One of the first written codes of law in recorded history come from Hammurabi, who ruled the kingdom of Babylon 1,750 years before Jesus walked the earth.
He is known for the set of laws called Hammurabi’s Code, which were written almost 3,800 years ago, and were inscribed on stone tablets standing over eight feet tall. Owing to his reputation in modern times as an ancient law-giver, Hammurabi’s portrait is in many government buildings throughout the world.
Here is one of the several laws that Hammurabi formulated in his times…
If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.
Well, if Hammurabi’s Code was to be implemented in today’s times, we would have seen a lot of corporate managers being taken to task in the ways the law suggested.
However, given that the penalty for stealing Rs 10,000 these days is harsher than the penalty for stealing Rs 10,000 crore, managers are often seen duping investors and getting away with their crime as if nothing happened.
The latest example is that of Cairn India, and its promoter Sesa Sterlite, where the latter is borrowing a US$ 1.25 billion loan from the former in what is called an “arms-length transaction”.
Cairn is extending this loan to Sesa for two years at a floating rate of 3% plus Libor (1-Year Libor rate is around 0.55%), which it says is significantly higher than comparable rates being received on fixed deposits of same tenure.
On the face of it, Cairn India, with around US$ 3.8 billion of cash reserves and annual cash generation of around US$ 1.5 billion is in a comfortable position to extend such a loan.
But the question is – if Cairn India and Sesa Sterlite were two independent business groups – and the former knew that the latter is deeply mired in debt (net debt of US$ 4.5 billion), would it have extended such a loan to the latter?
That’s questionable…also because Cairn itself needs US$ 3 billion to spend over the next three years to develop its oil reserves and maintain production from its tapering Mangala field in Rajasthan’s Barmer basin (as per its latest annual report).
Now, whatever the faithful managers and shareholders of these companies were to believe, in all related-party transactions, the chief concern is the nature of the transaction and its fairness.
In this specific case, the way fairness can be judged is by assessing whether Cairn had a bigger need to lend money or Sesa Sterlite had a bigger need to borrow money. Given that both the companies are looking to spend US$ 3 billion over the next three years, and the latter has an extremely stretched balance sheet, it becomes clear that the transaction has been driven by the latter i.e., Sesa Sterlite.
The intention also becomes clear because this is the same Cairn which, in April 2013, had said that considering the exploration activity lined up for the coming years, it would retain its cash (around US$ 3 billion then).
“We will retain the cash in the company,” said Cairn’s then CEO. “This will give us flexibility for accelerated discovery and production from the Barmer basin.”
So what has caused this major shift in view is a big question.
Assessing Management Quality
Assessing management quality isn’t an easy thing to do as compared to studying a company’s past financial performance and concluding whether it has been good or bad.
In other words, you can’t put a numerical value to a company’s management. You can’t create any specific metric to measure its quality.
What I consider ‘good’ management might be ‘bad’ management in your eyes. So the response to the question – whether the management is good or bad – is very subjective.
But here is a very important point from Thomas Phelps in his book 100 to 1 in the Stock Market – “Remember that a man who will steal for you will steal from you.”
In this specific case of Cairn-Sesa, it’s thus important for you as an investor to avoid falling for information that is made “available” (arm-length transaction, Libor+3%, high cash reserves, blah-blah) and focus on the management’s real intention that is not readily known or available.
“But how do I know the management’s real intention?” you may ask. “Isn’t it difficult to assess?”
It is difficult, dear investor…and thus it pays a lot to read the history of management’s actions, and how it has dealt with money and minority investors.
Just search Google for company name plus keywords like “scam”, “fraud”, “allegations” etc., and you will know in a few minutes how well or bad behaved the managers have been in that past.
Like, search for “vedanta+scam” and you would know what I’m talking about.
Generally, past may not be a good indicator of the future. But when it comes to intentions, behaviour, and habits, past is a near-perfect indicator of what to expect in the future.
So, if managers have misallocated cash in that past, made bad acquisitions in the past, or mistreated minority investors in the past, there is a great probability that they would repeat their actions in the future as well.
From Hammurabi to Hippocratic
In 2009, in the midst of the global economic crisis, a group of Harvard Business School students proposed a “Hippocratic Oath for Managers” to “transform the field of management into a true profession.”
The MBA Oath attracted a good deal of publicity, and graduating students at many business schools signed the social contract to pledge that they would behave in an ethical fashion.
This was necessary because, over the past decade, the scions of the most celebrated business schools on the planet have presided over a glaring string of criminal misdeeds and macroeconomic catastrophes.
The Hippocratic Oath’s essence is to “do no harm”.
But given the way corporate managers discard all rules of ethics and governance, and the incentives they have to do so, no oath will work in this field where money is the prime motivator and often the sole purpose of being.
Buffett has famously said that he looks for three things in a manager – intelligence, integrity and energy; and of these three characteristics, integrity is the most important.
When you hire someone to run your business, you are entrusting him or her with the piggy bank. If these people are smart and hardworking, they are going to make you a lot of money, but it they aren’t honest, they will find lots of clever way to make all your money theirs.
