India being a country of trust deficit, it has become a policy to micro analyse promoters' every move all in the name of looking out for the little guy, the shareholders.
There certainly isn’t any debate on shareholder interest against promoter interest but where do we draw the line?
It is important to step into the shoes of the promoter to understand his afflictions. Let us explain how things could perhaps look on the other side of the fence.
Skin in the Game
A very common doubt amongst the investing community is if the company’s future growth is certain, then why wouldn’t the promoter increase their own stake? But there’s little empirical evidence of any correlation between the two.
We can have ample example where the stock has performed extremely well inspite of promoters having reduced their stakes at regular interval. For example, Aarti Industries and in fact promoters of one of India’s biggest wealth creation stocks, Page Industries, have sold 1-2 percent of their stake in the company almost every year in the past 10 years!
Reading promoter stake sale directly as a 'red flag' is a market cliché!
The High Price of High Compensation
All hell breaks loose when an analyst in the market sees promoter group/directors remuneration hitting the ceiling of 11 percent as permitted by Companies Act (although that even can be increased by passing a resolution).
We should consider the base effects. Imagine a small-cap company with 50 crores of sales (at 2 times multiple a market cap of 100 crore) operating at 5 percent PAT margins leading to a PAT of 2.5 crore.
Do you really expect the promoter to withdraw a salary of 5 percent of PAT i.e. 12.5 lakhs after creating a 100 crore company?
Although this topic is debatable and we will go deeper into the issue some other time.
The Family Tree
People hate paying taxes and also there is “Lala” nature in terms of controlling the decision making. Hence to reduce tax paid on income they diversify the earnings among family members and include them into the board to control decision making.
The Cash Trap vs Dividend Dilemma
Sometimes business booms due to industry tailwind and the promoter decides to declare good dividends (which benefits even minority shareholders) to cash-in some money from his booming business. The analyst community would rip them apart stating it is a “no-growth” story. Funnily enough, if the promoters decide to do the exact opposite and start accumulating cash on the balance sheet, even then the promoter would be tagged as a `fool’ as it will reduce Return On Invested Capital and Return on Equity numbers!
In small companies, this is a regular event by promoters to fund their liquidity positions. What’s the issue if business had surplus cash even after achieving sustainable growth rates and he is paying market level interest on the same? but sadly, the analyst community would still penalise them citing corporate governance issues!
Till the time a promoter is not taking undue advantage
a) by increasing his stake through amalgamations of private promoter owned entities at absurd valuations or
b) by giving himself ridiculously cheap Employee Stock Ownership Plans to increase the stake, or
c) by diverting funds out of the company for private purposes without interest payment and history of such loan write-offs, or
d) by holding obscene amount of private assets on company balance sheet, or
e) by owning private entities in similar lines of business that are actually performing better than the listed ones.
Let other small things go. Else it becomes a perfect case of analysis-paralysis.
Further, there can be multiple reasons for which a promoter might have to dilute his stake - Qualified Institutional Placements, SEBI regulation to bring shareholding to 75 percent, bringing a strategic buyer on the table which may provide key technology/asset, to release his pledged holdings, classification of shares in the non-promoter category due to family issues leading to reduction in promoter holding or transferring it to some Trust due to taxation purpose or, infact, his business in the lumpy in nature where he cannot predict cash flows so it's better to dilute equity than taking debt etc.
The main things to note that is forgotten by market participants is
A) look at the track record of the promoter has he ever defaulted on payments
B) how has the business performed during bad phases of business/industry
C) did the promoter reduce his salary in bad phases of business and
D) how much money has he raised by diluting equity and for what purpose.
I will tell you from personal experience a bad promoter will latch on to the first opportunity he gets for raising money from the public without even having a clue where he will use that.
I still remember a statement by Madhusudhan Kela in an interview when the insider trading case of one of the employees of Divi's Laboratories came into limelight - That boss look at the total equity of Divi's today. The promoter of Divi's has raised money from the public only once during IPO which today in front of total equity he has created is a drop in the ocean and he pays tax fully and such guys cannot be frauds.