The comfort of ownership : Alignment and Incentives

At Itus Capital, one of the key metrics we look for when we make an investment in our portfolio companies is the alignment of ownership. Historically, it has been important for us as a firm, to invest in companies where the promoter holding has been going up or atleast steady (we prefer avoiding companies, where promoters have been selling their stakes – the reasons could be valid and just).

It’s important that when one comes up with basic checks and balances for investing, he/she must understand the pitfalls of the same. As we have said before in the past, while there are no rule books for investing that one can follow to the ‘T’ and achieve success, what one hopes to achieve through checklists, are a broad framework/guidelines, that one sticks to as a process.

As with any checklist, we have been both rewarded and hurt with the above: where we have had guidelines looking for incentives alignment with the promoter. To the reader, it may be surprising as to under what scenario/s can the promoter/owner of businesses have a high ownership and continue to destroy shareholder value. The objective of this note is to discuss and highlight one such scenario.

When economic times are tough, and bonuses are tied to financial performance (which most of the time is a good thing), there’s a strong incentive for the managers of any business to aggressively recognize revenue. End of the day, when the value of your equity is being measured by the broader public on a quarterly basis, who does not cheer an aggressive growth number?

In order to check this metric and to be falsely lured into buying such businesses, I believe there’s a quick way to cross-check. Aggressive revenue recognition nearly always gives rise to an associated increase in accounts receivable and work in progess. We should be able to see any such movements in the Tangible Net Assets/Net Revenue metric. A reduction in the metric alongside growth in topline is a  comforting measure for every investor to look at.

Do remember, while there are no shortcuts/rules that are foolproof in investing, it’s a framework that we look for, which we constantly look to improve upon, to minimize the errors in our portfolio.

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