Wednesday, December 30, 2009

Capital Prudence

One gauge for management which is often overlooked is how they manage the firm’s capital. Do they see the firm’s equity and cash on its balance sheet as valuable resources that belong to the shareholders and think twice about doing funny things with them? Well most management will do funny things when given the chance.


We look at 4 aspects of what crappy management will do:

1. Dilution

Most management couldn’t care less about diluting shareholders’ stake bcos they get the much coveted capital to cover up their mistakes. In Singapore, dumb retail investors actually rejoice when management wants to do rights issue: bcos they can get more shares at a cheaper price! The irony!
When management comes cap in hand to shareholders for money, multiple times in a span of a few years, run for the trees! This is one of the most unforgivable management mistakes.

2. Aggressive Capex

Beware of management that always announce huge expansion projects in the name of growth. Especially, when they are done at the top of the cycle. Most of these projects will not recoup its capital fast enough ie ROI is very low, like maybe 3% (ie 33 years to recoup the investment).

A good management should always be prudent with capex, expanding slowing at a regular pace and keeping expansion cost low.

3. M&A

This is a double edge sword. Some management are very good at M&A and can actually help to grow the company through M&A, however the fact is 70% of all M&A fails (ie 1+1 less than 2). If the management is always looking to do M&A, esp in unrelated fields, beware!

4. Cash Hoarding

Some great companies have such beautiful business models that the companies just overflow with cash as time goes by. You see companies with cash to market cap of 30-50% bcos the business just keeps churning money!

The management mistake then becomes how they keep hoarding the cash and not putting it into good use: like giving back to shareholders. Most management would say that they need the cash for expansion ie doing 2 or 3 stated above. Which destroys shareholders’ value.

Buffett sometimes just buy over the whole firm and dictate that whatever cash that is generated goes to the parent co: Berkshire Hathaway. This is the ultimate trick!
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