You can't make a good deal with a bad person.
- Warren Buffett
Able and trustworthy management is one of the preconditions for Buffett/Munger to make any equity investment. Although the reverse may not be always true, even a great business in the hands of poor management often dampens shareholders' returns.
Management is an important factor (and with one of the highest weights) in my business quality ranking model. It is mainly qualitative, thereby being not easy to get quantified and seemingly one of the most underrated in today's stock market full of machines and algorithms.
Below, I list the aspects that I would examine to evaluate the management (as part of searching for wonderful businesses) from a long-term buy-and-hold investing perspective.
Focus on ROIC (more than growth)
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.
In the investment world, growth is not always a good thing. For long-term investors, the nightmare scenario, value destruction, usually results from those fast growers that generate low returns on capital. This means that management has to better actually slow down business growth as much as possible if the ROIC is low (or not high enough) and should always focus on increasing ROIC to deliver shareholder value. However, this mentality is not common at all among corporate managers.
Partly thanks to shortsighted Wall Street culture, public companies typically consider (short-term) growth as their top priority. Financial media follows thereafter and puts growth numbers in the spotlight in front of the public, which creates the cycle to motivate management to pay even more attention to growth.
Here, investors may want to go through annual reports and shareholder letters carefully to understand management's strategic goals. For example, management at Fuchs Petrolub (OTCPK:FUPBY) (OTCPK:FUPEF) and Kakaku.com (OTCPK:KKKUF) (OTC:KKMMY) explicitly incorporate ROIC into their central KPI - something that investors should applaud for.
Capital allocation skill
For long-term shareholders, investing in stocks should be no difference from delegating your money to the management team of the company to generate future profits. In that sense, C-level managers at the corporates just function as the fund managers who need to deploy retained capital to achieve alpha returns. Therefore, capital allocation skill is crucial here, but how can we tell the good from the bad (or average)?
One metric that we can leverage is the Return on Retained Capital or RORC. I usually look at management with track records of recent RORCs of above 12% as good and above 20% as great.
As you may find out (by examining your own interested stocks), great capital allocators are a rare species. Among the quite few examples are Paychex (PAYX), a leading provider of integrated human capital management solutions for payroll, human resources, retirement, and insurance services for small- and mid-sized businesses. The management retains very little capital from earnings every year (i.e., from 10% to 40%), but generates extraordinary returns on redeploying the capital (i.e., 35% for the past 10 years and 49% for the past 5 years). Do check the link above to see some other high-RORC achievers.
If the management is willing to openly communicate with their shareholders, that would be a plus to me. Investors can conduct an easy test themselves by emailing the IR team of the company with questions. Those who never respond should have some minus points on your scorecard.
Berkshire Hathaway set a good example of shareholder communication through their annual meetings. Chairman and CEO, Warren Buffett, has repeatedly told everyone that he is more concerned with what shareholders think of the company rather than what analysts do.
As a much smaller company with shareholder interest in mind, Credit Acceptance (CACC) employs a unique but highly effective approach - answering questions in writing via the company website. The management explained:
We believe this strategy is preferable to other approaches for several reasons. First, we believe we can provide more thoughtful and substantive answers in writing. Second, every shareholder receives the same information at the same time. Third, it is more efficient since questions only need to be answered once. Fourth, over time as the library of previous communications."
Adjusted EPS, EBITDA, and guidance
I favor management who stays objective, straightforward, and outspoken regarding their performance. This is why I dislike companies who emphasize numbers prone to sugarcoating, such as adjusted EPS, EBITDA. Instead, it should be up to investors themselves to adjust financial figures to their respective purposes and assumptions based on the information given by the management.
It would also be great, in my view, that the company does not issue short-term guidance so that the team can more easily focus on the long-term prospect of the business.
Facebook (FB) is a good example here. The management seldom (if ever) uses adjusted earnings or EBITDA in their communication materials to shareholders. Nor does it try to set Wall Street's (and many other people's) expectation by issuing near-term growth estimates.
By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.
- Warren Buffett's 1984 Letter to Berkshire Shareholders
As this over-heated market is gaining popularity among stock investors, so is the popularity of repurchasing shares among corporates. But, just like the former group (i.e., investors who chase hot stocks), the latter (i.e., managers chase to buyback shares) often disregards one important question - how expensive are the shares bought.
These days, you may often hear that managers talk about their plans to return capital to owners by spending a certain amount on share buybacks. But here, the real question - which is usually left unanswered (or even unasked in the first place) - would be: At what cost (of shareholders' money)?
Investors can easily check the prices those shares were repurchased in the quarterly/yearly financial reports. Compared to historical price multiples (e.g., P/E, P/S, P/FCF), they would know whether the management overpaid or not.
The management at Rollins (ROL) demonstrated its prudence in share repurchase - in 2012, 11.3 million shares were authorized to be repurchased, but the company did not buy back any shares on the open market in 2017 and 2018 when the stock was pricey (i.e., P/E of roughly 50x).
To make sure of the alignment of interests between managers and shareholders, I am looking to see some insider ownership but not too much. A range of 5% and 50% of shares owned by insiders would be optimal in my view, although the judgment here should also depend on the size and stage of the company.
Also, insider buying and selling activities for the recent 12 months are a valuable source to gauge the level of management's interest and confidence. While constant insider buying is a bullish sign, insider selling is not always bearish on the stock as some executive may cash out some of their holdings from time to time to make big spending (e.g., housing, kid's education).
A frugal manager, who is incredibly cautious with money, often leads to the frugality across the company - one of the common traits among successful businesses (e.g., not wasting money on vanity projects or fleets of private jets).
Nominated by Inc.com as the cheapest CEO in America, Bob Kierlin is the founder of Fastenal (FAST), a wholesale distributor of industrial and construction supplies, which has grown from a start-up run out of a 20-foot-wide storefront in Minnesota to a national powerhouse that operates hundreds of stores across North America in 30 years. The company finds all sorts of ways to save money, both big and small - no 401k plan, no stock options, no meal per diems for business travel, no airline ticket for more than $400, and so forth; money for the annual Christmas party comes from the "pop fund," profits generated by company vending machines; some Fastenal furniture is secondhand, often purchased at government auctions; the company produces annual reports in-house for 40 cents a copy. The end result? Cost-cutting helped the business earn better margins than its competitors and made shareholders millions, as the stock price (adjusted for splits) has soared more than 6,800%.
Putting new management in place inevitably increases business risk. To protect the downside in this regard, investors may want to favor companies with a relatively stable executive team and board. Usually, I look for an average tenure of above 3 years. If the current executive is also the founder/co-founder of the business, that would be a huge plus to me.
The compensation plan could imply how management is incentivized when dealing with shareholder interest. As Charlie Munger's insightful quip goes, "Show me the incentive, I'll show you the outcome." Hence, stock-picking value/quality investors do need to carefully examine such info in the company's annual report.
Ideally, reasonable CEO pay should be consistent with company performance (e.g., ROIC, economic profit, top/bottom-line growths) over time. It can also be compared to the average remuneration for companies of similar size in the same region.
The board structure is an important source for investors to gauge the effectiveness of corporate governance in terms of generating shareholder value. Ideally, I would prefer to see a non-executive chairman and as many as independent directors on the board as possible.
As you can see above, unlike many other business factors (e.g., financials), management quality is a complex one and involves multiple aspects throughout the evaluation. In my opinion, a good management team is a prerequisite of a wonderful business that value/quality investors should look for. Therefore, a comprehensive and careful analysis in this regard is quite necessary to generate long-term risk-adjusted alpha.
Disclosure: I am/we are long ROL, BRK.B, PAYX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.