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Tenets of Value Investing: Evaluating Management

April 01, 2011 | About:
John Emerson

John Emerson

145 followers
"When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." —Warren Buffett

I begin my discussion of management efficiency with the following qualification: The greatest management team in the world cannot overcome the secular decline of a dying industry; they can only prolong the inevitable. That was the lesson Buffett learned when he purchased the Berkshire-Hathaway textile business in 1965. That said, it is virtually impossible to invest serious money in a company, regardless of the perceived competitive advantage of the business, unless one is reasonably assured that the management is not only trustworthy but also competent. I believe that establishing a tangible way to evaluate the performance of a management team is infinitely more desirable than basing one's opinion of management on subjective measures such as conference calls.

I still listen to conference calls on a regular basis and at times I find them very informative, but I have become as skeptical of management claims as the villagers became in the Aesop's Fable, "The Boy Who Cried Wolf." Instead of "crying wolf," they proclaim, "Profits are on the way," when in reality, they should be crying "uncle." A few years back I owned Wildan (WLDN), a small engineering firm. The company was bought from a successful private owner/operator, IPOed, and assigned a new management team. Mind you, this was a very successful company with a long history of profitability.

Foolishly I waded into the land of the Anti-Buffett approach, more specifically the new management team quickly dismissed all the former management, employing sort of a Bizzaro World approach. Every quarter, the optimistic CEO delivered his positive message of upcoming profitability complete with improved guidance, and every subsequent quarter they missed their projected guidance by a country mile. To put it in the terms of a Texacan, the management team was "all hat, no cattle." For the life of me, I do not understand why any small company provides guidance. I am almost to the point where I run away from small companies that provide such information, particularly the Chinese reverse merger companies. I simply do not trust overly optimistic management teams.



Back to the principle matter. How can an investor tangibly discern between a highly effective management team as opposed to "all hat no cattle" types? First, allow me to define the principle duties of a management team: 1) Run the business as efficiently as possible in order to maximize profits, 2) Redeploy the profits of the business in the most effective manner to maximize shareholder value, and 3) Significantly increase shareholder value over the long term. Point one can be measured by such metrics as Revenue/Income per Employee, Inventory/Asset Turns, etc. Point two is best measured by Return on Invested Capital (ROIC). Point three is my favorite metric and the one which I will discuss in detail in the following paragraphs.



How does a value investor define increasing shareholder value? Here I turn to Warren Buffett for help: Increasing shareholder value over time should be described as a steady increase in tangible book value per share over time rather than an increase in price per share. Incidentally, that is my quote not his—I merely took a cue from him. Anyone who has ever read a Buffett Annual Letter is aware of the fact that Buffett always makes it a point to discuss yearly gains in the tangible book value of Berkshire. He also makes it a point to note that the true net worth of Berkshire is significantly understated by its tangible book value, but I will leave that discussion for another day.

Here is my formula for defining an increase in shareholder value: Rate of increase in tangible book value per share plus dividends per share. The key word here is "tangible." For instance, let's say that the management of Emerson Widgets acquires Widget.com, a business with little tangible equity, in an attempt to enter the online world of widget sales. Under accounting rules, any price paid for the business over the tangible book value must be recorded as goodwill on the balance sheet. Let's assume that the acquisition is a total bust, and five years later all the goodwill on the balance sheet is totally impaired. The book value per share at that point drops precipitously; nevertheless, the tangible book value per share is not affected. Should I judge management as a failure due to one poor acquisition and the resulting drop in book value? The answer is maybe yes or maybe no. What if the company doubled their tangible equity per share in the five-year period even though the total equity per share showed little or no improvement five years later due to the large goodwill impairment?

Allow me to use a beaten down tiny casino operator as an example of an under-appreciated management team. Take a look at the 10-year improvement in the book value per share of Century Casinos (CNTY): The rise in book value per share from 1.62 per share to 4.54 per share in ten years is quite impressive. However, if one reviews the 10Ks for 2000 and 2010, the tangible results are much more impressive. CNTY had a tangible book value of approximately 93 cents per share at year end of 2000. Yesterday's release of the current 10K revealed that the 2010 tangible book value had risen to approximately $4.46 per share. The company had over twice as much goodwill listed on the balance sheet at the end of 2000 as compared to the close of 2010. I will grant you that the management has been handsomely paid in the form of options over the last decade, but the huge increase in tangible equity seems to indicate that they have earned their pay. At some point I believe the market will recognize that fact and price CNTY accordingly.



Long CNTY

No position in WLDN

I will return next week to discuss emotion as the Tenets of Value Investing continues.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (13 votes)

Comments

paulwitt
Paulwitt - 3 years ago
Here's another interesting small casino operator - Full House Resorts (FLL). I have to say I was pleasantly surprised when I found out Lee Iacocca is on the board of directors.

Disclosure: Long CNTY, FLL

Adib Motiwala
Adib Motiwala - 3 years ago
Good series of articles. thanks
superguru
Superguru - 3 years ago
"The greatest management team in the world cannot overcome the secular decline of a dying industry; they can only prolong the inevitable."

Does that apply to WPO?

