The riddle

Do institutional investors and auditors have different standards of due diligence?

Well-meaning investment advisers recommend ticking a long checklist before venturing to trade. A basic requirement is consistent growth in revenues and profit. Corporate actions such as dividends, bonus and stock-splits come next. Growth plans and capital expenditure, too, are important. Presence of foreign investors and mutual funds offer comfort. Valuations tell a story, either of sluggish earnings growth not keeping pace with price gains or yet not reflecting the potential. At the tail-end is corporate governance. Unable to pin a definition, the explanation ranges from timely release of quarterly results and holding AGMs to having independent directors on board as per regulations. With the exercise done with, the attention shifts to stock-picking. The preference is for high-growth mid and small caps due to the messaging that large caps are reliable but slow in appreciating. Amid the unrealistic discounting of the mid-cap and small-cap indices, some stocks stand out. Trading at an attractive P/E of 20 based on trailing 12-month ended December 2017 earnings compared with the hefty valuations of the BSE Mid-cap index, this particular scrip reported CAGR of 24% in sales and 28% in profit after tax in the five years till FY 2017. The dividends in the range of 7% and 10%, with FY 2017 seeing no payout, no doubt disappoint but are in line with a company undertaking expansion to grow: Rs 100 crore are being tapped from internal accruals for Rs 600-crore expansion to add a fifth plant. Importantly, finicky foreign institutional investors held a huge 39% stake. Mutual funds owned a reassuring 12% equity end March 2018.

External factors, too, are favorable. A scorching summer is set to be followed by a normal monsoon, thereby boosting the prospects of consumption-based sectors such as FMCG in which the company operates. Despite the alluring factors, there is a hitch. The auditor has refused to sign the accounts for FY 2018. In fact, the firm has quit, citing lack of access to material information. The dilemma for investors is if the halving of the stock price from its September 2017 peak following a 1:1 bonus issue opens a window to take a bite of the lucrative business of mango-flavored drinks or a warning to stay away due to a corporate governance issues.  Manpasand Beverages smashes all conventional theories of investing. Since debuting in the primary market, the reliance of the net debt-free company considering cash in hand is on equity for capital expenditure, indicating the confidence of the promoters in servicing the enhanced base. Yet, there were warning signs. Retail participation in the 40% over-subscription of the IPO was marginal.The shares listed nearly 11% below the offer price. Operating profit more than doubled in the year after listing but could expand only about 20% in the next year.  After mopping up Rs 422 crore in the run-up to listing in July 2015, a slightly higher amount was collected from institutional investors a couple of years later to set up bottling plants at two existing locations and another in a new geography.

As the outcome of the examination of the books by a new auditor is awaited, the episode triggers memory of another case of breach of trust. Welspun India, the largest supplier to the US and the second largest producer of towels and bed sheets in the world, has lost 60% of its market value since its high end March 2015 after a prominent US retailer, among the top five customers, terminated its relationship, accusing the company in August 2016 of wrongly selling Egyptian cotton bed sheets. Target refunded all customers who bought these sheets over two years. Walmart followed, though it did not cut off ties. Others such as Bed Bath & Beyond and JC Penney, too, launched probes. Two class-action suits have been filed. The bath and bed linen maker exports nearly all its produce, with the US comprising a major chunk, followed by Europe. Operating profit that had doubled in the previous three years rose about 12% in FY 2017. The 80% jump in other income seemed to have restricted the fall in the bottom line to half. Dividend plunged from 100% to a measly 3%. Though net profit crashed more than 40% in Q3 of FY 2018, institutional investors have not given up. FIIs controlled about 9% and mutual funds 6% stake end March 2018. The trailing 12-month negative return has disappeared since the past month. The consultancy firm hired to examine the issue is yet to submit its report. In the meantime investors are left to speculate if the market’s impatience to seek growth year after year prompts companies to seek shortcuts. Besides, the divergence in the due diligence between institutional investors and the auditors is a puzzle that needs to be solved.    

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