In a recent conversation with another investor, we discussed how important it is only to buy what you know and understand – what I believe to be one of the most important aspects of investing.
There are two parts to this notion of only buying what you know. First, you have to be able to understand the business; sometimes this is not possible because companies such as Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) have multiple operating divisions that do not break out all the figures.
Does this mean you should avoid Warren Buffett (Trades, Portfolio)'s holding company? No, because it is run by an astute manager. And this is the second part of the equation.
If you trust and know the management team has a substantial interest in the business and is looking to achieve the best returns for investors, understanding the business as a whole is less important because you know the management.
I understand this is a bit of a cliché. If you trust in the management only and do not understand the rest of the business, do you know and understand the company as a whole?
That is an interesting concept, one that requires some consideration. If you were to adopt a policy of only investing in businesses you understood and ignored investment conglomerates and proven value creators such as John Malone and Buffett, as well as groups such as Fairfax (TSX:FFH, Financial), Markel (MKL, Financial) and Amazon (AMZN, Financial), you would be holding back your investment performance significantly. All of these examples are famous for having relatively opaque business models where a lot of trust is put in management to achieve the best returns for shareholders.
It is also the case the companies are controlled by the most significant shareholders, so the owners are highly incentivized to achieve the best results. Additionally, in most cases, the managers of these companies have been around for decades, and know the business inside and out.
On the other hand, many poorly performing companies only keep managers for several years, which is why, in these cases, it is important to understand the business inside and out so that you are not wrongfooted when managers eventually change (investors with a horizon of 10 years or more generally stay around longer than most CEOs). On the other hand, someone like Buffett knows his business better than almost anyone else out there.
To overcome this issue, you could argue the best way to invest is only to invest in those companies with owner-operators, and founders in control. That is one solution, but it is not a foolproof strategy. Dryships (DRYS, Financial) and Snap (SNAP, Financial) are both owner operated, and neither company can claim to be looking out for other shareholders.
Trust in management is one of the key points on my investment checklist, the list I always use to evaluate any opportunity. When it comes to management, I believe the following six criteria do an excellent job of separating out the best managers from the worst value destroyers:
Checklist
- Does the owner have a proven record of value creation?
- Is management paid sensibly? This is difficult to qualify and depends on a company-by-company basis.
- How has the business fared under its tenure? Has the company grown, stagnated or contracted? Employee reviews can be a great way to discover management’s temperament and environment within the company.
- Does management have a majority shareholding?
- Are management’s voting interests aligned with shareholders? I am cautious of shared structures where owner-operators have total control, especially if management has no record of value creation.
- Does management have sensible capital allocation goals and does it have a record of meeting these targets successfully?
This is not an exhaustive list, and it is certainly not designed to be a definitive guide. However, I believe if management meets all of these criteria, it is unlikely you will make a mistake by investing alongside them.
Disclosure: The author owns no stock mentioned.
