I begin the article by quoting this paragraph from the book “From Graham to Buffett and Beyond” by Professor Bruce Greenwald. This quote came from value investing legend Walter Schloss who outperformed the market for 45 years.
My personal investment philosophy is to avoid buying stocks based purely on good management, but always avoid buying stocks with known bad management. To use a racing horse analogy, a good jockey may not win you the horserace, but a bad jockey will ruin the race and may even throw himself (and the shareholders) off the horse on purpose.
There are three types of management, each with its own set of pros and cons: (1) Founder or substantial shareholder (2) Long-service employee who rose through the ranks (3) Outside hire.
The background and track record of the manager is crucial. Managers with a non-operating background could fail to connect with the ground, or in the worst case be out of touch with the core business needs of the company.
Is the management in for the money or the business? Distinguish the “build and sell guys” from “the business is my baby.”
In most cases, the CEO is best unknown and out of the media spotlight. The CEOs of high profile failures and corporate scandals are mostly media whores, who show up on television more than they show up in the corporate office.
Differential disclosure is also a key criterion in differentiating between good management and bad management. Read through all the material to find consistencies or inconsistencies between what management is saying and doing.
CEOs with low salaries and high stock ownership and that promote a dividend policy are the best management. On the other hand, companies who pay excessive stock options to management, but refraining from paying dividends should be avoided.
Management as Allocators of Capital
Besides being operators of businesses, management are also judged as allocators of capital. Cash on the balance sheet will be eroded by inflation; while reckless acquisitions will destroy capital. Dividends and share repurchases are preferred if there are no competing opportunities for growth that are value enhancing.
Share repurchases are also a favorite of Warren Buffett. A shareholder sees his ownership interest rise without any cashflow out on his part. Repurchases made to offset options dilution should be disregarded.
Management – Alignment of Interests
Insider sales should be watched closely. Management selling into a falling market are not the kind that shareholders should be entrusting their money with.
I prefer to bet on the horse, rather than the jockey. For me, management matters - only the bad ones. I am more concerned about the negative impact of bad management than any positives from quality management. I hope this article provides a useful checklist for avoiding companies with bad management.