Why Investors Should Have a Healthy Distrust of Management

Source: Flickr by marcopako

A few happenings with CEOs had me thinking. Valuing management in the investment decision is important as management has a lot though not ultimate influence over the success or failure of a business. Thus much attention needs to be given to who is at the helm of the businesses in which an investor has placed his money.

Some stories that caught my attention over the past couple of days:

• Wednesday, Apple Computer (AAPL) founder and CEO, Steve Jobs, announced he would be taking a leave from the CEO post due to pre-existing health issues that suddenly became more serious than he had originally thought they were. The stock had to be halted in trading for a time and ultimately dropped from $85 to $81 on Thursday. Prior to this Jobs and Apple had insisted he was in perfect health.
• Late last year, Ken Lewis, CEO of Bank of America (BAC) offered to buy Merrill Lynch and insisted his bank was financially stable. According to the Wall Street Journal, Lewis was simultaneously negotiating $20 billion in TARP funds with the Treasury department.
• American Eagle Outfitters (AEO) had a conference last week in which CEO Jim O’Donnell assured investors the company was well positioned for the coming future despite the tough holiday season. About a year ago, O’Donnell said he did not think we were in a consumer led recession.

Candor is among the rarest of traits amongst people and CEOs and management of large corporations are no exception. Sometimes it is simply not being forthright. Other times it is outright lying. Even the most sophisticated of investors can succumb placing more trust in the CEO than they ever should. I can recall an article in which managers of mutual fund company Janus had to explain why the firm as a whole owned over 40 million shares of Enron even as the company filed for bankruptcy. Their answer essentially came down to they believed the pack of lies Enron management told them.

Bottom line is that while an investor should assess management, everything management says should be verified in the numbers. If management’s words do not show up in performance of the company, then their words are meaningless. And if management cannot be honest about its CEO’s health, or deals they are negotiating, or is eternally optimistic despite the evidence of a tough market, then they should be viewed with even greater skepticism.

Disclosure: I and the clients of Brick Financial Management owned shares of American Eagle at the time of this writing. But positions can change at any time.

Comments

[skipaq:]

Quote: "Prior to this Jobs and Apple had insisted he was in perfect health."

I don't believe this statement is true. It was known before this that Jobs was under treatment for an ongoing digestive problem. His weight loss was well noted by Apple and the press. Hardly what one would call perfect health. It has also been pointed out many times that the health of Apple's CEO has been factored into the price of their stock.

While it would be foolish to invest in a company based solely on the CEO; there has to be some level of trust in the management. The question really is this: Can you trust the management at Apple to run this company and continue to produce? This article provides little in the way of giving an answer.

As far as Apple's answer to that question is concern the investor should look at their past performance and the management that produce it. If that management remains intact then one should have some level of trust. There are risks. This would be true even if Steve Jobs was in perfect health.

Jan 18 09:31 AM

[mollytjm:]

it's important to look at how secure the company is and how innovative, when it's a tech company. apple is more secure than almost any company on earth and also more innovative...the people who innovate are ALL still there.
Jobs always said his surgery caused problems with digestion and getting nutrients into the system. but he made the company well able to prosper without him, thankfully! All CEO's should be this good!!!

Jan 18 09:54 AM

[2bitRick:]

With all due respect your article is full of BULL CRAP when commenting on the health of Steve Jobs.
As previously stated it has never being claimed that he was in "perfect health".
Is it just possible that he and his doctors did not fully understand his condition? Is it not possible that it has taken this amount of time for the doctor's investigations to determine the cause of his loss of weight?
and
Is it not possible that being human just like you and I, it has taken this amount of time for Steve to fully accept that he needs to take some time off to care for himself and to trust that the team he has built is quite capable of carrying on?
What is it about the American culture that has to find a conspiracy in every action?
To all the so called analyists, LET GO OF IT

Jan 18 11:27 AM

[DonSuper:]

I dont think these are particularly good examples. As pointed out, there was some disclosure with respect to Jobs health. Also, in the case of BAC, maybe they were foolish with the MER acquisition, but not dishonest. They seeked help in december, much later than when the acquisition was announced, not at the same time as the article says. And it was prudent from management to try to cancel the acquisition given that conditions got much worse in the last months of 2008. The government didnt want BAC to cancel the acquisition, that is why they are offering the guarantee.

Jan 18 12:07 PM

[jenny:]

Well, I understand where you were getting at with the "Prior to this Jobs thing." Although your use of perfect health might be exaggerated. Duh, Apple has told us Job's was sick but to what extent? They left a lot up for media and investor speculation without really giving too many concrete facts- many of which people either assumed OK, yes he is really sick or Nah, Jobs is fine. But nonetheless, you still had people sitting on both sides of the fence. It's no surprise then that the notoriously sensitive stock would drop on any Job's rumors. Although it is strange to look at the one month sentiment (www.predictwallstreet....) and see how bullish sentiment was in the beginning of the month and how drastically it dropped in such a short period. Just goes to show you how entirely crucial Jobs is.

Jan 19 02:25 PM

[Benjamin Ta...:]

I want the management of companies to be candid even if they must admit their mistakes or paint an unrosy picture. Management doesn't necessarily have to lie to fall short in the trustworthiness department. Ken Lewis for example has been questionable in his candor with shareholders for quite some time. The following is from a letter a sent to my clients in 2006 (www.brickfinancial.com...):

"On a recent conference call Ken Lewis stated that the company was able to grow earnings by 31% over a two year period. The GAAP figures revealed something not quite in line with what Lewis’s statement. Hedge fund manager Thom Brown (bankstocks.com) pointed out this discrepancy and recounted an email exchange he had with the company.

'This is what we refer to around here as ‘Charlotte math. By the lights of my Bloomberg, BofA earned $3.57 per share in 2003, $3.86 in 2004, and $4.15 in the year just ended. So over the past two years, earnings have risen by 16%, half the 31% growth that Lewis alleges. In response to my inquiry, a company spokesman emailed to say that the 2003 EPS Lewis was referring to are the pro forma numbers the company filed at the time of the Fleet deal in 2004. Which is to say, Lewis’s statement is nonsense. [emphasis ours] The fact is that investors don’t have a claim on retrospective pro forma numbers, nor do those numbers help build economic value over time. What matters are actual, here-and-now GAAP numbers. Lewis knows that, of course, but he threw out those phony numbers to make his performance look better than it really is. That’s our Ken!'

Evaluating the management of companies is essential to our investment process. We look for capable management. We look for management groups that treat their shareholders (and customers) with high regard. We need to feel like management is speaking with us candidly and honestly. We do not want management painting a rosy picture, where there really is none. We want management to “give it to us straight”. We just don’t get that feeling from the management of BofA."

Jan 19 08:16 PM