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Steven Chen
Steven Chen
Articles (206)  | Author's Website |

Urbem's 'Quality Strategy' Series: The Management

You can't make a good deal with a bad person

Although the reverse may not always be true, even a great business in the hands of a poor manager often dampens shareholder value. This is why able management is a prerequisite of business for Warren Buffett (Trades, Portfolio) to invest. It should be noted here that “able” here does not just equal “intelligently capable” but also covers “trustworthiness.” At Urbem, we mainly look for certain pivotal traits in the management team when evaluating a stock, including trustworthiness and intelligent capability.

Effective capital allocation

Much to investors’ disappointment, most public companies put more emphasis on the earnings growth than the return on capital. However, as was wrote in previous articles, not all earnings growth creates value for shareholders. Take the airline industry as an example – every year, a typical airline business absorbs massive invested capital and produces a scant profit. In this regard, any rapid growth would destroy value. Hence, rationally speaking, its shareholders should vote for a “negative” growth (i.e., divestiture) to allocate the capital somewhere else for a more rewarding ending.

As Buffett stated in his 1979 letter to Berkshire Hathaway (BRK.A) (BRK.B) shareholders, “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”

At Urbem, we appreciate management with a strong track record of capital allocation as evaluated by looking through the history of returns (in both income and cash flow) on invested capital, equity capital, total earnings reinvested and total assets. A consistently industry-beating return is more significant to us than any stellar growth.

Investors should also examine annual reports and shareholder letters to understand management’s strategic target, agenda and KPI. While most public firms (and most financial media) follow a short-term growth mindset, we do have the fortune to encounter a few management teams (e.g., Fuchs Petrolub (XTER:FPE3) and Kakaku.com Inc. (TSE:2371)) that prioritize returns.

The effective capital allocation also applies to share repurchase programs. We observed that investors tend to get enthusiastic about management’s plan to return capital by buying back and reducing shares, while they often disregard a crucial question – at what cost are the shares being repurchased? To create shareholder value, a company should disciplinarily repurchase stocks only at a price below its intrinsic value. This is what Rollins (ROL) and Credit Acceptance (CACC) have been doing, if you reference their buyback records against valuations in history.

Open communication

We enjoy dealing with management that communicates with its shareholders objectively, straightforwardly, and outspokenly. On the contrary, sugarcoating through metrics like adjusted earnings or EBITDA would be a severe warning sign. We also favor management that forgoes issuing guidance, and instead conveys its long-term thinking.

In our opinion, investors may quickly get a sense of the shareholder friendliness of the management by communicating directly with the company’s Investor Relations department. To illustrate this, let’s take a look below at the management’s explanation at Credit Acceptance concerning its unique approach of answering shareholder questions – in writing and posted on the company website:

“We believe this strategy is preferable to other approaches for several reasons. First, we believe we can provide more thoughtful and substantive answers in writing. Second, every shareholder receives the same information at the same time. Third, it is more efficient since questions only need to be answered once. Fourth, over time as the library of previous communications."

Frugality

A frugal manager often leads to a frugal corporate culture (e.g. not wasting money on vanity projects or fleets of private jets) - one of the typical traits among many sustainably successful businesses in our experience.

One of our heroes here is Bob Kierlin, the founder of Fastenal (FAST), who was nominated by Inc.com as the cheapest CEO in America. Under Mr. Kierlin’s leadership, the Minnesota-based startup has transformed from a tiny local store with a 20-foot-wide front to a nationwide wholesale distributor of industrial and construction supplies with hundreds of outlets in 30 years, while making shareholders millions. The secret sauce? Best-in-industry margins thanks to all sorts of cost-cutting, both big and small. There are no 401k plans, no stock options, no meal per diems for business travel, no airline tickets more than $400, second-hand furniture (often from government auctions) in office, low-cost in-house production of annual reports and so on.

Aligned interest

To demonstrate an aligned management interest with shareholders, we prefer to see management taking a modest portion of fixed and cash pay but holding a significant equity stake in the company. It is also necessary for investors to trace the development of total management pay in light of business performance. Furthermore, recent insider transactions are another good indicator in this respect. Lastly, we favor businesses that are still founder-led, such as Check Point Software Technologies (CHKP). It is worth noting that the founder, Gil Shwed, has not paid himself any salary or bonus over the last few years and currently owns 17% of the company.

Disclosure: The mention of any stock in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway, Kakaku.com Inc., Rollins, Check Point Software Technologies, and Credit Acceptance.

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About the author:

Steven Chen
Steven CHEN is a quality-focused, business-perspective investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected], LinkedIn, or WeChat (ID: LSCHEN2005).

Also, check out his column at Smartkarma on the Asian market - www.smartkarma.com/profiles/steven-chen

Visit Steven Chen's Website


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