As an investor, you also need to decide whether the manager managing your company (yes, you partly own the company by being its shareholder) is honest or dishonest.
This may seem irrelevant when stock prices are rising, but then as Ben Graham said…
…in the short term, the market is a ‘voting’ machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a ‘weighing’ machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.
Rest, you decide.
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Great post as usual Vishal!
Not that it matters but the stock market seems to have taken cognizance of this on 24th July 🙂 (Link)
Reni George says
Good afternoon to you……
I would like to Quote Benjamin Franklin here………..
“Let no pleasure tempt thee, no profit allure thee, no persuasion move thee, to do anything which thou knowest to be evil; so shalt thou always live jollity; for a good conscience is a continual Christmas.”
Vedanta as a group is known to arm twist the poor tribals and hobnobbing with the political class,to benefit for itself.We know how they tried every cheat game available in the books,starting from manipulating the record books of the orissa governemnt to throw out the tribals from the Niyamgiri Hills,for their Bauxite requirement for their Langigarh refinery.If it would not have been the supreme court,this tribals would have been thrown out.There are various complaints about how they took over some tribal land around their langigarh refinery,by promising them jobs,but never actually gave out the jobs after taking over the land.
I was a shareholder in cairn,but I sold off my shares as soon as the news of vedanta resources buying cairn cam out.I would not like my money to lie with a watchman,who always finds out newer designs to usurp that.
At last we should remember that the management integrity is one of the prime force that is needed in the company that you are investing,if that is not there,even if your company is making billions of cash from operations,but hardly anything would come out.
If ever someday,check out the books of Reliance communications,you would not believe,how they bill the customers,in which company the cash goes etc etc.It is like a mirage,you would see the water,but when you go near you would no the truth.
There are scores of companies out there…….jet airways,kingfisher etc etc.
Always go through the annual report,go through the notes this will tell you how your companies management is performing in terms of INTEGRITY.
Good Post Vishal
Thanks and Regards
Vedanta group is major shareholder in Cairn and democratically can vote for a loan to any party.
Oil companies typically generate consistent cash flow and give away dividends and do buybacks.
Cairn tried to do a buyback which was spoiled due to GoI litigation against the original Cairn Energy.
They could give away one time higher dividend from the cash not spent on dividend. This doesn’t sounds a very logical thing to do either.
The next best option is to give consistent higher dividend which they cannot do as they need cash for EOR. EOR is a technique to use chemicals, water, sand mix to extract more oil from the same field.
Now cash outflow for EOR is needed in small chunks spread over a long time.
So what could the company do with the excess cash?
In my view, the only point of contention if any is that the loan to Vedanta is given at a low interest rate.
If we get into debate of what Vedanta did with tribals in Orissa, then lets talk about health benefits with holders of ITC, about displacement of villagers with all hydro power generators and about fertilizer companies which are spoiling the soil quality and poisoning our food. Till then, lets view Cain in isolation without a bias against Vedanta.
And Anil Agarwal’s companies have all created wealth over time – long term value.
If we start focusing on corporate governance we would be out of stock market.Just look at the list of industrialist whose coal blocks have been cancelled, its virtually who’ who of corporate india.
Transferring free cash to group concerns is a worldwide practice and nothing unusual.
From fundamental point of view this is a good stock i think so.
Gampa Rakesh kumar says
I have gone through the financial statements of cairn india and tried to find out the rationale of lending loan to its parent
Here are my observations
Interest income on (all figures in lacs)
Bank deposits 20,248
Current investments 16,328
Dividend income on current investments 452
Total income on liquid investments and deposits 39,264
Similarly if i see on what assets have they earned this earnings
Total liquid holdings 19,17,246 ($3.2 bn approx at 60 exch rate)
Therefore the returns come out to be = 39,264*100/19,17,246 = 2.04%
If we consider the decision taken by Cairn India management i.e, lending 9,00,000 lacs ($1.5 bn) at 3.55% (Libor+300 bps)
The total returns earning would be more than previous year returns of 2.04%
Hence i think there is nothing wrong with the above decision except that the liquidity of Cairn india is reduced
But as clarified by the management that the loan is for 2-3 yrs and the capex of company will not be affected considering net positive cash flows
P.S: I have holdings in Cairn india and Sesa Sterlite and hence due to holding bias may have missed out on something important
Please read this article carefully and seems some of the investors are still blinded about what is going on. It is so painful that existing stock holders are still trying to support the rationale of the decision. Think as an independent analyst make a neutral review. One would realise the blunder committed by Cairn Mgmt.
In India, even if you keep in savings account one would get 4% interest. Cairn should explain why it earned only 2% interest.
Second as the article raised, imagine if these two are independent firms. Would this cash rich company would extend the loan for a company riddled with massive debt?
One last thing. Cairn expected that its stock would tank after announcement. Suddenly they brought in massive gas discovery on the scene to shore up the stock. Better to dump this stock and move on.
How can we forget what happened to Kingfisher Airlines. I think it happens only in India that Promoters can get away with such crimes. Borrowings to the tune of 7500Cr and the entire Equity have been made zero. Looks like management didn’t make any serious attempts to retain shareholder value.