Evaluating Good and Bad Management Strategies

Oftentimes investors make the mistake of judging a company's management team on a subjective level and may be mesmerized by the CEO’s rhetoric filled with hopes and dreams of the future. But what really matters is management’s ability to create wealth for shareholders. If this ignored, investors might fall victim to some unpleasant returns. For example, let’s compare the levels of Economic Margin (Economic Profit) of Circuit City (CCTYQ.PK) and Best Buy (BBY)):

Clearly you can see that Circuit City’s Economic Margins were mostly negative through the last 10 years, so it was no surprise they recently filed for bankruptcy.

As we had previously discussed in, Has General Motors Earned a Bailout?, you can see a very similar trend between CC and GM.

We recently published the in-depth article, CEO Wealth Creators… and Destroyers, which ranks the best and worst CEOs. The list also contains those in between, so how do you begin evaluate those not at the top or the bottom?

How to Start Evaluating Management:

• Assess the company's Economic Margin.
• Evaluate the ability for a company to sustain historical levels of Economic Margin performance.
• Build out future cash flows to better evaluate expected future performance relative to its peer group.
• Look at investment prospects of firms and review how they are growing or shrinking their business.

Economic Margin:

Economic Margin (EM) EM = (Cash Flow - Capital Charge)/ Productive Capital. In simple terms, EM seeks to measure the ability for a company to make money in excess of a risk-adjusted cost of capital. A positive EM means a firm is earning a profit above its cost of capital while a negative EM indicates a firm is earning less than its cost of capital.

Why Economic Margin:

• Economic Margin is designed to correct accounting distortions and properly measure the true profitability a firm is earning.
• AFG’s Economic Margin methodology shows us that earnings are important but are not sufficient to properly measure a company’s operations.
• Economic Margins helps to analyze how well management teams run their business.

AFG Facts:

• AFG’s understanding of corporate performance and valuation has led it to grow its client base to over 200 institutional investment, consulting, and corporate firms around the globe, which directly manage over $300 billion U.S. equities.
• AFG’s methodology is applied to over 4,500 companies and has consistently helped professional money managers make better buy/hold/sell decisions and corporations to better understand how to improve their business operations.

Management Strategies, The Good and the Bad:

Review and Conclusions:

Microsoft (MSFT) Positive Management Strategy

• Many large companies find limited growth opportunities. MSFT has managed to grow its invested capital by 12.7% in the last fiscal year (ended June 30, 2008).
• Microsoft has managed to increase EMs since 2004 while amazingly improving them 70% in a short 4 year period.
• Less than 1% of firms are able to maintain EMs above 10% a year for 10 consecutive years. Microsoft is one of those firms.
• As seen on the chart below, MSFT has continued to grow its invested capital base while increasing its Economic Margin.
  

Review and Conclusions:

Colgate (CL) Positive Management Strategy

• Colgate has consistently maintained very high EMs.
• In the past, one of the major questions for CL is whether or not it could grow its profitable business. In fact, CL had underperformed the market from 1997-2006 (in part because their lack of growth opportunities).
• Over the last three years CL has grown its asset base by 3.5% in 2006, 5.2% in 2007, and 5.5% in the current year while maintaining a very high EM.
• As seen on the chart below, CL has continued to grow its invested capital base while increasing its Economic Margin.

Rite Aid (RAD) Poor Management Strategy

• Since 1999, Rite Aid has earned (on average) a negative Economic Margin, which means the firm has been unable to meet or exceed its cost of capital.
• RAD grew its asset base by 47% last year with forecast negative Economic Margins. Growing an unprofitable business is wealth destroying.
• RAD has grown its business 3 of the last 5 years while not earning a spread above its cost of capital. A clear wealth-destroying strategy.
• RAD should refocus its attention on the products that make its stores profitable while closing stores that have contributed to its history of negative EMs.
• As seen on the chart below, RAD has continued to grow its invested capital base while earning a negative Economic Margin.

Cree Incorporated (CREE) Poor Management Strategy

• CREE has went through the cycle of the Tech bubble and recovered, and now it is deploying capital at a time when it should be concentrating on its profitably.
• The last two years the firm has grown its asset base by greater than 10% while earning negative economic margins.
• As seen on the chart below, CREE has continued to grow its invested capital while earning a negative Economic Margin.

Appendix: Quality Management Strategies

TICKER: FLS

TICKER: ACN

TICKER: FOSL

TICKER: BKR

Appendix: Poor Management Strategies

TICKER: AVX

TICKER: LUV

Comments

[Dan Jacome:]

interesting, but somewhat backward looking -- is this not all priced into shares? What do we do now?

2008 Dec 15 09:44 AM

[feedback:]

"is this not all priced into shares?"

Not necessarily, that is why it is important to look at the forecasted change in the level of Economic Margin. Also, the market might be pricing in higher Economic Margins or lower Economic Margins. If you can identify what the market has priced in, it will help you make a better investment judgment

This seeking alpha article lightly covers your valuation question:

seekingalpha.com/artic...



On Dec 15 09:44 AM Dan Jacome wrote:

> interesting, but somewhat backward looking -- is this not all priced
> into shares? What do we do now?

2008 Dec 15 11:39 AM

[vbprogrammer:]

Since Cree has zero debt and $350 Million in the bank, how does this relate to the Economic Margin (EM) equation? Cree's does not borrow money, so it has none to repay. So the EM would be just the Cash Flow which Cree has had for many quarters. Am i missig something?

2008 Dec 15 01:19 PM

[feedback:]

EM = Operating Cash Flow - Capital Charge
----------------------...
Invested Capital

Here is a graphical representation of the Economic Margin:
www.economicmargin.com...

Below is a link to an independent article from CEO magazine that compares the Economic Margin to other Value Based Metrics. It’s definitely worth a read if this is something of interest to you.

www.chiefexecutive.net...

2008 Dec 15 01:46 PM

[Whodat?:]

And since when is Cree an IT company? Are you the same guy who published an article earlier this year about how Cree stinks in the memory chip space?? :-P

2008 Dec 15 08:20 PM

[sumosama:]

Good article. Stuggle with LUV. ONLY profitable airline. I would say that there are industries in which there are road blocks to good results (overcapacity, unforeseen changes - read: un hedged, ...) Still, LUV is best of class.

2008 Dec 16 12:29 PM