John Emerson
John Emerson - 3 years ago


My guess would be that all traditional print newspapers will continue their slow and steady erosion in circulation. Fortunately for the Washington Post Company, they have a considerable amount of other businesses which are not secular decline. The future of Post newspaper will probably follow the lines of the Huffington Post, in other words an online publication. That is a sad commentary for the nostalgic people of this country who enjoyed getting up on Sunday morning to read the funny pages, check the baseball stats, etc.
graemew
Graemew - 3 years ago
In some cases the intangible assets of a company need to be included in the book value, since they form the major part of the sustainable competitive advantage. An example would be Coca Cola Company. In other cases it would be more appropriate to look at the tangible assets alone. I believe that you have to decide company by company and that it is best to avoid rules written in stone, but rather apply valuation or performance techniques in a flexible manner depending on the specific aspects of each individual company. Easier said than done though....
John Emerson
John Emerson - 3 years ago
Point well taken Graemew, certainly economic goodwill is a genuine asset and it may differ materially from accounting goodwill which is now carried permanently on the balance sheet rather than amoritized, unless it is impaired . Intangible assets such as the formula for Coke are also legimate and I agree that their value should be reflected on the balance sheet.

In the article, I borrowed Buffett's idea of monitoring gains in tangible equity per share over time, to measure the effectiveness of management. Legitimate economic goodwill will be reflected in ongoing profits which will translate into a steadily higher tangible book value per share for investors over time, so long as management does not put the gains into their own pockets (through options or bonuses) or squander them on such things as frivilous acquisitions.
graemew
Graemew - 3 years ago
Thanks for the clarification John...I found your article very useful and I´ll certainly consider changes in tangible equity per share in future analyses.
pbtown
Pbtown premium member - 3 years ago
Good article, John. When a ABC corp. makes an acquisition (XYZ) for cash, the cash comes off ABC's balance sheet's cash line and the balance sheet of the acquired business is merged into ABC's balance sheet. But unless ABC bought XYZ for book value or less, the entire purchase price hasn't been accounted for until the excess purchase price over book value is added to intangibles. For example, if XYZ has a book value of $200,000 and ABC pays $1 million for XYZ, cash goes down by $1 million on ABCs balance sheet and equity only goes up $200,000. There is a missing $800,000. GAAP rules say to put that amount on ABC's balance sheet as an 'intangible' asset. If you only look at tangible book value growth, wouldn't you see a sudden drop in tangible growth that year? Essentially, the tangible book value of ABC went down by $800,000. I totally get your point about how important tangible book value is as a means of evaluating management, but its growth rate has to be evaluated carefully or you will end up with some glaring errors. In the case of CNTY we get a rocking tangible book growth rate in a business that has really mediocre growth of sales, earnings and cash. No doubt you'd suggest we look at the whole picture and I'd agree because clever financial managers can make one key ratio look pretty good but only at the expense of other key ratios.
John Emerson
John Emerson - 3 years ago
In the case of ABC, the 800K would be listed on the asset section of balance sheet as goodwill. Accounting goodwill is defined as any acquisition price paid above the tangible equity of a compay of course goodwill is an intangible asset, but it is differentiated on the balance sheet from intangible assets. You are correct in assuming that any acquisition price paid over the tangible equity will result in no change in total equity, although a reduction in tangible equity will result based upon the amount of the goodwill. Total equity would not be reduced unless the goodwill was impaired. Under current accounting rules companies are required to run goodwill impairment tests on an annual basis. If they fail, a writedown is taken, otherwise the goodwill remains of the balance sheet. A few years back goodwill was amortized on a yearly basis, 2.5% a year as I recall. My point is that successful managers increase tangible equity per share over time without regard to any temporary change in tangible equity. Witness See's Candy, Buffett paid well over tangible equity for the business but that temporary decline in tangible equity of Berkshire was quickly replaced by a continual stream of earnings that ultimately added to millions and millions of tangible equity gains to the Berkshire balance sheet.

As far as CNTY they have increased tangible equity largely over time by acquiring casinos at discount rates, improving them and then selling them for a fat profit. Their latest rebuilding project is the newly named Century Casino in Calgary. Not so different than some of the moves at Leucadia. Hence if one focuses on operating earnings or revenue growth they will not recognize the underlying value at CNTY. It is play on price to book as well as a play on the managements ability to turn a sow's ear into a silk purse.

Thank you for your thoughtful comment!
pbtown
Pbtown premium member - 3 years ago
Thanks for the great insight into CNTY as well as your thoughts on tangible bvps growth, John. I'll look at it again in a new light. What do you see as the current value of CNTY

? Much appreciated.
John Emerson
John Emerson - 3 years ago


I think CNTY has a bare minimum value of around 4.5 per share which merely reflects it tangible book value per share as reflected on the balance sheet. Certainly if all it properties were put up for sale and liquidated the number would be higher. That of course will not happen. I also consider that CNTY has another slight margin of safety for American investors since it makes the lion's share of its earnings in Canadian dollars. That gives US investors a hedge against a weakening dollar. Monitor potential earnings gains at the rebuilt Calgary casino as a possible catalyst.
pbtown
Pbtown premium member - 3 years ago
$4.5 per share does seem reasonable. It would be hard to argue the value is less than the liquidation net revenue unless the management is wasting the assets. I'll dig in on it. Thanks for the information and rational discussion.
jhodges72
Jhodges72 - 3 years ago
I've held CNTY for sometime and written numerous articles concerning it. I've valued the real estate to be worth $6 per share after all liabilities. Something this article doesn't mention and that is a huge selling point for it, CNTY has a sustainable competitive advantage in that a competitive restriction exists in Edmonton in which no additional casino licenses will be issued for the next 5 years, except to non-profit organizations raising money on a short term basis. This is important information to have knowledge of.

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