Corruption & Investing: The many shades of grey

 Does the corruption we see around us matter to us in any way whilst chasing an investment strategy? Assuming that everyone is corrupt, in principle, it just boils down to understanding the degree. It is merely a relative measure. If we use absolute measures, believe me, it is unlikely that any entity will be able to withstand scrutiny. Take the simple act of keeping money in a bank. We know there are bad loans and there is dishonesty in the banking sector. Do we, therefore, keep our money under the pillow? We live in the faith that banks will be bailed out by the government, with taxpayers’ money, time and again.

If we accept that corruption is a part of doing business, as a given, how does it impact our investment choices? 

Corruption matters to the extent that, in most companies, the risk of getting caught in a scandal that increases with each passing day. However, historically, it has also been evident that companies that get caught (by companies I also mean promoters) continue to thrive in business. As a society, we are inured to corruption and tend to see it as a part of daily life. The affliction and scandals have not spared anyone—regulators, investors, managements or intermediaries. Investments and stock markets continue regardless, pushed by a spectrum of need that stretches up to greed.

Let us try and break down corruption into segments, so that we can learn to tackle it. Most crimes would fall into two buckets.|

The first level of corruption, to avoid, is where the management plays foul with shareholders. This could be by ‘window dressing’ of accounts, siphoning off money from purchases & sales, overstating fixed asset costs, charging personal expenditure to the company and a few other ways. It is possible to cook each and every line and create a story. The difficulty is in spotting such companies early on. Most probably, this will be in the small- to mid-cap segments, as promoters try and build a story that will enable them to tap capital markets and obtain private equity. One way to check this is to scrutinise the cash flow, watch for ballooning current assets, low depreciation, low taxes and no dividends. A combination of these should ring bells. I will not bother to look at names of audit firms since even the biggest and holiest of them have been involved in accounting scandals.

The second category is common and afflicts all companies—stealing money. Any businessman, who starts small, enhances his lifestyle beyond what the legal sources indicate. S/he may also create sources that feed off a company where others are involved. It is so rampant that many have become ‘accepted’ practices and no one considers it as a transgression. For example, many things enumerated as ‘staff welfare’, ‘conferences’, ‘gifts’, ‘travel’, etc, are taken for granted. These are now clubbed under ‘perks’ and have graduated to the level of moral acceptability. On the other hand, there would be robbery by taking cuts on purchases, writing off bad debts, inflating expenses (revenue and capital), taking kickbacks and so on. This variety of corruption generally would exist in most companies. Whilst they do dilute non-promoter earnings, they are difficult to measure or quantify. One cannot ignore companies because of this corruption. If you do so, you may have less than half a dozen companies worth investing in.

When the promoter and/ or the management steals and dilutes earnings, in effect, it gets reflected in the valuation. Valuation adjusts in the faith that the fundamental business is profitable and what we see is what we pay for. In an accounting fraud, it is just like believing a fairy tale. It’s only when we grow up that we learn to disbelieve Santa Claus. The other problem with accounting frauds is that they take very long to get exposed, since the analyst community is generally not very keen to focus on wrongdoings committed by such corporates. They passively contribute to the problem by maintaining silence.

Corporate corruption is decades old. From the time companies paid bribes for getting industrial licences to fighting a ridiculously low ceiling of Rs3,000 per month as managerial remuneration, promoters had to dirty their hands. The problem is that it is no longer a habit but a culture. There is no distinction between a public sector undertaking or a private company. Neither is there any distinction between Indian and multinational companies. It is just different shades of grey.

Some sectors are more prone to corruption—real estate, construction, capital goods, etc. Banking and finance is another sector where action is rare, but when it happens, it can be severe, to the extent of closing down a business or industry.  These are high-risk sectors for investment in today’s environment of activism and the RTI (Right to Information). Today, the investment catalysts are the FIIs (foreign financial institutions). Some of them can take a holy stand of ‘governance’ issue and not invest in a company (not that it has happened so far in India). Neither government action nor judicial action is a cause for concern, because our regulators treat white collar crimes very leniently.

Today, there are many empires which would not have been created if ‘grease’ were not the prime mover. We have to accept the fact that we rank low on governance and that corruption extends to every walk of our life. If we take any investment manager, s/he is, typically, forced to invest in a majority of index stocks. And, to the best of my knowledge, governance or corruption issues are not a criterion for inclusion or exclusion of a company from the indices.

Honesty, integrity, governance, etc, are good for lectures and seminars. In real life, they exist in different shades of grey across businesses and professions. Investment choices may vanish, if you use the filter of absolute integrity. Instead, use a sieve of different grades. Fraud lurks at every corner, but the corporate and financial world has survived it all with the help of friendly regulators and persuasive businessmen.

If we go back to a not very distant past, we had instances of wrongdoing in companies like LIC Housing Finance or Satyam Computers. Banks are in the limelight each day for handing out loans that will not be repaid. They still exist and find investors, institutional and retail. All our scriptures talk about ‘forgiveness’ being a divine quality. So let us all chase some divinity.

Trust is something that is fictional, when it comes to investments. It is all a question of willingness and ability. Willingness can be judged by past actions or by some background check. To find out about ability, it takes a lot of expertise and experience. In any investment, go with eyes wide open to detect a fraud lurking round the corner that could adversely impact investment. So keep your nest egg in domains where there is absolute certainty about compulsions to honour obligations (deposits with PSU banks, government bonds, provident fund accounts, etc, or physical gold). On all other investments, live with a fear that there is always a possibility of getting cheated.

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