from analyzing numbers, investing requires understanding the relevant qualitative attributes of the business and sector. Our framework is a perfect blend of qualitative and quantitative parameters which aids our understanding of the environment in which businesses operate which keeps our future projections in check.
1. Business part of the framework amongst other parameters focuses on
a. Competitive advantages: We like businesses which have highly “sustainable” moat. Understanding the competitive position of the company and success factors leading/may lead to the leadership is of paramount importance in understanding the quality of the business.
b. Disruption risk: Constant changes in businesses is essential to be relevant in a dynamic world. However, a highly disruptive business environment means constant pressure on the revenue-generating ability/market share, profitability and cash flows of these companies which could structurally damage the financials and competitive advantages of the company. Hence, we have a Clear “No Go” for these businesses
c. Opportunity size of the sector the company operates in: Apart from the disruptions and competitive advantages of the company, headroom for growth of a particular business is dependent of the opportunity size of the company. We like companies which offers either a huge opportunity size or operate in a high growth industry.
2. Management part of the framework helps us understand the DNA of the business managers and the organisation. We give the highest weightage to the management to arrive at the PIU score. We try to evaluate companies on the comprehensive “IMPRESS” framework as defined below
M Modest and Capable
P Passionate and Driven
R Realistic but aggression
E Efficient Capital Allocator
S Skin in the game
S Strong governance and Risk Management
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