What do you spend most of your time researching: the numbers or the management behind the stocks you buy?
My guess is that most of us focus primarily on numbers -- and that's not a bad thing. After all, you can use revenues, cash flows, and earnings to value a company and predict the stock price going forward; it's far more difficult to quantitatively measure the value of a CEO.
So when D3 Family Funds chief David Nierenberg recently visited Fool HQ, I expected him to explain the math he's used to generate market-smashing 18% annualized returns in micro caps over the past decade.
To my surprise, however, he spent almost no time talking about numbers.
Then again ...
OK, so maybe I shouldn't have been too surprised about his focus on management. See, Nierenberg invests only in small companies, where the quality of the people running the business is paramount to long-term success.
Starbucks (NASDAQ:SBUX) founder Howard Schultz, for example, still has the largest personal stake in his company. The same can be said for Michael Dell at Dell (NASDAQ:DELL). Because they were such large shareholders in the early years, Schultz and Dell had strong financial interests in seeing their companies succeed.
Simply put, a good management team can take a small enterprise to the next level, while a bad one can ruin an otherwise perfectly good business. In order to separate those winners from the losers, Nierenberg's team believes "that thorough evaluations of people, processes, and governance are as important as quantitative financial and competitive analysis ... we insist on interviewing management and directors before investing."
Acting on insight
For instance, one of Nierenberg's largest holdings, Natus Medical (NASDAQ:BABY), is up more than 200% since CEO James Hawkins took over in April 2004. Before joining Natus, Hawkins had a proven track record with Invivo, where he helped acquire six companies. Hawkins' acquisition experience was put to quick use at Natus, which has since acquired, among others, Fischer-Zoth in 2004 and Bio-Logic Systems in 2006.
Another Nierenberg choice, Yamana Gold (AMEX:AUY), has been on a roll since Nierenberg made his initial purchase in May 2005. Since then, the stock is up more than 350%, thoroughly beating larger peers Barrick Gold (NYSE:ABX), Newmont Mining (NYSE:NEM), and Rio Tinto (NYSE:RTP).
What prompted his purchase of Yamana? According to a January 2006 interview with Motley Fool Hidden Gems, Nierenberg's team noted that the Yamana CEO Peter Maronne had previous experience working with Yamana's mines in Brazil and had a solid background in corporate finance. Unlike some of Yamana's competitors, Maronne possessed a great operating background and the ability to promote the company to Wall Street. In other words, Maronne was poised to be a competitive advantage for Yamana and its outside shareholders.
How you can play
So what can you do to check out the people behind the stocks you buy? Nierenberg recommends a few things: read proxies and 10-Ks, contact the company's customers and suppliers, and read local newspapers and industry trade publications. You could even try contacting the company's management directly, which is not impossible with smaller companies. The idea is to "keep turning over rocks," Nierenberg says.
The Foolish bottom line
Small companies offer the market's best returns, but they also require great leadership in order to become tomorrow's large caps. Unfortunately, you won't find an accounting term to gauge management's character and work ethic. For that, you need to analyze the background of the people running the business.
One of the attributes Fool co-founder Tom Gardner and the Motley Fool Hidden Gems team look for in great management teams is founders with large, personal stakes in the outcome of the business -- not temporary CEOs that are hired one day and resign the next.
This strategy is working: Hidden Gems picks are beating the market by 28 percentage points on average since June 2003. You can take a look at all of their picks and get thorough analyses of each company by signing up for a free 30-day trial. There is no obligation to subscribe.
Todd Wenning wishes the St. Joe's Hawks luck against St. Bonaventure on Saturday. The Hawk Will Never Die! He owns shares of Starbucks. Dell and Starbucks are Motley Fool Stock Advisor picks. Dell is also an Inside Value choice. The Fool has a disclosure policy.
