One of the most noticeable areas of difference between the first and fourth edition of Benjamin Graham’s “The Intelligent Investor” is that the chapter regarding management is much smaller in the final version. Graham writes in the final edition:
Ever since 1934, we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their management….Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration.
In Jason Zweig’s commentary to the fourth edition, Zweig reminisces that Graham’s earlier pronouncements were that shareholders should turn their attention to two main ideas;
1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?
Perhaps in his later years, Graham gave up on the idea of active shareholders attempting to communicate their displeasure with management.
Later on, Warren Buffett has also communicated his three tenants of management, which include:
1. Management should be rational
2. Management should be candid with the shareholders
3. Management should resist the institutional imperative
Both Graham and Buffett emphasize that shareholders need to be active, but in evaluating management, we have mostly failed. Because some of these tenets are more abstract, it is easier for most of us to consign the skills of management into metrics that we can study objectively, mostly regarding return on invested capital (ROIC), return on assets (ROA) and return on equity (ROE) and “calling it good”. If those metrics are good, then management must be doing their job. We would like to believe this, however; if you look at the metrics of companies like Microsoft (MSFT, Financial), you cannot get much better numbers for the metrics and yet we are still unsatisfied with the returns. So, what gives?
Graham and Buffett believe that companies should listen to their shareholders. It often appears that they don’t. But is that true? A more precise question that we must face is, which shareholders should management be listening to? We value investors are in the minority…..remember? So, is management listening to the vast majority of investors known as “growth” investors? Whose interests are more important?
In 2005, an academic paper was issued, entitled “The Economic Implications of Corporate Financial Reporting”. The report was written by John R. Graham from Duke University, Campbell R. Harvey from National Bureau of Economic Research and Shiva Rajgopal from the University of Washington. The study included a survey of 401 financial executives and in-depth interviews with another 20, to determine the key factors that drive their performance measurement.
The study offered these conclusions:
Our results indicate that CFOs believe that earnings, not cash flows, are the key metric considered by outsiders.
An overwhelming majority of CFOs prefer smooth earnings (versus volatile earnings)….The executives believe that less predictable earnings – as reflected in a missed earnings target or volatile earnings – command a risk premium in the market. A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
Most executives feel they are making an appropriate choice when sacrificing economic value to smooth earnings or to hit a target….Therefore, many executives feel that they are choosing the lesser evil by sacrificing long-term value to avoid short-term turmoil.
Several CFOs indicate that they would work aggressively within the confines of GAAP to reduce the perception of uncertainty about their firm’s prospects. One executive cited the example of realizing a $400 million unexpected gain on the sale of a company. Instead of reporting the gain in the quarter that it occurred, the firm purchased collars to smooth the gain into $40 million of income in each of the next 10 quarters. Since the collar costs money, we surmise that this behavior indicates a willingness to pay real cash flows in order to report smooth accounting earnings over the next 10 quarters.
The report was troubling, but with this background, how do we, as value investors, view management? If management mostly cares about earnings and manipulating them to appear smooth, we certainly have our work cut out for us.
It is the David Einhorn’s of our world and others like him that speak for us, but we need to find our voice and start speaking up also.
Ever since 1934, we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their management….Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration.
In Jason Zweig’s commentary to the fourth edition, Zweig reminisces that Graham’s earlier pronouncements were that shareholders should turn their attention to two main ideas;
1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?
Perhaps in his later years, Graham gave up on the idea of active shareholders attempting to communicate their displeasure with management.
Later on, Warren Buffett has also communicated his three tenants of management, which include:
1. Management should be rational
2. Management should be candid with the shareholders
3. Management should resist the institutional imperative
Both Graham and Buffett emphasize that shareholders need to be active, but in evaluating management, we have mostly failed. Because some of these tenets are more abstract, it is easier for most of us to consign the skills of management into metrics that we can study objectively, mostly regarding return on invested capital (ROIC), return on assets (ROA) and return on equity (ROE) and “calling it good”. If those metrics are good, then management must be doing their job. We would like to believe this, however; if you look at the metrics of companies like Microsoft (MSFT, Financial), you cannot get much better numbers for the metrics and yet we are still unsatisfied with the returns. So, what gives?
Graham and Buffett believe that companies should listen to their shareholders. It often appears that they don’t. But is that true? A more precise question that we must face is, which shareholders should management be listening to? We value investors are in the minority…..remember? So, is management listening to the vast majority of investors known as “growth” investors? Whose interests are more important?
In 2005, an academic paper was issued, entitled “The Economic Implications of Corporate Financial Reporting”. The report was written by John R. Graham from Duke University, Campbell R. Harvey from National Bureau of Economic Research and Shiva Rajgopal from the University of Washington. The study included a survey of 401 financial executives and in-depth interviews with another 20, to determine the key factors that drive their performance measurement.
The study offered these conclusions:
Our results indicate that CFOs believe that earnings, not cash flows, are the key metric considered by outsiders.
An overwhelming majority of CFOs prefer smooth earnings (versus volatile earnings)….The executives believe that less predictable earnings – as reflected in a missed earnings target or volatile earnings – command a risk premium in the market. A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
Most executives feel they are making an appropriate choice when sacrificing economic value to smooth earnings or to hit a target….Therefore, many executives feel that they are choosing the lesser evil by sacrificing long-term value to avoid short-term turmoil.
Several CFOs indicate that they would work aggressively within the confines of GAAP to reduce the perception of uncertainty about their firm’s prospects. One executive cited the example of realizing a $400 million unexpected gain on the sale of a company. Instead of reporting the gain in the quarter that it occurred, the firm purchased collars to smooth the gain into $40 million of income in each of the next 10 quarters. Since the collar costs money, we surmise that this behavior indicates a willingness to pay real cash flows in order to report smooth accounting earnings over the next 10 quarters.
The report was troubling, but with this background, how do we, as value investors, view management? If management mostly cares about earnings and manipulating them to appear smooth, we certainly have our work cut out for us.
It is the David Einhorn’s of our world and others like him that speak for us, but we need to find our voice and start speaking up also.
