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.
No position in WLDN
I will return next week to discuss emotion as the Tenets of Value Investing continues.
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