Investment in stocks has been gaining momentum for quite some time now. Especially in the post covid era, there has been a tremendous increase in the small investors that have taken a plunge in the stock market as an alternate source of income.
Many investors have also now started to target stock markets as their primary source of income given the multiple job losses or pay cuts due to the pandemic. It is important to learn the basics of stock markets in such a case to ensure that the investors make sound investment decisions. While other factors like market and stock analysis are quite important while investing in stocks, most investors often ignore the importance of assessing the management quality in the decision-making process.
Given below are the importance and the factors involved in assessing the management quality before buying a stock.
What are the points to consider while buying a stock?
While investing in stocks, it is important to first understand the basics or the top criteria that need to be considered while buying a stock. Some of such key factors are discussed hereunder.
a. Understand investor’s profile
The first and foremost criterion to understand in stock investment is the detailed analysis of the investor’s profile. The investor has to ascertain the budget for investment based on their usual financial obligations and ensure that only surplus funds are used. This will not put a hurdle in the routine financial obligations and impact their lifestyle. The other important analysis is the risk-return expectation of the investor. It is important to not overestimate the returns as well as not underestimate the risk from stock markets as they are highly volatile. Another important aspect is understanding the investor’s goals and ensuring the investment is in line with such goals. For example, a person with a low to medium risk profile and long-term investment goals can invest in blue-chip stocks or mid-cap stocks to achieve their goals.
b. Selection of stock
The next important step based on the above considerations is the selection of the stocks for investment. The investor has to understand the following parameters while selecting the stocks.
- Select the target industry
Stock markets are an ocean of opportunities and hence it becomes difficult to tap every opportunity track in every sector. Therefore, it is a prudent practice for new as well as seasoned investors to first target a sector based on their market analysis and the past performance of various sectors. Such target sectors can be based on factors like the risk profile, past returns, their volatility to market fluctuations.
- Consider the top stocks in the industry
After selecting the target sector, the next step is to select the top stocks in those sectors. The selection of top stocks can be based on various factors like,
- Past performance of the stocks
- Industry share
- Risk meter
- Fundamental and technical analysis of the stock
One of the main criteria in the selection of stocks is their thorough analysis. It includes the fundamental and technical analysis of the stocks. Such analysis forms the basis of an opinion on whether the stock is overvalued or undervalued and can help the investors make a sound investment decision.
c. Assessment of management quality
Management quality is also an important factor to be considered while buying a stock. The performance of the company is translated into its stock prices. It is therefore important to assess the management quality as part of the basic analysis of stocks. This will help the investors weed out quality stocks against average stocks.
Why is the management of a company important?
Shareholders are the owners of the company but the management of the company is responsible for its day-to-day workings and its growth and progress. It is therefore important to assess the quality of management based on various parameters to ascertain if the management is taking all the necessary actions that help in ensuring consistent profits and growth prospects.
Many investors (especially new investors) may not think that the assessment of the management is not as important as the analysis of the stocks. This is a dangerous notion as the fundamental and technical analysis of the stocks may show it to be a good investment but the promotors of the company may be on a selling spree of the company shares. This can raise many questions like the possibility of any fraud or some insider information that could lead to a downfall in the share prices in near future and promotors may be safeguarding their interest before such news is made public. The management could also be transferring the company’s funds fraudulently to their personal wealth in the form of falsified related party transactions or transactions with subsidiaries.
Hence, assessment of management is an important aspect to be considered while buying stocks for investment.
What are the factors to look out for while assessing the management quality of a company?
We have established that assessment of management quality is an important aspect that cannot be ignored. It is now important to understand the various parameters for such assessment. Given below are the details of a few such parameters.
Research of the promotor’s background is the starting point in assessing the management quality. This basic background research can be regarding the professional qualifications of the promotors, their experience in the industry, their holdings, and their position in other companies in the same sector or others, or if there are any frauds or criminal cases attached to their name. This will tell the investors about the basic information of the management.
Promotor’s or management’s stake in the business
The owners and the management of the company are typically separate parties. However, the promotors usually have a substantial stake in the business that assures the other shareholders (especially minority shareholders) of the management’s intent to strive for the company’s growth and progress. A consistently reducing management stake could be like a warning sign for the other shareholders to dig deep into the company affairs.
Management remuneration is another key factor to be reviewed in assessing management quality. The remuneration should be within the limits specified by the Companies Act, 2013 (up to 5% of net profit in case of one key managerial person and not more than 11% of the net profits in case of multiple managerial personnel). It is also important to study that the management remuneration is in line with the growth of the company and not adverse. If the company is suffering losses and or a downturn in profits, an increase in the management remuneration can raise a red flag for the other shareholders regarding the management intent and integrity.
Clarity and correctness of financial statements
The management of the company is responsible for preparing its financial statements. These financial statements have to show the true and correct picture of the company affairs and its financial position. There have been many cases when the management has manipulated the books of accounts and has resorted to windows dressing of the financial statements to project a healthy business to lure the investors. Investors should therefore check the financial statements thoroughly and look out for any signs of trouble or falsified financial statements.
Related party transactions
Related party transactions are an important section in the annual reports of the company. This section tells the shareholders of all the transactions that have been done with business organizations where the management or the promotors have a significant stake. A detailed analysis of this section helps the investors know if there are no unlawful or unethical transactions in favour of the promotors under the pretense of related party transactions.
Analysis of dividend payments
Dividend payments are one of the main attractions while buying stocks. Some companies provide regular dividends to their shareholders while others prefer to re-invest such profits back into the growth of their business. Investors have to ensure that the dividend payments are made from the real profits of the company and not borrowed funds. Management may make dividend payments to their shareholders as an attempt to hide the true financial position of the business. Hence, the dividend payments should not be taken at face value and have to be analyzed carefully as a measure of the management’s ability to run the business.
Management projections for the future and its analysis
The management projections for the future of the company and their plan for its growth and expansion are laid out under the ‘Management Discussion and analysis’ or ‘Director’s Report’. This section highlights the company’s future goals and the pathway to achieve them. Any deviations from the company’s ethics or the general business model can be taken as a red flag and have to be further analyzed to ascertain management intention and direction.
Assessing the quality of the company’s management is a huge task and requires a lot of research and analysis. It requires the investors to read the financial statements as well as the detailed annual report and the audit reports to analyze the quality of management and their decisions for the better future of the company. It is important to understand that a company’s management is an important aspect and more like the driving force behind the company’s survival and growth. Hence, along with the fundamental and technical analysis of the stocks, it is also important to thoroughly assess the management to safeguard the investor interest.
The resignation of an auditor reflects negatively on the management quality and its administration. It shows that the management is not able to manage company affairs correctly which may have led to the auditors resigning from their position.
A company has to disclose related party transactions in its financial statements and annual reports in case of any transactions with such parties. As per the Companies Act, 2013, a related party is defined as,
1. A director or key managerial personnel or their relatives
2. A firm, a private company in which the partner, director/ manager, or relative is a partner
3. A private company or a public company in which a director or manager is a director and holds along with his relatives, more than 2% of its paid-up share capital
Any transactions with the above parties will need to be duly disclosed in the annual reports of the company.
Some incidents that can raise an instant red flag regarding management quality are,
-Frequent change in the auditors of the company
-Excessive remuneration of the auditors of the key managerial personnel
-Less independent directors on the Board
-Consistently poor profits or losses
The ideal debt-equity ratio differs from industry to industry. However, a high debt-equity ratio along with a poor interest coverage ratio can indicate the poor financial position of the company and potential liquidity and solvency concerns in the long term.