The Mithyam in Satyam

“It is when the tide goes out that you know who has been swimming naked.” Warren Buffet laid out an “if….” statement, that helps you to anticipate markets and the economy bottoming out. The last boom — bust was created by IT, and the most spectacular non-existence of revenues and profits turned up at DSQ Software (also audited by Lovelock & Lewes, now part of the self-same Price Waterhouse). That time, DSQ was (in 2000, I think) the no.5 IT company as per the then NASSCOM ranking’s. Today, it is again the no.4 IT company, Satyam + PWC combination. Shouldn’t we be getting a sense of déjà vu?

Oh yes, I forgot…extenuating circumstances!!! This time, the focus is on cash balances, not so much mis-stated revenues but only/just mis-stated profits. The people and the customers are real, there are SOME profits, this was an innocent search for market cap, meeting expectations, just some small “teeming and lading” of profits that went a little out of control, et al…

Frankly, as a continuing citizen of the CFO community, who has achieved a subtle shift in class, from being a CFO of “lala” companies to now actually running Finance as more than a “paisa lao + profit dikhao” function, I don’t remember which company does not do a little bit of the above. This is seen as ‘jumping red lights’, worthy of news only when you kill 6 people with a BMW, in a drunken state. The only thing new about the “Mithyam in Satyam” is the scale of the lie, not the lie itself.

It is a big reason why the investing pundits recommend diversification. You never can tell….

There are thumb rules that we need to follow as investors. Look for tax payments, as indirect evidence of real profits, look for cash balances (sorry, that is no longer enough. Look for interest income booked against those cash balances). Look for independently verifiable assets; no asset list (or auditor certification) seems to be safe enough to trust. Don’t buy companies with financial assets (whose Balance Sheets can disappear overnight in an MTM revaluation), intangible assets/ Current Assets (like service companies). In short, don’t buy Balance Sheet quality unless you are sure of their reputation. That takes Behavioural Economics. Look for character in the face of adversity, the kind that Infosys has. At least, when you tell yourself that you are buying culture and morality, you will look very carefully and you will look again and again. And you will never get complacent and stop looking, every time, just in case!

The world is neither clean nor safe: caveat emptor applies more to stocks than any other commodity. There are many more scams and wilful mis-statements permeating in financial markets, than just mere profit and balance sheet items.

How many more such stories are there? I will try and take a guess. The last IT boom had 550 listed IT companies, at the end of which the ‘top 5’ accounted for 65 per cent of exports. Today, there are more than 20 good, real IT companies; the IT story is robust, it will continue and some world class companies have already emerged. But look back at 1999, and ask yourself whether you could have seen the current list of IT majors-in-the-making. Find them with rules—

1. Look for the “Tata” culture: slow, bureaucratic, but clean and long-term. While Tata may be just a name, the actual behaviour represented by the brand is a well-codified, long-established pattern. Infosys is just a repeat of the same pattern, with some minor embellishments.

2. Look for the ability to admit to bad news. This critically establishes the existence of character, because it (i.e. admitting to bad news in the middle of a sea of bad news, a.k.a. recession) is fraught with quite a bit of danger. If you admit to bad news, bankers, shareholders, etc will use your own admission of truth against you. Your truth will be compared against someone else’s lie. This puts you even more under pressure. The ability to ride out these cyclical squeezes in liquidity as weak stakeholders flee the ship, tells you that the company is adequately capitalised in terms of a wide variety of resources, both financial and people. Take a look at what Tata Motors is going through just now (or Tata Steel). In case India comes back, watch these companies.

Compare this to the ongoing story in Realty, Infrastructure and Banking. Look for the ‘culture’ of the companies at the heart of the last boom. While the numbers were the same, with about 500 companies populating the RIB boom in each sub-sector, I don’t see the robust business models and the culture of admitting to bad news, the reserve resources that will step in to pick up the mantle when in each stakeholder list (equity investors, bankers, employees, even customers), the rats desert in droves. I wouldn’t give realty any chance whatsoever, although infrastructure will produce some winners, and banking maybe some more winners. The names I can think of are all predictable, but there may be some surprises. My guess is that the number of ‘naked swimmers’ in the denizens of the last boom is going to be much denser than in the IT boom.

Other ways to look for tomorrow’s winners’ are mostly soft behaviour patterns:
Watch companies to see if their problems are because they joined the energy in the middle of the boom, over-leveraging themselves with debt.

The same companies would today be blaming some outside event, trend or environment to explain their situation. They will not hold up their own behaviour for scrutiny.

See whether their prescription for a pullback has any determinable internal change of behaviour. These same companies would be in denial, looking somewhere else for the genesis of their problems, till the train hits them.

Are these companies conscious of their own limitations/constraints, or do they still talk big? Have they started talking about the limitations imposed on them by the environment, especially by non-financial resources that demand conscious management action?

Look at the sheer number of non-performing assets and programs launched by the co during the boom, and see whether it is ready to pull the plug on some of them. The ability to take this pain is what sets out tomorrow’s winners from the also-rans.

The narrower and deeper a company’s processes, the more likely it is, that it will not run out of resources during the recession. The more carefully a company enters into new programs, waiting for them to yield results before going on to the next one, the more likely it is to survive. Such a company will automatically find itself liquid and profitable. A top-down study of the Balance Sheet and Profit & Loss Account may show up some interesting leads, but they are not by themselves an exhaustive indicator of tomorrow’s winners. You need to understand that the resource-discipline that you see in the financials is an indicator of the company’s culture, and not merely an accident that happened because the macro-trends of the boom ignored the company.

The “Mithyam in Satyam” does not refer to Satyam, the company. It is an indicator of culture that hides a much deeper truth. In the long run, this truth must out. The Tatas have taught us that if you codify these rules, you build the basis of long-term business success, which is the only ‘steel frame’ to hold up an institution. All you need after that is a leader who holds up that culture; the rest will take care of itself.