Bad Management Strategies: Unattractive S&P 500 Companies

It is very important to understand a company’s management strategy and management’s ability to create wealth for its shareholders. By using The Applied Finance Group’s (AFG’s) Management Quality score you have the ability to grade management’s ability to make wealth creating decisions and eliminate wealth destroying firms from your list of constituents. AFG’s Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses when they are not even profitable (generating negative Economic Margin or negative EM, which is AFG’s way of understanding a firm’s economic profitability).

When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit and concentrate on the parts of their company that have been creating wealth. Instead, the corporation needs to fix the broken parts of its business first by divesting losers and work on improving profitability to earn the right to expand. The best strategy AFG or any investor likes to see is a very profitable business (generating positive EMs) that grows its assets to maximize its profitability.

The companies listed below (which include CAT & AMAT) have been following a wealth destroying strategy by growing their assets as their EMs have been declining which is reflected in their stock prices as none of these companies have been able to create any value for their shareholders over the last year. Along with managements inability to create shareholder wealth, these firms also look unattractive according to AFG’s valuation model and other key criteria AFG evaluates when considering the attractiveness of potential investment opportunities.

These companies must stop growing their assets or divest some losers and focus on improving their EM’s before these firms will begin to see sustainable improvements in their stocks price and begin to add wealth to their shareholders. The expected change in the level of a company’s EMs has proven through back-tests to be highly correlated with the subsequent performance of its stock price. The 2 company examples below show the levels of each companies EMs through time as well as their asset growth. CAT and AMAT have continued to grow their assets as their EMs have declined and that strategy is reflected in their falling stock prices.

Management Competence Factors

• Have there been any changes in the executive management team?

• Has the company had any significant write-offs or poor earnings quality?

• Has the company recently made any significant acquisitions and, if so, what are the strategic implications and costs?

• How is the company spending any excess cash?

• What did we learn from the company’s most recent earnings call and what was the tone of analyst questions?

Management Quality Score Insights:

• Measures a company’s EM+1 and LFY Asset Growth.

• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

• Un-bias quantitative way to analyze a company

• Holds management teams accountable for unprofitable growth

Below are examples of AFG's Wealth Creation Reports and pricing charts of CAT & AMAT that show deteriorating EMs while continuing to grow their assets and the subsequent poor performance over the past 1 year.

CAT Price Chart - 1 Year

AMAT Price Chart - 1 Year

Comments

[perremon:]

Strongly disagree. They need to build assets in order to be prepared for a stronger economy. CAT can't be empty handed when orders start coming back. How would their EM be then??

Sep 22 02:41 PM

[perremon:]

I bought 6 months ago. I'm pretty pleased with CAT.

Sep 22 02:42 PM

[billd10:]

This is the problem when you focus narrowly on a selected set of numbers and ignore the fundamentals of the company. Caterpillar should be a long term success. You can't expect wonderful results in the middle of a recession for them or any other company.

Sep 24 03:44 PM

[puerhfan:]

The same logic applies to AMAT. They are investing a lot of resources in their solar business. They went from not being in the solar sector in 2005 to being the #1 equipment supplier last year. The investment may or may not pay off in terms of profits down the road, but strategic investment is different than "destroying wealth."

Sep 27 04:23 PM