The importance of Management in stock picking

By Morningstar Analysts |  18-06-18 | 
 

Most investment research focuses on the quality of business operations, competitive position, returns on equity, earnings growth, and so on. And rightly so. However, the attention paid to the quality of the people running the business is often underestimated.

While management itself cannot constitute an economic moat, management’s capital-allocation decisions can lead to the establishment, enhancement, or erosion of an economic moat.

Put another way, it is good to comprehend the intersection of management and moat with the company being researched.

Warren Buffett has often spoken about the importance of evaluating the people who run the business.

Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value.

One of the most important things a Chief Executive Officer does is to allocate capital. In other words, how he invests money, either retained earnings or fresh capital.

Buffett wisely noted that few CEOs are trained for capital allocation because they rose through other streams in the business such as operations or sales. So when they grab the top job, they are “like a concert pianist arriving at Carnegie Hall – only to be handed a violin.” Often, CEOs who are inexperienced in the field of capital allocation will rely on so-called “experts”. 

It's hard to over emphasise the importance of who is CEO of a company.  

While everyone who is familiar with Buffett is aware of the moat-investing style. But Buffett went a step further and explained that you need two things--a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle.

Inc.com recently did a post on the four CEOs Buffett is impressed with; Jeff Bezos (Amazon), Wang Chuanfu (BYD), Mark Donegan (Precision Castparts) and Tim Cook (Apple).

I look for companies that have able and trustworthy management.

In The Warren Buffett Way, author Robert Hagstrom, Jr. reviewed Buffett’s past investment decisions and came up with a kind of checklist that Buffett uses when looking for companies in which to invest. Divided into four categories (business tenets, management tenets, financial tenets, market tenets), we shall look at management tenets.

  • Is management sensible, especially in allocating earnings retained in the business versus returning it to the shareholders by way of dividends or share purchases?
  • Is management candid with the shareholders in their reporting?
  • Is the management group resistant to the “institutional imperative”?

Buffett sees the “institutional imperative” as a big impediment to business success. It is the tendency of company executives to imitate the decisions and behaviour of other managers, no matter how irrational they may be.

In the 1989 Berkshire Hathaway Annual Report, Buffett said that the institutional imperative exists when: “(i) an institution resists any change in its current direction; (ii) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (iii) any business cravings of the leader, however foolish, will quickly be supported by detailed rate of return and strategic studies prepared by his troops; and (iv) the behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be meticulously imitated.”

Burgundy Asset Management in its recent publication A quarter century of investing, emphasized that there is no doubt that the capability of the senior management is perhaps the most important variable in the success of a business enterprise. As a result, management is ultimately critical in how the shares of a company perform over the long run.

Yet assessing management is extremely difficult for someone who isn’t really on the inside of an enterprise. Any attempt to assess management of companies is one of the most important, yet most certainly the least scientific part of the investment research process!

Here is what they suggest:

  • Invest in companies in which you have confidence in the management with respect to their honesty and competence.
  • Examine in particular their capital allocation actions – when to pay out and when to retain.
  • Seek out managements that stress share price performance and return on shareholder’s equity (ROE), rather than the absolute size of the company (many large companies fall into this trap of size versus per share progress).

Ian Cassel in this post, explains why management and boards who own large pieces of the business make better long-term decisions.

Why? i) Because he wants to see significant skin in the game. ii) He does not want to invest in a business whose management doesn’t have to live with the consequences of their decisions. 

I like to see the management and board owning at least 20% of the business. I prefer to see a significant portion of the CEO’s net worth in the company’s stock. It’s even better if he or she purchased their entire position (i.e. it wasn’t given to them in the form of options or RSU’s).

Find and invest in owner management, not caretaker management – leaders that have large ownership positions, low salaries, and that are frugal.

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