DLF Fraud: One Big Lesson for Investors

Warren Buffett wrote this in his 1989 letter to shareholders…

Stick to proven management with a lot of integrity, talent and passion. After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.

Sadly, 25 years after Buffett first said this and after his countless repetitions of this thought, investors continue to deal with managements that lack integrity, and have talent and passion not in conducting their business affairs honestly but in looting other stakeholders.

The latest case is that of India’s leading (if size matters here) real estate company, DLF, which has sent its customers and investors into a tizzy. This is after the stock market regulator SEBI barred it from raising money from the capital market for three years.

So, home buyers who have invested in DLF projects are worried because they fear the projects that have already been delayed may be pushed back further or even get stalled due to lack of funds with the company.

As for investors (or let me say speculators, who were playing with fire), they have already lost a bucket-load of money in the company’s stock. The stock is down 55% in just the past four months, and 90% down from its post-IPO highs in January 2008.

Now, individual investors own just 4% of DLF currently, and thus I’m sure most people reading this may have not lost money in the stock. But then, what about other similar businesses like Unitech and Suzlon, where small investors own over 15% and 21% respectively?

What makes more small investors buy such businesses and not well-performing ones like TCS, where they own just 3%, or Asian Paints (13%), or Pidilite (9%)?

Of course, valuation is one issue given that this latter class has been trading at reasonably high valuations for quite some time now. But it’s sad to know that most of us often forget the importance of avoiding gruesome businesses and their managers, however ‘attractive’ they may be trading.

Now, I am not going to talk about the quality of business in this post, for I have already written about it several times in the past, like here.

What I want to talk today is about the importance that investors must lay on management quality, and what Warren Buffett has said on this subject for years and years in the past.

Of Greedy Managers and Losing Shareholders
One of the most pervasive themes that Warren Buffett has dealt with in his annual letters over the years has been the relationship between corporate managers and shareholders, i.e., between the stewards of capital and its owners.

In case you have some doubts, the managers are the stewards of capital and you, by virtue of your shareholding in a company, are the owner.

This is what Buffett wrote in his 2002 letter to shareholders, while discussing the subject of corporate governance…

Both the ability and fidelity of managers have long needed monitoring. Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking (Luke 16:2) approvingly of “a certain rich man” who told his manager, “Give an account of thy stewardship; for thou mayest no longer be steward.”

Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ’90s, as a result, CEOs who traveled the high road did not encounter heavy traffic.

Most CEOs, it should be noted, are men and women you would be happy to have as trustees for your children’s assets or as next-door neighbors. Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements.

These otherwise decent people simply followed the career path of Mae West: “I was Snow White but I drifted.”

In the same letter, he added…

CEOs must embrace stewardship as a way of life and treat their owners as partners, not patsies. It’s time for CEOs to walk the walk.

Now, given the way countless CEOs and their teams have treated minority investors in the past, Buffett’s advice has surely lost its way in the corporate circles.

Like in DLF’s case, it took SEBI almost seven long years to understand that the management “misled and defrauded” investors while raising money in its IPO in 2007.

We can obviously ignore that some of the company’s advisors during the IPO included reputed brands like Kotak, DSP Merrill Lynch, Lehman Brothers, Citigroup, Deutsche Equities, ICICI Securities, and UBS Securities.

After all, it’s not the job of a banker or an investment banker to advice you on the risks to his advice. His work starts and ends with his fat incentives.

This also holds true of the CEOs and their cohorts of talented MBAs and CAs, whose information disclosures are aimed at getting the best credit ratings and the lowest interest rates for their companies, shareholders be damned!

Anyways, Buffett wrote this in 1994…

The people who make the decisions should be accountable for the consequences and face both the downside as well as the upside.

In our book, alignment means being a partner in both direction, not just on the upside. Many “alignment” plans flunk this basic test, being artful forms of “heads I win, tails you lose.”

Assessing Management Quality
In the original version of The Intelligent Investor, Ben Graham began his discussion of a chapter on “The Investor as Business Owner” by pointing out that, in theory…

…the stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will.

But he changed this part in the subsequent editions of the book. In practice, says Graham…

…the shareholders are a complete washout. As a class they show neither intelligence nor alertness. They vote in sheeplike fashion for whatever the management recommends and no matter how poor the management’s record of accomplishment may be.

The only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him.

Well, this is a fact that is true for not just American shareholders, but all shareholders.

Most of us overlook the human aspect of operating a business. This is despite the fact that, in most cases, the future success of a business is directly tied to the quality of its people.

Instead of focusing on management, most investors would spend their time determining whether a business has a competitive advantage or moat, or if it is trading at a low valuation, because they believe that products or operational strengths are what set the most successful organizations apart.

The truth is that, over time, these advantages can be imitated, and if the talented managers who created these advantages leave the business, then the business will struggle to continue to innovate and create value.

Thus, I am not surprised when legends like Warren Buffett and Charlie Munger lay great emphasis on well managed enterprises and form an opinion of the management of any company before buying a stake in it.

Now you may wonder – “But how do I check for management quality, especially when it cannot be put into numbers?”

In his 2002 letter, Buffett suggested three management quality checks for investors…

First, beware of companies displaying weak accounting. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.

Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.

The case of DLF and several other such companies may not always be of making up numbers. In fact, the numbers here have clearly shown for years how these companies are meant to be destroyers of wealth.

Despite this, it’s tough to understand what makes investors lap up these stocks knowing well in advance that they can lose their capital permanently.

Please remember that in the stock market…

• Whatever can be sold will be sold, and
• What seems to be too good to be true often is.

Richard Feynman, the celebrated American physicist and a great teacher, said…

The first principle is that you must not fool yourself and you are the easiest person to fool.

One key lesson from the DLF fiasco for you is to remember this above quote. You are easiest person to fool, and the CEOs, investment bankers, and stock brokers know this for a fact.

Of course, cases like DLF pull a lot of investors out of the market as they are not sure whether they can wade through this jungle of fear and greed.

But if you are willing not to get fooled, you can have a great future as a stock market investor.

Here’s a final word from Buffett from his 1985 letter…

Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: “All I want to know is where I’m going to die so I’ll never go there.”

Cases like DLF are constant reminders to you that your first job as an investor is to avoid businesses that can kill your wealth – simply say ‘no’ to them – and then try to gain insights on the ones that can help you compound your wealth over the next 10-20 years.