This is part 4 of the Investment Research Process series. In this post we discuss how to assess the quality of a company’s management from an Investor’s point of view.
We, as investors, want the management to be good stewards of Capital.
What is a “good steward of capital”? Lets look at the definition of stewardship.
A good steward of capital is someone who recognizes that he has been entrusted with his investors capital, not given it. His primary responsibility is to look after and grow the capital. He respects the implicit contract between Investor & Entrepreneur and knows that it is his responsibility to work for the benefit of all his shareholders. (Brad Svrluga – Venture capitalist)
From my own personal experience, investing in companies which are run by ethical management has always been safe and highly rewarding.
In one such case, the primary reason for choosing a company was its founder manager at the time (Kochouseph Chittilappilly of V-Guard). Since I was from the same state, I happen to know about his ability to start, survive and grow a successful business in a notoriously business-hostile state. His actions also revealed his principled stand about responsible citizenship – he was the highest income tax payer from Kerala and was felicitated by IT department.
V-Guard shares have given good returns (more than 50% annualized return for the past 6 years – it grew from 45 to 950+). The company grew from being a small player in a single state to a major electronics consumer goods company with pan-India presence in the meanwhile. The founder has retired and his son has taken the reigns. I am still invested as I haven’t found reasons not to be. (That’s my disclosure there and I am not making any recommendations.)
I also have personal example of a disastrous investment where the management quality was somewhat questionable. I was invested in Bartronics in 2006-2007 period. I was not aware of (or cared enough about) the management quality at the time of investment (major mistake). It was sheer luck which saved me from losing my money as I sold those shares in some profit in 2007 to meet some big expenses at that time.
Later I learned that it had a business model which relied a great deal on favorable political conditions and also that the promoters were continuously reducing their shareholdings. Articles like this helped me become more wary about the company. Had I stayed invested, I would have nearly lost all my invested money by now.
Enough rant. Let us get back to the topic.
Great investors will always look very carefully at the quality of management. Warren Buffett’s letters to shareholders always contain lavish praise for the excellent CEOs of his companies. Without exception, he has chosen great companies run by great managers. This is what he thinks about choosing managers:
Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence and energy. And if you don’t have the first, the other two will kill you.
You think about it; it’s true. If you hire somebody without [integrity], you really want them to be dumb and lazy.
How do we assess management quality?
There is no easy way for this. There is no single metric in the financial report using which we can say that the management is able and trustworthy. However we can get a general ‘feeling’ about the quality of management if we look at the following:
Read ‘Directors report’ & ‘Management discussion’ sections in the annual reports of the company for the past 10 years.
Start from the oldest one and read each one of them.
Note down the points the management said they will do and check whether they ended up doing them or not in subsequent years. How did they explain deviations?
Do they own up their past mistakes? Do they impart blame elsewhere? Difficult market conditions/ Global slowdown etc etc…
How did they fare in the most recent ‘bad- patch’? How did they come out and what are they doing differently based on the lessons learned?
Are the ‘Cash flow from Operations’ generally in line with ‘net profit’? Remember, ‘Net profit’ value can be manipulated by a number of non-cash accounting entries such as depreciation, deferred taxes etc. Whereas the Cash flow from operations is the actual money arriving into the company.
If reported Net profits are way higher than cash flow consistently for several years, that is a red sign.
Is the company paying out regular dividends? A decent and consistent dividend history is always a good sign.
Are the return ratios (Return on Capital Employed for e.g) sufficiently high? I would want the company to be generating at least 15% on its equity employed. Preferably much more than its cost of capital.
What is the trend on Operating profit margins over the last few years? Is it staying stable or increasing? Or is it decreasing? How does this trend compare with its peers/competitors?
How leveraged is the company/ How much debt does it have? Is the debt levels increasing over the years? Is the company paying off debt?
How aggressive is their accounting? How early/late in the sales process do they recognize revenue?
Does the accounting method remain consistent or do they change from time to time?
Top Management remuneration: Is the ‘C’ level salary in line with industry peers? What percent of net profit is paid as CEO compensation?
Are there any suspicious related party transactions? (remember Satyam? Satyam, a software company, was moving money to a group company in real estate business, even before the overall fraud eventually came out). If the company moves capital or resources to a subsidiary/ group company in a totally un-related sector, it is a big red warning sign.
What are the qualifications and track record of the executive team?
How are the board members selected? What is the depth of expertise in the board room?
Google search each of the key people. These days, if there is some dirt, it’s bound to be exposed in the news somewhere.
From the news or annual reports do you see any evidence of unethical practices or crony capitalism?
The list is not exhaustive. But you get the general idea. Once you go through the history of the company, you get a big picture view of the overall quality of the business and management.
Warren Buffett advises us to look at each company not as a static picture but as an unfolding movie.
To understand and analyze the management quality better, I strongly urge you to read the below:
- Prof Sanjay Bakshi’s post about ‘Owner-Operator’ types: Understanding India’s Family Owned Businesses
- Safal Niveshak’s post on Monitoring the behavior of Management
- Contrarian Value Edge‘s extracts from Investment checklist.
- ValuePickr Forum’s presentation on Management quality by Donald Francis.
- Jana Vembunarayanan’s post on categories of stocks producing 100-to-1 returns
By the way, if you haven’t done so already, do join/subscribe the above blogs and forums.
Trust me – this will be an excellent investment. (Disclaimer: I am a subscriber/member of all of the above. And I strongly recommend these ‘investments’ 🙂 )
End of part 4. We will look into reading the financial data in the next section.