SATYAM Scandal (Fraud Case): How can we detect rogue company??

Are we in Recession? This has become the common question everyone asking last year. When the economy deteriorated faster than you can imagine, coupled together with credit crunch, more crack signs have appeared at the once so-called SUPERSTAR company.

Warren Buffett once says that: “It's only when the tide goes out that you learn who's been swimming naked!” This quote exactly point out the scenario we have right now.

Recently, there are more and more accounting fraud cases happen. It is getting sophisticated! The most notorious one is SATYAM. A very promising rising star, which provides software services to mostly US & Europe companys. No one has noticed or detected it, even the company is well covered by the analysts. Is this really the case?

I am very curious with it and decided to run an analysis on their earning quality. In here, I need to explain a bit about accounting method. There is 2 type of accounting methods: one is Cash Accounting and the other one is Accrual Accounting, which is widely used and applied by I GAAP & US GAAP. Accrual accounting has a lot of weakness and is subjected to manipulation. I can’t suggest a better way of accounting method. I left it to those smartest brains from I GAAP member.

First of all, we need to calculate out Net Operating Asset (NOA) for the past 6 years for comparison purpose.

Below is the equation I used inside the analysis:

NOA = (TOTAL ASSETS-TOTAL CASH)-(TOTAL LIABILITIES-TOTAL DEBTS)

SALES-CASH COLLECTED = INCREASE ACCOUNT RECEIVABLE + INCREASE DEFERRED REVENUE

The result is self shocking. The rule of thumbs for Accrual ratio is it should be not exceed 10%. The CF Accrual ratio constantly above 20% signals that the earning quality is poor! This means that most of the earning you see at income statement is based on accrual basis. There is no real cash $$ coming in!

Furthermore, Sales/Cash collected ratio is on uptrend. These signify that Satyam management has been using aggressive revenue recognition to push up their revenue growing rate.

All of the accounting data is collected from Satyam India GAAP statement. Some adjustments are needed to perform on the statement, as India GAAP is different than US GAAP. I also do the same analysis on Satyam US GAAP. However, what puzzled me is that Satyam website stop providing financial statement on US GAAP standard from 2006! I have to dig out the data from NYSE website (SEC filing). The result from US GAAP is the same. The accrual ratio is above 10% and sales over cash collected ratio was not constant. The delta is huge!

The conclusion is that this kind of bad investment decision can be avoided if we perform analysis on the business earning quality. This Satyam case also serves as a good example, whereby growing revenue and income does not necessary means the business is doing fine! The most recent example happen in M’sia is Transmile Group. They bloated the account receivable to increase their revenue.

Fundamental vs Technical Analysis (2th)

In this website, I would like to continue share out some of my investment knowledge. I will try to balance the contents, either from technical analysis method or value investing method in coming post.

In my opinion, value investing is the best for people who want to have a soundness sleep at night. All you need to do is to understand a business. I had layout the guidance for value investing in my previous post. If you are willing to work hard and dig more info from the business, and try to understand it, the chances for making a good profit are high!

The last thing you need is to be disciplined and have a cool mentality. “Fear is your friend, Euphoria is your enemy!” Warren Buffet clearly points out the differences from a good investor and a bad one! When the market is on uptrend move, it is best to avoid the most popular stock at the market. More often, all of this superstar end up in super-dust! I will layout a few of these market darlings in 2007 to 2008. For instant, KNM, Dialog, Petra, Muhibah, LCL in KLSE and Cosco, SC Global, Keppel Corp, China Oilfield, Raffles Education, China XLX, Hong Xing, in SGX. There are more of them and I can’t list out everyone. If you still hold on to all this stock, most likely your portfolio return now is –40% to -50% or even more!! All of the stocks I mentioned above are all well recommended for buying from the analyst previously.

I don’t want to say that all of the analysts are stupid! It is the best that you don’t follow blindly the advice from them. You have to go out and check on the business yourself.

In the coming post, I will discuss more in details on how to do a good trading without burning a hole on your pocket!

How to do well in Investment with Value Investing Method?

How does an ordinary investor can do well with value investing? First, you must understand the true meaning behind of buying a stock. It is not just holding on a paper, but it is a business that you are investing in. All you need to do is spend some time reading the annual report and understand the business.

Below is guidance on how to make a good investment:

i. Business Growing Potential:
How fast is the business growing? Is it sustainable? You have to find out the answer and check out whether the story is true. A simple rule of thumb of at least 15% annual growth rate is a good investment. However, you have to be cautious with business that is growing at more than 30% annually. There are not many company are able to maintain that kind of growth rate!

ii. Return on Shareholder Equity (ROE)
How to calculate ROE? Take the year net income and divided by average of 2 years shareholder equity. ROE is used as a measure of how fast the business returns to existing shareholder equity. An average ROE of above 15% is a good business, but you have to look carefully into the company balance sheet and understand why the business can command such a high ROE. Some of companies are able to maintain high ROE by constantly paying out 60% to 90% of net income as dividend. As a result, the shareholder equity is increasing at very slow rate and the net income is not increasing faster either. Therefore, ROE will be able to maintain at previous rate, as long as net income is not decreasing! This scenario happens to most of the cash cow company where the business is at mature stage and the growth is very slow. There is another scenario where business is taking excess leverage to maintain the ROE. In this case, you might want to check out the debt level of the business. Are they increasing over the year? Most of the property & commodity business is growing by leverage.
The best case is having a high ROE by maintaining high net margin with less leverage.

iii. Pricing Power
A business which can control the selling price without facing deteriorating demand is a fantastic business to invest in. For example, food, beverage & glove maker business is a fantastic business to invest in, as the demand is in-elastic. Both of them are able to pass on extra cost due to inflation without slowing down the demand. There is many more business like this. You may be had noticed that if you are shopping in NTUC or any retail mart. Most of them are boring business but it is essential of human daily living!

iv. Superior Management
You might want to know who is running the business. A good management team is definitely a plus. There are many ways to check. First, read on the annual report and understand what are the messages from CEO and Chairman are trying to deliver. Are the messages very fancy or more like prepared speech by PR? You might want to look out for a decent tone. A good management team will try to feed more info of the business, rather than trying to hide some details from investor. Second, you also can check with the company employee and dig more info from them. In this case, you might want to talk to the manager, as they have more info on company policy and management capability. The last thing you can do is attend the annual general meeting and talk to the management yourself.

v. Strong Corporate Finance
Good company always comes with strong corporate finance policy. A chairman should be an independent candidate and have strong background of related business experience. An audit and remuneration committee should not have any of the executive directors inside! ESOS (Employee Share Option Share) is a way to reward the hardworking employee. However, excess issuing of ESOS with low exercise price is a disaster! This will dilute the existing shareholder value. The rule of thumb is ESOS should not more than 1% of existing common share.