Working out a company’s value can mean pouring over its financial statements, analysing the quality of its business operations, assessing competitive position, returns on equity, earnings growth, and the list goes on.
However, one thing missing from this list is the importance of the quality of management in a business.
Management may make decisions that are, while in their best interests, not in the interests of the company. This is called agency risk.
Warren Buffett frequently talks about the importance of knowing the people who run the businesses he owns.
“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… Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”
How to identify good management
Good management should:
- stick with what they know best and focus on strengthening their core businesses rather than engage in conglomerate building,
- make good quality capital-allocation decisions, including being willing to sacrifice short-term results to create long-term shareholder value,
- have a thorough investment evaluation process,
- effectively handle crises,
- effectively communicate with shareholders in both good and bad periods,
- have incentivised compensation tied with what is in the best interest of shareholders.
Things to watch out for:
- Does the company have a record of taking large impairment charges (permanent reduction in the value of a company’s asset, usually a fixed asset),
- Has it engaged in a ‘growth-for-growth’s-sake’ strategy?
- A myopic focus on short-term results with minimal concern for long-term consequences, such as increasing debt to increase their earnings per share ratio.
- A history of cost overruns or expensive operational missteps.
- Aggressive accounting practices that overstate the true financial position of the company.
- Clearing the decks with results early in their tenure, such as making excessive write-downs and provisions in early years to subsequently make performance and earnings targets easier to reach in later years.
- Has the board established an appropriate incentive structure that rewards value creation? Management decisions are often based on ‘heads I win, tails you lose’ scenarios, in which management are rewarded when things go right, however do not face any consequences if they go wrong. The shareholder is the only one to wear the consequences.
If you have any questions about assessing a business’ management for investment purposes, or would like to refer a friend for a complimentary consultation, please contact me.