In the last post, I mentioned some methods for generating investment ideas. Now, I will talk about some corporate governance checks and balances we should conduct to ensure we don’t get burned.
For this exercise let us assume that out of the 259 companies in the Dhaka Stock Exchange around 35 look interesting based on the idea generation methods I discussed earlier. In this step we will be working with these 35 names and try to remove the rotten apples. After this filtering process we are likely going to have a shortlist of around 15-20 names.
Background of company sponsors
The first step would be to know the main sponsors of the company better. We should be trying to understand whether the sponsors will act in the best interest of the minority shareholders. The questions we should try to answer include
a. Who are the sponsors?
b. What kind of reputation do they have?
c. Do they have any bad records? Any legal cases?
d. What are some of the other business that they own?
e. Are there any conflicts of interests?
Quality of financial reporting
This is another key area of concern. There are many companies who are probably quite profitable but they hide their profits in many ways. The opposite also happens where companies inflate their earnings. A quick view of earnings volatility can give some insights. If there is no logic for extreme numbers the statements should be a suspect automatically. I also find that comparing margins with similar peers give good idea on whether companies are manipulating or not.
Other issues related to financial reporting would be timeliness of information dissemination. A company which takes 5 months to publish its annual report is surely inefficient or hiding something.
Related party transactions
Companies are supposed to report related party transactions in the their annual reports. This is something every investor should check. It is true that companies might not report all the related transactions. However, even without explicit mention an analyst can do a bit of investigation to figure these out.
I can mention one example of a company where the largest distributor was owned by the Chairman. Furthermore the building premises were also owned by the same person. These sort of relationships clearly raise red flags as there are clear conflict of interests.
These are some of the few basic checks that we should perform to filter our shortlist further. This list is by no means exhaustive and there are many other things we can look into. Companies which have corporate governance problems can never serve the best interest of the minority shareholders and it is best to avoid them under all costs.