Taking a call on a small-cap company is, to a large extent, taking a call on the promoter(s). Besides the promoter's track record of capital allocation and experience in dealing with crises, another important assessment of promoter quality is the extent to which she is financially & emotionally invested in single-mindedly running the company. Some of the parameters we use to evaluate this are percentage of the promoter's shareholding, the extent to which her remuneration is linked to financial performance, her business interests outside the company, and whether she prioritises reinvestments over dividends.
Evaluating Promoter Quality In Small Caps
Smaller companies are, by and large, family-owned and family-operated businesses usually involving a single promoter or a few promoter family members who are at the helm of the affairs. For such companies, the promoter's or group of promoters' skills (technical, sales, and/or managerial) becomes the defining competitive advantage of the company.
Furthermore, the promoter's strategic and capital allocation decisions shape the destiny of the company. Thus, taking a call on a small-cap company becomes akin to taking a call on the promoter(s).
Besides the promoter's track record on capital allocations and her ability to deal with crises, another important aspect of promoter quality is the extent to which the promoter is financially and emotionally invested in single-mindedly running the business of the company – i.e. does she have skin in the game which aligns her interests with that of the minority shareholders?
1. Extent of shareholding in the company and changes to that shareholding
The higher the promoter's stake in the company, the greater the likelihood that the promoter would think and behave in the best interests of the company's minority shareholders. Furthermore, how the promoter's shareholding in the company has been evolving can also provide vital clues regarding her view of the company's prospects.
2. Remuneration – fixed vs variable
Another measure of the promoter's skin in the game is the proportion of their remuneration which is variable (i.e. dependent on profitability) rather than fixed. The higher the share of variable (versus fixed), the greater the promoter's incentives to focus on profitability, the greater the alignment with the interests of minority shareholders.
3. Dividends vs reinvestments
Promoters have an option to either take out the profits of the company through dividends or reinvest them back in the business for growth. Prioritising reinvestments over dividends is a sign that promoters are not driven by short-term gratification but by long-term value creation through fully exploring the business potential. The only caveat here is that reinvestment should not be return-dilutive or below the opportunity cost of capital for the shareholders.
4. Business interests outside of the listed company
Significant business interests of promoters outside of the listed company, notwithstanding the high shareholding in the latter, raises question marks surrounding the time and focus that can be allotted to the company's business. This is particularly concerning where promoters are involved in an executive role in the listed company's business as is the case with most smaller companies.
How Do We Address The Pitfalls Of ‘High' Skin In The Game?
While plenty of skin in the game indicates a high level of promoter involvement, a potential pitfall is the spectre of governance lapses in such companies. For instance – a promoter with a very high shareholding in a company arguably wields much greater influence relative to a promoter with a relatively distributed shareholding. Similarly, profitability-linked remuneration may create a perverse incentive to report higher than actual profitability.
We tackle this issue through the following steps in our investment process.
1. Forensic framework and checks
Evaluating the accounting quality of a company needs to be a cornerstone of any investment process in India and more particularly for small caps. At Marcellus, we have developed a set of 12 ratios that help to grade companies on their accounting quality. The selection of these ratios has been inspired by Howard M. Schilit's legendary book on forensic accounting called ‘Financial Shenanigans'. These 12 forensic accounting ratios cover checks around key financial statement categories like income statement (revenue/earnings manipulation), balance sheet (correct representation of assets/liabilities), cash pilferage, and audit quality checks.
The companies that score below a particular threshold don't make it or don't remain in the portfolio.
Besides this quantitative framework, the deep pool of accounting talent in our team also closely scrutinise the company's financial statements to look for accounting/governance red flags. Finally, we also weave in forensic checks in our primary data interactions and on-ground checks. (links to Dec. 2019, Sept 2020 content)
2. Succession planning framework
While our investment process rewards high-quality promoters who are ambitious, driven, and possess sound judgment, our succession framework tracks softer aspects such as the institutionalisation of the business at different levels i.e. decentralisation of decision making amongst members of the Board, CXOs, as well as ground-level execution through systems and processes.
The detailed succession planning framework (alongside the key parameters used to score the companies on the framework) is discussed here, where we also discuss how most Little Champs portfolio companies have made rapid strides in succession planning in recent years thanks to a well thought through succession roadmap, the proliferation of professionals in key roles, the democratisation of company ownership through stock options and through high-quality independent director appointments.
Making The Pick
In summary, the ideal promoter to back combines a high level of skin in the game with high standards of accounting. Such a promoter would ideally have negligible business interests outside the listed entity and would have built a strong line-up of high-quality managers reporting to her. Ideally, the promoter and her direct reports would largely be compensated through variable pay rather than fixed pay. This compensation construct will then incentivise the promoter and the executives to reinvest the internally accrued surpluses in growing the business at a steady rate.
Saurabh Mukherjea, Ashvin Shetty, and Harsh Shah are part of the Investments team at Marcellus Investment Managers. Disclaimer: Read here.
The views expressed here are those of the authors, and do not necessarily represent the views of BQ Prime or its editorial team.
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