Bah, Bah, Black Sheep

American comedian Bill Cosby had once said: “Women don't want to hear what you think. Women want to hear what they think – in a deeper voice”.

Let me reserve my opinion on the truth of this statement and ask a simple question.
Do you think we, as investors, have our own contribution in the making of corporate scandals like Enron and our very own Satyam? Puzzled? Think about your reaction to the news of your company posting a 15% decline in profits or to the news of production cuts? Think about your preference for a company that’s always in the news for good reasons. Think about your apathy to a nondescript business consistently making good returns far away from any metro.

I have reasons to believe that investors of this empowered world, (where information is available on fingertips; sliced, diced, cooked and served hot) are creating enough incentive for the people to indulge into actions that start with an intention to please these very investors and end up cheating them.

We want perennial growth. We want quick bucks. We want the toplines and bottomlines to keep rising in a predictable manner so that we can create our chimerical world to justify our mistakenly high opinion of an otherwise ordinary business.

Wait a moment and look at the following graph.
The graph has 3 lines and each line has a linear trendline along with it. The line on the top is the GDP of US for the last 7 years. It’s a smooth line because GDP is an aggregate number. For a matured economy like the US, it may rise about 4% in the best case and may fall few percentage points in a recession. The number R2 (R squared) is a statistical indication of how neatly the trendline fits the graph. If R2 is equal to one, then the trend line perfectly fits with the .

The other two lines are quarterly revenue and profit numbers of a NASDAQ listed Indian IT company for the last 7 years. Note how smooth the lines are. It’s still OK for revenues to show a consistent pattern but profits!! Such smoothness is more becoming to a lie than to the profits of a business.

We are not robbed by scoundrels. We ask for it. We keep the companies showing such consistent performance, in very high esteem. We give them fancy valuations. We keep saying that these companies are making the country proud. We bestow the leaders of these companies with award after award.

They give us the numbers we want. We invest our money in them believing in what we wanted to hear. It’s that simple. Bill Cosby will soon expand his quote to include us investors.

Before you jump on to conclusions let me clarify, the company whose revenues and profits are depicted in the graph is NOT Satyam. It is Infosys, the darling of Indian investors.

I’m not saying these numbers are incorrect, and I sincerely hope they are correct to the second digit of decimal but at same time I maintain that they leave me wondering ‘how’.

I’m not the once-burned-twice-shy skeptical investor. IT is my profession. In the past 12 years, I’ve worked in top IT companies including Wipro and HCL Technologies. I know how customers allocate their IT budgets, and I know how the workloads vary throughout the year. What I don’t get is how these IT companies come out with numbers as smooth as we have gotten used to seeing.

It’s time we all woke up to the truth that the ‘smoothening’ of profits has become a standard practice. The companies do it because we are unwilling to let go of our fascination with Q-on-Q growth. We are unwilling to believe the managements, who refuse to give earnings guidance and admit that they have no visibility to the future earnings.

Smoothening of earnings is such a widespread phenomenon that it gets special mention in the owner’s manual of Berkshire Hathaway, signed by none other than Warren Buffett.
“At Berkshire you will find no ‘big bath’ accounting maneuvers or restructuring. And we won’t ‘smooth’ quarterly or annual results: If earnings figures are lumpy when they reach headquarters, they will be lumpy when they reach you.”

The investors, in general, are better off being a Devil’s advocate than god fearing individuals whom the managements can hand out whatever crap they want. I want them to question the people who are handling their money. I want them to ask uncomfortable questions which cast doubt on people whose integrity has been proven beyond doubt. If they are worth the esteem we bestow upon them, they won’t mind our questions.

I want to ask Mr. Narayan Murthy why is he sitting on top of the pile of cash on which he is making less returns than I do in Fixed Deposits. I want to ask Mr. Ramadorai why he has invested Rs 2,505 Crores in mutual funds which gave just 104.27 Crores in dividends. I want to ask him why does the list of his mutual funds investments run into 11 pages and contain names of asset management companies whose Fixed maturity Plans came into light due to their investments in real estate sector (these investments being way beyond their mandate). Does he really know that the money the investors have entrusted him isn’t making its way into speculative bets? Can he assure investors TCS won’t play the lender of last resort if the finances of Tata Motors come under strain? Can Mr. Ajim Premji explain why Wipro’s balance sheet shows 4,485 Crore debt when it has 3,927 Crores in cash and cash equivalents earning less that what they are paying on debt?

Look at this cash pile and remember that this is not a capital intensive business.

CompanyCash & bank balancesInterest earnedReturns on cashdividend payout ratio





40.8% *











All amounts are in Rs Crores
* considering special dividend

Let me be utterly skeptical and state this:

If the proof of the pudding is in eating, the proof of the earned profits is in dividends.

These companies definitely represent the pinnacle of success achieved by Indian companies in a globalized world but they need to do enough to win the trust of investors. The Satyam scandal cannot be wished away by the phrase ‘just one bad apple’ which Narayan Murthi used. The people who have lost money want something to be done.

The saddest part is that everyone in the industry is more inclined to adopt bad practices than better ones. If one company does something stupid, others follow suit. If Infosys gives stock options, everyone else will. If Infosys doesn’t account for their cost in the profit loss statement, others won’t either. If Infosys follows a policy of retention of earned cash, Satyam will use it as an example. The good companies will sure use the cash to earn better returns (I hope) than what the investors would have earned themselves but the dishonest managements will siphon it off; overconfident and ambitious managements will splurge it on acquisitions, the overoptimistic ones will invest it in stocks and the foolish ones will burn it sooner or later.

The euphemism used for this is: ‘standard industry practice’. I don’t know to what extent it can be attributed to coincidence, but many times I find that the ratios closely followed by the analysts are tantalizingly similar across all IT companies. You will have roughly same attrition rates, and the same % of people on the bench. I’m not making it up. Look at the following table for example.

CompanyNet Current AssetsdebtorsLoans &advancesRevenueDebtor days



















All amounts are in Rs Crores
#consolidated accounts of march 2008

For the Indian IT companies, the working capital requirement has been surprisingly high. It is reflected in the high debtor position along with high loans and advances. Although you arrive at net current assets by subtracting current liabilities from current assets, you must know that these two items do not have same chance of going bad. As a strong company, Infosys will always pay off its liabilities but some of its clients, perhaps those hit by subprime crisis, may not settle the dues. Some of its subdiaries may not pay back the loans. Hence these figures are always looked at with suspicion. The metric used to analyze this is debtor days which is the average number of days it takes a company to receive payment from its debtor. Somehow the entire industry has a figure of 72 point something. Raises my eyebrows!

Don’t be alarmed. With Infosys, there is very little likelihood of the action replay of the Satyam saga. But we investors have to change to protect our interest. We have to be like hawks, who
can rip apart the colorful annual report. Who can stand up in the AGM and start singing in a voice loud enough to shut the mouths

Bah, bah, black sheep,
Have you any wool?
Yes, merry have I,
Three bags full;
One for my master,
One for my dame,
But none for the little boy
Who cries in the lane.

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