Determining management quality is key for any investor picking a stock. For good reason: It's tough enough for any business to make more and more money year after year. At the very least, a potential investment must have excellent managers who are above reproach. In the case of a newer, Rule Breaking company, the company starts out with one hand -- maybe both -- tied behind its back.
Of course, it's one thing to intone "management quality" with a deep voice and great seriousness, but quite another to evaluate it, for at least two reasons:
- Management can just plain lie, and no one may know -- until it's too late.
- We have a tendency to want to forgive mistakes and show our loyalty by discounting rumors. But in investing, it may be best to observe the adage, "Where there's smoke, there's fire."
Cheaters and liars
We can all recognize liars and cheats -- they're listed on the company's 10-K right under the "low-life scum" heading, right? Too bad they aren't. Most of the time, we just don't know about management malfeasance until we've been had and the stock price blown to smithereens.
And even a lengthy background check before hiring someone can come up with bupkis (scroll down). For example, everyone now may shake heads knowingly at the mere utterance of the name "Chainsaw" Al Dunlap, fired chairman and CEO of Sunbeam, the company he pillaged and whose shareholders he robbed. Yet it turns out that at hiring he had failed to disclose to Sunbeam -- and background checks didn't reveal -- his termination from one job in 1973 after seven weeks and another in 1976 after two years, the latter leading to "lengthy litigation that alleged fraud involving its reported profits during his tenure," according to The Wall Street Journal. At least knowing about those jobs would have raised question marks.
Today, with the Internet and each day's addition to searchable stuff, it will be harder to hide this kind of thing (unless you have a common name like, say, yours truly). But for now, there's little you and I can do to protect ourselves if the information provided in a 10-K is incomplete or incorrect. Investing is not riskless.
It can happen to anyone. Take my debacle investing in small-cap wireless components maker Vari-L Company. It looked like a lovely little find with steadily increasing profits, until one day it adjusted prior year financial statements to reflect overstated income and announced an investigation, after which the controller resigned and the CFO retired. Then the company's small local accounting firm quit, telling the Securities and Exchange Commission (SEC) they'd found irregularities. After which the CEO and president said good-bye, and the company soon brought in an interim CEO and the accounting firm KPMG to help investigate. Nasdaq delisted the stock, and the company founder and another director resigned from the board. In the face of all this, Anne "The Weakest Link" Robinson might look at me and say, "Is there no end to your ignorance?"
Anne, without warnings in the financials or elsewhere, how could I know until the bad news hit? I suggested in the column that the only thing an investor can do to insure against the risk is probably to invest in very large companies with ancient histories. Now I agree more with one writer who sent me an email arguing persuasively that there really isn't anything you can do. Sure, you just might lose less investing in a larger company with diversified revenue streams that could survive a bad manager better than a small-cap company could. But you'll still take a hit.
Loyalty and forgiveness or run for your life!
On the other hand, what do we do when we have hints of trouble? By hints, I mean more than a stray post on a discussion board or a cocked eyebrow and innuendo, more in the vein of previous business failures or Al Dunlap's prior questionable employment. In our personal lives, we often respond to this information with loyalty, forgiving our friends' mistakes and ignoring rumors about them (Note: I said "friends." Relatives are different.)
As long-term investors, we may do the same and stick by our companies whose track records of success suggest that they can withstand the occasional problem: We may even see a buying opportunity and add to our holdings. But this same strategy is not applicable to potential investments in younger companies, such as Rule Breakers, which present enough risk to the investor already and are less able to withstand the trouble.
I thought about this when reading Brian Lund's excellent Rule Breaker column that examined Actrade Financial (Nasdaq: ACRT), a company profiled in the May issue of The Motley Fool Select. Brian noted some real problems with management, then wrote: "Smart people sometimes make mistakes. I'm not condemning [the managers]. They deserve second chances. Their pasts, however, may scare some investors off, including us. We want superior management with high levels of honesty, forthrightness, and integrity. We could use more evidence of those qualities at Actrade."
Brian feinted in the friendly direction at first, but then in my view he recovered, saying in effect, "Sure, they deserve second chances, but not with our money." To me, this is the same thing as saying that one doesn't think that certain mistakes represent the highest levels of honesty, forthrightness, and integrity. We may not have evidence of any current problem, but why take the risk? "Where there's smoke, there's fire," after all.
Take the Lernout & Hauspie Speech Products horror story that includes bankruptcy and fraud. I once researched the company for a possible investment. This included reviewing posts on our discussion boards, and one poster brought up Lernout & Hauspie exec Gaston Bastiaens' allegedly shady former tenure at software maker Quarterdeck -- which this Portfolio's predecessor sold short in 1996.
It made me nervous, but sadly not enough to keep from buying shares of Lernout & Hauspie. I did sell before the awful end and managed to lose "only" 50%. Recent pictures of Bastiaens in handcuffs as he began his extradition to Belgium for Lernout & Hauspie legal proceedings reminded me of my narrow escape. Lernout & Hauspie's business made it a risky, Rule Breaker stock, and I shouldn't have unnecessarily taken on more risk with Bastiaens.
Let's not confuse loyalty with smart investing. It may be good to stick by your friend when she is accused of misconduct -- even to visit her in the pokey if convicted -- but not when you are looking to invest in riskier, younger companies. If a manager's track record is questionable, she may have learned from it, or she may not have. It's hard enough for execs as unimpeachable as Caesar's wife to succeed in any business, whether new or established. Why ask for trouble? Let someone else take that risk.
Be critical and don't treat your managers like friends
You can't do much about the crooks whose deeds are unknown, unrevealed in the financials or anywhere else. But where there is smoke -- past misdeeds or rumors that go well beyond the occasional discussion board hypester -- at a company without much of a track record, it may be best to look elsewhere. A large, established company such as a Rule Maker can withstand mistakes here and there, but a Rule Breaker may not.
Had any brushes with management mistakes or rumors thereof? Share them on the Rule Breaker Strategies discussion board!
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In other Rule Breaker news, AOL Time Warner (NYSE: AOL) reported cash earnings of $0.32 per share, beating estimates of $0.28. Revenue, however, was lower than expected, and caused lots of important people to say that the company would have a hard time in the second half of the year. As a result, shares fell hard this morning. This is not a company, though, that lends itself well to 15-minute analysis. We'll dissect AOL's report in the near future.
Tom Jacobs (TMF Tom9) thinks he just may get cable to watch the reruns of The Sopranos starting in August. At press time, he owned shares in Vari-L Company. To see his other stock holdings, view his profile, and check out The Motley Fool's disclosure policy.