In the original version of his book 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. In his 1989 letter to shareholders Warren Buffett said:
“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.”
Buffett and Munger, for instance, are mostly interested in acquiring majority shareholdings (with certain exceptions) and understandably need to have confidence in the management of a business that they own.
However, most small investors who normally acquire a very small (almost negligible) shareholding in percentage terms, often think that in this situation the quality of the management is not so relevant.
“All I need to consider,” people tell me often, “…is the price paid for the share in relation to its intrinsic value. Why should I care about the quality of management till the business is doing fine and stock price is rising?”
Well, Buffett would strongly disagree on the above remark. In his opinion, assessing the quality of management is of utmost importance in making a decision on either acquiring a controlling shareholding or making a minority investment in a business.
What is more, this assessment (of management competence) should be done before acquiring the shares in a business and not after the money has been committed. If the management is not considered to be of sufficient quality to take the company forward in the right direction the investment should not be carried out.
Of course, in the long run, the quality and underlying economics of a business holds a greater relevance than the quality of management, still you won’t want to be a part-owner of an enterprise that is run by incompetent and/or unethical people.
It’s important for you, as an investor, to looks for a management that keeps in mind your concerns as a shareholder, because when you buy a share of a company’s stock, you also become a part-owner of the business, however small your shareholding.
What Thomas Phelps said in his outstanding book 100 to 1 in The Stock Market, aptly captures the theme here:
“A man who will steal for you will eventually steal from you.”
And Buffett adds his flavour of simplicity to the above statement:
“You can never do a good deal with a bad person.”
To appreciate how essential sound management is to the long term success of a business, consider that top managers typically:
• Are responsible for designing the business;
• Determine the future growth rate of a business;
• Are in charge of choosing the right people and providing the right environment for these people to perform at their highest potential; and
• Determine how to allocate the firm’s capital.
Knowing the type of management team you are partnering with will help you forecast the future of the business, because the most logical predictor for the future success of a business is its management. A business does not need to have every manager be a star, but at the very least, the managers in key positions need to be stars. Give yourself plenty of time to understand the quality of the management team running a business.
How to Assess Management Quality?
Michael Shearn, in his brilliant book The Investment Checklist, writes that it is important to classify the type of manager you are partnering with at a business. This way, you will be in a better position to gauge potential execution risk. If you are investing in a manager who has a long track record (i.e., more than 10 years) of successfully managing a business, the odds that he or she will continue to manage the business successfully are in your favour.
On the other hand, if you are investing in a new management team that has limited experience serving the customer base of the business, the odds are not in your favour.
Here is a simple classification system Shearn shares in his book –
• OO – Owner- operator, typically the founder of a business.
• LT – Long- tenured manager or one who has worked in the industry for at least 3 to 10 years.
• HH – Hired hand, a manager who has limited experience serving the customer base of the business and has worked at the business for less than three years.
He further classifies OO type managers as –
Owner-Operator 1 (OO1) – These are the ideal managers to partner with in a business. An owner-operator is a manager who has genuine passion for their particular business and is typically the founder of that business, for example –
• Sam Walton, founder of Wal-Mart
• Warren Buffett, CEO of Berkshire Hathaway
Shearn writes that founders of most family-controlled businesses would also fall in this category.
These passionate leaders run the business for key stakeholders such as customers, employees, and shareholders alike, instead of emphasizing one constituency over the other.
They typically are paid modestly and have high ownership interests in the business. For example, according to the Berkshire Hathaway 2010 proxy statement, Warren Buffett earns US$ 100,000 in salary and directly owns 37% of the stock. These managers take a long-term perspective when making business decisions and identify their personal success with the survival and growth of their businesses. Much like a parent who will do anything to save a critically ill child,these CEOs will go to great lengths to ensure the survival of their businesses.
Owner-Operator 2 (OO2) – This is an owner-operator who is passionate about running the business but is in between the two extremes of being completely stakeholder oriented and operating the business for his or her own personal benefit. These managers typically receive higher compensation packages than OO1 managers.
For example, Leslie Wexner, founder of the Limited Brands (owner of Victoria’s Secret), earned more than $10 million in total cash compensation in 2009, and he owns 17.7 percent of the business.
Owner- Operator 3 (OO3) – These managers are owner-operators who are passionate about the business but primarily run the business for their own benefit. They do not take shareholder interests into consideration and will often siphon off profits to themselves through egregiously large compensation packages. You can usually identify these types of managers by viewing the Related-Party-Transaction section found in the company’s proxy statement, where you might find such items as personal use of company aircraft, estate planning, personal or home security, and real estate that is owned by the CEO and then leased to the business.
For example, in one business, the company’s founder received a loan from the business that bore an interest rate of 1 percent over prime to buy a personal aircraft. Another CEO was reimbursed more than US$ 2.6 million a year for security expenses. Both CEOs of these firms could easily afford to pay for these luxuries out of their own pockets, but they used the company to pay for them. You should be careful investing in companies with these types of CEOs because they typically fail to create a lot of value for shareholders over long periods.
Is the Manager a Lion or Hyena?
Another simple way to categorize management is to classify management teams as either lions or hyenas. This idea was created by Seng Hock Tan, CEO of Aegis Group of Companies, a Singapore based investment management organization, who came up with this classification while watching a Discovery channel program about lions and hyenas.
As he learned about how lions and hyenas interact in the wild, he felt that their behavior was very similar to that displayed by managers.
As he watched the program, he learned both are super predators and are often in direct competition with one another. However, here’s the difference between the two. Lions typically hunt together in a group (called a pride), so that they can go after bigger game, which means more food for everybody.
Instead of having a single dominant leader, as is commonly believed, males have equal status, as do females. In contrast, hyenas group together only when hunting is easy: After an easy kill, they disband. On their own again, they go back to scavenging carcasses. Status is extremely important to hyenas, with a higher rank netting more respect within the troop. They do not build a team under them except when it immediately benefits them, and loyalty is weak.
If a hyena becomes wounded or weak, the troop abandons that hyena. Interestingly, the hyena recognizes the lion’s status: As the hyena’s only natural predator, the lion commands the hyena’s respect. Tan applied these differences in the animal world to management styles.
Tan goes on further to explain that a lion manager is able to build the infrastructure for a 100-story skyscraper, whereas a hyena manager can construct only a five-story building because it can be done in less time: Investing and building a long-term infrastructure taxes the nature of the hyena.
For example, investing in a team and sustainable infrastructure takes a lot of time, which a hyena manager does not have the patience to do. The hyena continually enriches himself by repeating the short cycle of building and selling five-story buildings. Hyena managers never build the more valuable 100-story building that lasts longer than a five-story building. Steve Jobs is a great example of Lion manager whereas Vijay Mallya could be called as Hyena manager.
Sometimes, even if you find that the management is competent and very ethical but you may not feel comfortable with the business. Perhaps the business isn’t in your circle of competence. It may still be worth keeping abreast with what the management is doing. Why? Cara Goldenberg, from Permian Investment Partners, says –
If you follow brilliant management teams, it will lead you to brilliant investment ideas. It’s pattern recognition.
Investing your time and energy (even the involvement is indirect) with first class people is a brilliant way to ensure success.
Today, you may not hold the Berkshire stock or get a chance to partner with Buffett but you will still benefit immensely if you keep an eye on what he is doing and saying.
I hope you would realize that assessing management quality is not an easy job but if you keep at it you will develop a knack to identify the right managers.
It’s an art and takes time to learn but has huge payoffs.