Lesson #18: Assessing Management Quality

Value Investing Masterclass - Safal NiveshakIn his 1989 letter to shareholders Warren Buffett wrote …

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.

Most of us overlook the human aspect of operating a business. Small investors like you and me, 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.

But we forget that in most cases, the future success of a business is directly tied to the quality of its people.

According to Buffett, 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.

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.

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.

You can’t put a numerical value to a company’s management. You can’t create any specific metric to measure its quality. The process of evaluating a management is not only very subjective but very qualitative in nature.

Most errors in assessing managers are made when you try to judge their character quickly (like how they have done in the recent past) or when you see only what you want to see (like how they have done during good days) and ignore flaws or warning signs.

Ideally, you want to understand how managers have operated in both difficult and favourable business environments.

One of the ways to do that is to start learning about a company’s management by gathering historical and current articles written about the top managers. These articles serve as a trail of evidence as to the past accomplishments of the management team, the type of people they are, and how they have dealt with different types of situations.

A search engine like Google and company annual reports serve as great media where you can learn about the management’s past, its business philosophy or how they operate the business.

Look for evidence in four basic areas – honesty, passion, transparency, and competence.

Now the question is – How would you judge these soft aspects of managements without knowing them in person? Here is a checklist that you must consider to assess these aspects.

1. How has the company performed – sales and profit growth – under the management over a 10-year period?
Good and stable growth implies good management. If done over a long period of time, say ten years, it shows the management’s ability to steer the company well through good and bad times.

2. How has the balance sheet been over these years?
Clean balance sheets, which are low on debt-to-equity, suggest managers are not willing to risk the business’s future by borrowing more than the business can digest. On the other hand, too much debt (D/E > 1x; and higher than industry peers) on a continuous basis is a sign of too much aggressiveness on the part of the management. Think of Suzlon, Reliance ADAG companies, and Tata Steel here.

3. How has been the management’s record in making capital allocation decisions?
Capital allocation is the manner in which the management team invests the excess free cash flows (FCF) that the business generates. It’s the management that decides when and where these excess FCF should be invested or distributed.
Now, there are five actions managers can take with excess FCF:

  1. Reinvest the capital back in the business – capex and working capital;
  2. Hold cash on the balance sheet;
  3. Pay dividends;
  4. Make acquisitions; and
  5. Buy back stock.

It is difficult to find CEOs who are both good at operating the business and at allocating capital. The main reason for this is that operating a business and allocating capital are two completely different skill sets; being proficient at one of these functions has no correlation to being competent with the other.

I suggest you read about Henry Singleton whom Buffett has called the “best capital allocator ever”.

You must also read Prof. Bakshi’s post on Ajay Piramal, and how the latter has been a great capital allocator over the past 20+ years.

4. For how long have the current managers been managing the business?
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.

5. How are senior managers compensated?
You can gain great insight into the character and motivation of managers by understanding how they are compensated. You want to understand if the compensation package rewards for long-term or short-term performance.

6. Is management behaving in ethical way?
Sometimes investors find themselves in a dilemma where the management is very competent in running the business but there are evidences of him being involved in unethical activities.  May be he’s just compromising for the sake of the business and his unethical conduct is not harming the shareholders.

Should you consider partnering with such a management?

Remember – A man who steals for you will steal from you. That should settle all doubts about this.

7. Are managers clear and consistent in their communications and actions with stakeholders?
You can know this while reading annual reports. They communicate things as they are and do not attempt to manipulate the information.

8. Is the CEO self-promoting?
You can identify these CEOs easily because they brag about their accomplishments and are often well-rehearsed, articulate, and enthusiastic. In other words, they focus on a great pitch. They also are usually:

  • Flamboyant.
  • Have lots of charisma.
  • Engage in aggressive salesmanship.
  • Tend to command the centre of attention.
  • Have an attitude that they are smarter than everybody else.

I’ve come across countless arguments over the past few years over the relevance of quality management when it comes to picking stocks.

“Managements don’t matter!” was the powerful argument that I heard in the heydays of the pre-2008 era when Ambani, Adani, and Dani (Asian Paints) were all seen as same. After all, stocks of all kinds of businesses, even with shaky management teams, were creating huge shareholder wealth.

Cut to 2014, and I’m sure you have found enough proof of what happens to companies who take minority investors for a ride.

In the long term, the stock market is like a weighing machine, which correctly weighs the quality of a company’s management and how it treats minority investors.

Clearly, you as a value investor must ensure that any company in which you acquire shares has a management that puts shareholder value above any superficial or selfish motives.

A good management is a factor in the computation of the intrinsic value of a company, although it may be harder to quantify than cash projections or profit forecasts.

Despite the difficulty of putting an exact figure on the value of management there is no doubt that it has a real value and the true value investor must take this into account. In addition to looking at the figures the potential investor must take a step back, read the annual report and look at statements from the management.

This is an integral part of the process of investing.

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