Two broad concepts I wanted to share that I have found useful in thinking about these things:
Concept #1: Know the type of error you will be comfortable with.
Statisticians have a very useful concept of errors called Type 1 error and Type 2 error. It basically means you either err on the side of caution or on the side of aggression; a false negative or a false positive. Let us say you are not so sure about, after all analysis, whether management mis-appropriates funds that is generally expected to be minority shareholders’. You either drop the firm however cheap it may be or you go ahead with putting it in the consideration set. Now if it turns out that you dropped them and management was really “clean” then you have made a Type 1 error. If you give a green signal and you find they are mis-appropriating, then you are committing Type 2 error. Maybe you can ask yourself if you are OK with Type 1 error or Type 2 error. As for myself, in areas of integrity towards minority shareholders, I err on the side of extreme caution (or at least tell myself so ) however cheap the stock maybe.
Concept #2: Promoters’ may be divided into 3 groups based on their “ethical nature”. - this concept is raw in my mind but I find it useful to apply.
I find there are really 3 groups of people.
Group #1 are those who will wilfully violate the law irrespective of enforcement. They will not let law come in the way of their desires or ambitions. If an employee comes and tells them that this will violate this rule, the promoter will say, where is your value-add for the salary you take?
Group #2 are those who will violate the law depending how strongly or lightly it is enforced. To give you an idea recall many years ago a lot of employees were sacked at Intel in Bangalore because they ‘fudged their LTC’. Now when I was an employee in a company considered highly ethical (about 22 years ago) I was just told to fill it up to get maximum tax benefit irrespective of whether I took a holiday or not. The general thinking was this is strictly incorrect, but who looks. But once enforcement increases or at least the threat of enforcement, compliance goes up. So the moment Related Party Transactions need to be disclosed, Group #2 promoter will call up his finance guy and ask him how to manage while complying.
Group #3 are those who do not need any law to make them ethical. They are by nature ethical and actively ‘seek to know their duties and obligations’. They certainly err on the side of caution while interpreting the law in spirit and comply irrespective of costs. The real good news is that many such people exist, irrespective of whether they are rich or poor. An extract from a letter by Abraham Lincoln to his son’s teacher captures this well: “…But teach him also that for every scoundrel there is a hero, that for every crooked politician, there is a dedicated leader.” The bad news is that they may be running really poor businesses!
In my own assessment or rather theory, bulk of Indian promoters are in Group #2, some are in Group #1 and some in Group #3. In my view Group #3 is slimmer than Group #1. And more often than not our first impression of these promoters of which group they fall in turns out to be true.