Evaluating management is one of the hardest chores a long-term investor faces, since there are really no ground rules to differentiate between "good" managements and "bad" managements.
Without fail, bad managers are easy to identify after the fact -- after the accounting scandals are revealed, or after the poorly considered acquisitions have come home to roost -- but are harder to finger from the outset. Meanwhile, good managers are usually only recognized for their excellent business sense after they have created considerable value for their company's shareholders. Needless to say, although it would be very helpful, corporate executives don't walk around with pins on their lapels saying "I'm really a crook!" or "I'll make you buckets of money!" as a way to tip off uncertain investors before the fact.
With small companies, being able to evaluate management competence is crucial. First of all, since most small companies operate in niches and lack the substantial "moats" that surround large and well-established franchises, there's more of a direct link between managers and business results. Let's face it, Wrigley (NYSE: WWY) is probably going to be able to sell gum by the truckload year after year regardless of who is running the show. The same is not automatically true for the small chewing gum firm scraping for market share and brand awareness.
Thus, how a small business "executes" -- a favorite Wall Street buzzword -- is directly tied to how its management performs. It's still helpful for the small company in question to have a business model that lends itself to economic value and for it to operate in a business area that offers plenty of potential for growth. But it's the employees, and the folks leading those employees, who will enable the firm to get from here to there.
So, what's a small company investor to do when it comes to sizing up management? There are two routes, both of which require different forms of legwork. The first method is to look to the past and see how a manager has performed historically, based on the idea that management excellence shows up in quantifiable business performance over time. The second route is to follow investor Phil Fisher, a hero to many of the Fool's Rule Maker Portfolio managers, and adopt his "scuttlebutt" method of management evaluation on the basis of two elements: business ability and integrity.
This first method is the easier of the two evaluation methods, as numbers tend to be easier to analyze than people. Rising margins, market share gains, and a growth rate above that of the industry on the whole are all good signs of a management's effectiveness. Another sensible yardstick is to look at a firm's retained earnings, which are an element of the shareholders' equity account on the balance sheet, for indications of a management team's ability to create value. If every additional dollar of retained earnings generates more than a dollar of additional market capitalization for the company over a three-to-four-year period, it's a good bet that management's interests are aligned with those of the firm's shareholders.
However, these quantitative measures have the potential to mislead the investor who puts total faith in the numbers and discounts the importance of the people behind the numbers. After all, one of the things that makes human beings so interesting is their tendency to be unpredictable. If your intent is to invest in a company for a couple of years or more, it is almost certain that the business environment will change at some point during your prospective holding period. How will management react to those changes? Will the company be able to adjust? Looking at last year's numbers won't tell you.
Investor Phil Fisher is probably best known for the idea of gathering scuttlebutt, or information, on a business' management before investing with it. This method rests on the premise that through discussions with employees, suppliers, customers, rivals, and even the managers themselves, a true picture of the management's quality will be revealed. This way, the investor has a better handle on the faces behind the numbers.
While this method has the advantage of humanizing the investing process, it has a downside as well. Primarily, very few individual investors find it possible to take Fisher's scuttlebutt advice literally and follow in his footsteps. Most of us do not have personal travel budgets for company visits, trade shows, or the like. If we're lucky, we might get to a firm's annual shareholder meeting once and a while. But building a personal relationship with management seems a bit far-fetched. After all, if every real or prospective individual investor followed the scuttlebutt method as Fisher does, when would managers find the time to run their companies?
Fisher's method for getting to know management likely works precisely because so few individuals take the time to do it. Still, there are ways to get a feel for a firm's top management team without meeting them personally. Conference calls, published interviews, special webcasts of meetings, and even online discussion boards are all opportunities to gain scuttlebutt. The individual investor should take advantage of these offerings, as well as any other opportunity to gain insight on the human side of business.
Brian Graney is addicted to Wrigley's Juicy Fruit gum. At the time of publishing, he did not hold shares of any of the companies mentioned. The Motley Fool is investors writing for investors.