According to Chairman Mason Hawkins of Longleaf Funds, investing is about good businesses, good people, and good prices. Evaluating management quality is the most difficult of the three, but investors should make every effort to invest only in companies run by capable, honorable, and shareholder-oriented managers.
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I have made it a habit to regularly review the annual and quarterly reports issued by some of my investing heroes, in search of any insight that will help me to become a better investor. I wrote an article last month praising Southeastern Asset Management, the folks who run the Longleaf family of mutual funds, for their consistent investment style and their behavior towards their investors as long-term partners. But, of course, these qualities wouldn't be worth mentioning if the funds didn't perform well over time. Over the long term, performance is what it's all about, and Longleaf has an enviable investing record. I believe part of this success is due to their investing philosophy, which is short and sweet: For the past 25 years, its managers have looked for three things: business, people, and price. As it says in its prospectus, "What we are looking for are good businesses operated by trustworthy, capable, shareholder-oriented managers." All at a great price, of course.
After reviewing my own investments over the past couple of years, I realized that I typically spend an awful lot of time trying to identify great businesses and figuring out what to pay for them, but often don't put nearly the same effort into attempting to assess the quality and integrity of their managers.
In looking at my worst investment decisions, I discovered something important: My worst investments haven't been because I totally blew the call on the business, or that I made a bad judgment on the price I paid. Rather, I didn't emphasize enough the value of good management or, conversely, the high cost of bad management. In fact, I have been guilty at times of making excuses for poor management simply because I liked the business or thought the stock was cheap. I have paid the price virtually every time.
Differentiating the good from the bad
Determining whether a given company's management is honorable, capable, and shareholder oriented is one of the most difficult, and most important, elements of the investing decision. I have resolved to look for the following four qualities before purchasing any stock in the future:
- Reasonable compensation and meaningful share ownership
- Demonstrated ability to handle the nuts and bolts of the company's business
- A history of intelligent capital allocation
- Honest and regular communication to the business and investor community, and corporate action that is consistent with pro-shareholder orientation
In a 1997 interview in Barron's, Mason Hawkins, Longleaf's chairman, explained that there are two skill sets required in managing a publicly traded company: traditional manager skills and the ability to allocate capital. He also noted that Longleaf likes to see people who are vested through their ownership of the business and have proper incentives. "We like owner-operators. When we go to the proxy statement, we prefer to see significant ownership and small cash compensation. And we have found that, over time, there is an almost direct link to really good performance in vested ownership positions."
The best source for insight into management compensation is the proxy statement, which is filed annually with the SEC and mailed to shareholders along with the annual report. When you get your copy, ask yourself the following: Does management pay itself reasonably, or does it transfer a lot of the company's value to themselves by way of lavish salaries, fat bonuses, perks, and overly generous stock option grants?
Also, beware of management teams that award themselves large bonuses based upon reported earnings, which can motivate them to use aggressive accounting to distort and magnify current income. Instead, look for reasonable salaries and meaningful stock ownership.
Judging a management team's ability to handle the basic blocking and tackling of the business is always somewhat subjective. Obvious operational problems and the lack of a coherent strategy are two warning signs. For example, the recent spate of operational and strategic problems at Bristol-Myers Squibb (NYSE: BMY) is a textbook example of a management team that has lost its way.
Next, evaluate how well management has allocated capital for the past several years. This can be done by reviewing previous year's annual reports (and 10-Ks) to look for past uses of capital. How has the company fared with past acquisitions? Have they bought back shares when the stock was cheap, or do they like to pay a dividend?
Make the effort to determine whether the company has made good use of the capital that has been entrusted to them by analyzing the information available. I performed such an analysis not long ago in an article about Bio-Technology General (Nasdaq: BTGC), a company that definitely gets a failing grade in this category.
Then, review previous annual reports, conference calls, and regulatory filings to determine whether the management team has been consistent and honest in its communication to shareholders. Does the story change from year to year? Are past mistakes swept under the rug, or do the managers take responsibility for them?
Does the company issue a press release every time something good happens, but then only discloses negative developments in small print in the back of its 10-K and 10-Q filings? Do the managers overly promote the stock? And most importantly, are managers painting a rosy picture while they themselves are selling their shares?
I remember listening to the Webcast of an annual meeting for Visible Genetics (Nasdaq: VGIN), a stock I wrote about not long ago. I had sensed that its management was in over its head, but I certainly should have hit the eject button after hearing the way the CEO Richard Daly defensively snapped at its already angry and disappointed shareholders during what was a very contentious meeting.
My recommendation to you is this: Look for honorable, capable, and shareholder-oriented managers in companies in which you invest. Tolerate nothing less.
Zeke Ashton is a former full-time analyst and writer at The Motley Fool, and is now the managingpartner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. Please send your feedback to zashton@centaurcapital.com. At time of publication, Zeke owned no shares in the companies mentioned in this article.
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