An Investment Approach to Assessing Management
Where to start with the important topic of management of listed companies. I often hear people say; ‘It’s important that a company has good management’ or comically; ’they seem like good guys’. Quite clearly good management is important, but what are the attributes of good management. To evaluate management let’s focus on four areas;
- what are management incentivised to do,
- what conflicts do management currently face,
- what type of lies are management currently telling us, and
- what skill set does the company require.
1. Management incentives
From a shareholder perspective, what do we actually want management to do? We want to know that the management team are steadfastly focussed on delivering strongly improving earnings per share using acceptable levels of risk (not using excessive leverage or dangerous business practices). Management’s focus on growing earnings per share needs to be effectively communicated so that this growth can translate into share price growth and dividends. The effectiveness of a management team in delivering will be borne out in share price appreciation and dividends. The concept is relatively simple but of course the ‘devil is in the detail’ and it is the subtleties in implementation that bear so much close observation.
What constrains management from delivering growing earnings per share and dividends? For one, the uncertain nature of business in general, as well as personal interests, alignment of interests and conflicting interests, play a key role in the entire process.
Generally speaking the bigger a company the more management gets paid. We would argue this should not necessarily be the case but in modern commerce this tends to be the rule of thumb. Managers know this and as such strive to increase the size of a company. Companies are very often trying to grow. This does not necessarily mean they are incentivised to grow earnings per share to earn more pay, but rather to simply grow earnings. Hence the constant mergers and acquisitions, trade sales, purchases, placements, capital raisings and all manner of complex financial engineering. Many of these transactions serve little purpose other than to grow the enterprise so that the management team running these enterprises can in turn earn larger salaries. This process also strokes the ego, running a bigger business makes one appear more competent. Depending on whose research you read, over the longer term, studies have shown that less than half of all such transactions are actually earnings per share accretive or create shareholder value.
2. Management conflicts
This peculiar set of circumstances brings us to a second and perhaps even more important issue….that of alignment and conflict of interests. Shouldn’t managers simply get rewarded on share price improvement over long periods of time? In theory they should. Some of the world’s best investors actually take an active role in overseeing the remuneration of management in listed companies. These investors spend extraordinary amounts of time making sure that remuneration of managers is closely aligned to shareholder return. A closely guarded secret of many micro and small cap managers is that they invest solely in businesses where management are also the founders and large shareholders in the company. This immediately creates an alignment of interests between the manager/founder and shareholders. This one simple fact probably doubles or triples the chance of a shareholder actually making a return. The owner managers are constantly looking after shareholders best interests, and have also already proven their abilities in growing a successful company.
In the evolution of a business the founder and largest shareholder will eventually hand the business over to ‘professional managers.’ At the moment a group of professional managers are introduced to a business, new conflicts of interest arise.
This transition from founder to professional manager also carries with it a change in the skill set required to manage the business. And so begins the ‘tension’ between professional managers and shareholders. Management are no longer the owners but rather work for the owners of the business. Each tries to extract their ‘pound of flesh’. Owners want management to make better returns, managers in turn want to get better pay. Management are now risking shareholders and founders assets, often not their own assets, creating additional tensions and conflict. And all the while the Board of Directors need to interface between owners and managers….not an enviable task.
3. Management omissions
As investors we are faced with these tensions and conflicts on a daily basis and we need to evaluate a management team to assess the extent of conflicts of interest as well as the level of lying taking place. We are constantly on the lookout for management lies. There are essentially three types of lies; the ‘good’ lie, the ‘bad’ lie and the ‘dangerous’ lie. Briefly, the ‘good lie’ comes from the experienced and competent manager who attempts always to under promise and over deliver. These managers have experienced the pain of over promising and under delivering and never want to experience that pain again. The ‘bad’ lie comes from the manager who is inexperienced and over promises and under delivers, or as is often the case, simply lies about the future prospects of the business. The ‘bad’ lie can often be detected in body language and nervousness and a general inability to deliver over time. The ‘dangerous’ lie is perpetrated by a manager who lies but convinces themselves that the lies are true. These are the truly delusional ones and are often difficult to detect since the person telling the lies actually believes them. These are the most dangerous lies and lead to the most extreme stories in corporate history and also very large financial losses……always be on the lookout for the different types of lies!
4. Management skill set
To offer some practical advice on what to look for in a good manager. A management team should ideally have experience in the industry in which they are operating and a track record of growing and managing successful businesses, this is particularly true of smaller companies. Management should be ‘good with people’….or more accurately good at mobilising people to perform the task at hand. Management should ideally have already demonstrated great success in a previous business venture or endeavour since nothing ensures success quite like previous success. Over the years business people tend to fall into two categories…those who can make money and those who cannot. Invest with management teams who have demonstrated an ability to make money for the companies they work in.
In summary we are looking for a management team who are focussed on delivering earnings per share growth, share price growth and dividends not simply growing the business for the sake of growing. We are looking for managers whose interests are aligned with ours, ideally as large shareholders in the business, or management whose remuneration is closely tied to earnings per share and share price growth. Where these factors cannot be clearly demonstrated look closely for
conflicts of interest. Be on the look-out for the types of ‘lies’ managers are telling. Good lies are fine, bad lies are not and dangerous lies are the worst. Finally, look for a depth and breadth of management experience with specific industry experience. When choosing between a good looking resume and a proven ‘money maker’ choose the ‘money maker’. Should you come across a management team with all of these attributes your life may be on the improve.
Written by Karl Siegling