Please find below our key excerpt from a brilliant paper written by Savi Jain & Amit Mantri of 2Point2 Capital on how to analyze with a forensic lens the employee benefits expense of the company. (Emphasis Ours)
Pattern 1: The companies compensation structure does not match the scale/brand/Market Share claim of the company and Industry requirements/structure. Especially when they are way different than the average Industry standards.
Case Study 1: Company A is a listed ‘Consumer-Tech’ business in a highly competitive industry. Excluding the Promoters, this ‘tech’ company has NO Engineers in its top management. The median salary of the employees in the company was less than 2 lakhs in FY21 (2.5 lakhs in FY20). The highest salary that any employee/senior management draws is less than INR 25 lacs per annum (ex of Promoters).
Case Study 2: A Beverage company listed in India. The median salary of the top management of the company was 4.6 lakhs per annum, an abysmally low number for people with 10-20 years of work experience. The educational backgrounds/prior work experience of the employees too was ordinary. The company has destroyed 100% of its equity value since then and the Promoters were arrested for GST invoice fraud.
IMPORTANT OBSERVATION IN CURRENT MARKET SCENARIO
"In current Bull markets We are seeing a number of companies with shallow management teams and limited human capital fetching billion dollar+ valuations. Focusing on the absence/presence of human capital is a good way to eliminate dodgy companies and increase the odds of investing in scalable franchises."
Broad Employee structure of Indian Businesses
a) Most companies in India are Promoter driven – both run and managed by the Promoters. b) Along the way, as they become big, they professionalize their companies by hiring external talent. It is imperative beyond a certain size.
c) As expected, despite high promoter holdings, most of the larger companies in India are professionally managed.
When we encounter companies that have grown big or are growing rapidly without any significant investments in human capital, we wonder if the business and its growth is real. If the business/growth is indeed real, then the sustainability of this growth is questionable.
It is also easy to fudge numbers/financials but it is not so easy to fudge human capital.
Measuring Human Capital
We measure Human Capital in any company using three yardsticks –
1) Quantity:A growing business needs a growing number of employees. Even if a business is not growing, the employee base should be commensurate to the size of the business.
How do we measure:
One primary source of employee count for any company is the EPFO website which captures the monthly number of employees for whom the company is depositing provident funds.This is primary data and difficult to fudge.
The company’s EPFO-linked employee count has expanded by 20% from 9,061 to 10,758 between January and July 2021. This ties in with the growth guidance given by the company.
LinkedIn is another source that gives a rough indication of the number of employees that work for the company and the number of new openings etc. When there is a large disconnect between business growth and employee growth, we must be wary. The growth maybe fake, or potentially short lived/unsustainable.
The growth in number of employees however may not be linear because of economies of scale in the business. The relationship may not especially hold true for platform businesses that have network effects.
For instance, Whatsapp had just 50 employees when it was already one of the largest social networks in the world. Most Indian companies, however, are linear businesses where we expect to see some correlation between business growth and employee growth.
2) Quality: Growing businesses require good talent to sustain the growth and protect the moat. Typically, good talent will have one or more of the following characteristics – it will be drawing a good salary, will have prior experience in good companies and may even have a good educational background.
How do we measure:
LinkedIn is a great source to check employee backgrounds, especially for mid and small sized companies.
For instance, when we made an investment in Garware Technical Fibres in 2016, we went through the profiles of all senior and mid-level employees on LinkedIn. We were impressed to see that for a company with less than Rs 1300 crores in market cap, it had employees with prior work experience in leading domestic and multinational companies. The company was already hiring from Tier 1 and 2 colleges. Not only were such employees joining the company, they were also sticking around for several years. Attrition was limited in senior management.
There are several sources such as the RHP2 (filed just before the IPO) or the Annual Reports that one can tap to get a flavor of the salaries of the senior employees (CFO,CS, other senior employees) and also median salaries. The RHP has to disclose the salaries of all the KMPs.
Inexperienced CFO and CS profiles and abysmally low salaries often indicate poor focus on financial controls and compliance. Many recent IPOs seem to have filed the CFO role with relatively junior personnel at the last moment just to meet the SEBI listing requirements.
The average salary of a recently listed specialty chemical company is 3.3 lpa which is 20-70% lower than other similar companies in this space. This is especially odd given that the company claims to have superior R&D capabilities, higher EBITDA margins, supernormal ROEs and is seeing strong growth in its business. Are these numbers sustainable despite such limited human capital investments?
3) Culture: Great companies are built on the base of a good corporate culture. But how do we measure culture?
How do we measure:
A high attrition is indicative of dissatisfied employees. We can get a rough sense of attrition at the senior management level from LinkedIn. Speaking to ex-employees can also give an insight into the company’s culture.
While current employees can give you a good picture too, but they have a conflict of interest. Reading Glassdoor ratings and reviews on the company can also give a good insight.
Having said that, a good score on human capital parameters alone is not sufficient for us to consider an investment in a company. There are several other factors that are more or equally important. For instance, see below the impressive profiles of few ex-senior management employees of a Jewelry company that has destroyed more than 95% of investors’ wealth: