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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