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Robert Abbott
Robert Abbott
Articles (801)  | Author's Website |

Book of Value: Due Diligence on Management

How to determine if management is doing an effective job

April 03, 2020 | About:

How can we assess the job being done by management? In the previous chapter, we examined business models and how well management was executing on them.

Now, in chapter 20 of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma has offered some specifics about managers and their "managers."

And why are managers so important? Sharma responded that the success of a company—and our investment in it—depends on how well top managers do at finding opportunities and then allocating capital to create new or additional streams of cash. Some outstanding examples were Steve Jobs of Apple (NASDAQ:AAPL), Sam Walton of Walmart (NYSE:WMT) and Ray Kroc of McDonald's (NYSE:MCD).

Of course, there are also examples of managers who destroyed companies and investors’ capital. Sharma added, “For shareholders, there is perhaps no more important an issue than the competence, integrity and character of the managers in control of the companies in which they have invested.”

All of this means investors should try to disconfirm or refute their investment cases by looking for problems with the character or actions of these people entrusted with their money. The author suggested three areas in which we should check the quality of management: Who they are (demographics), their track records and what oversight of management exists.

Demographics

In what he called the “demographics" section, the author focused on the backgrounds of managers, team dynamics and turnover.

In the background section, he emphasized the breadth and depth of their experience, as well as their demographic profiles (age, history and tenure). Next, to get a sense of their thinking, Sharma recommended that we read their letters to shareholders as well as what they say in interviews and on earnings calls.

My priority when looking at companies is to review the management discussion and analysis (MDA) section of the annual report. For example, here is how Walmart management introduced its most recent MDA (Dec. 4, 2019):

“We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period and the primary factors that accounted for those changes. We also discuss certain performance metrics that management uses to assess the Company's performance.”

I also like to review annual presentations. These documents are designed to attract new investments or to pull more investment from existing investors, so they must be taken with a grain of salt. Despite that, they usually provide a clear vision of where the company plans to go in the short and medium terms.

Sharma’s second area of interest in the demographics section involves management as a team. It’s not only the performance of the CEO that matters, but also how well all members of the management team work together. The second most important position is that of the chief financial officer, but other positions can be crucially important as well. These include sales and marketing, human resources and technology, to name a few.

Third, he looked at turnover and succession. When a CEO retires or dies, a company’s future can be made or broken. To some extent, this will depend on the size and the age of the company because more mature and successful companies have the processes, time and money needed for orderly successions.

Carrying on with his aim of trying to break an investment case for Walmart, Sharma examined what management had done in the years prior to publication of his book in 2016. He found no grounds for refuting the Walmart investment case.

Track record

Here, the author focused on financial performance, honest accounting and shareholder friendliness.

Financial performance may start with the fundamentals, such as operating ratios and inventory turnover. These are the basic operating metrics that may or not lead to good operating results. In the bigger picture, investors can also assess management’s record by looking at how effectively it has deployed its capital. The results show up in return on equity and return on capital over time.

Honest accounting refers to fair and consistent reporting in the financial statements. Sharma warned investors they should be particularly careful about the top line; some companies have been overly aggressive in their reporting in order to meet expectations. This may show up through inconsistent margins and operating ratios.

Turning to shareholder friendliness, a couple of matters should be given priority. First, is the company returning capital to shareholders through dividends or share buybacks? Or is the CEO using cash flow and profits to build an empire or to take measures that unreasonably bump up management compensation? The other area of concern is the dilution of shares (the opposite of share buybacks), issuing new shares for the wrong reasons.

Sharma concluded that Walmart had a good record on all three of these measures, and therefore could not refute an investment thesis based on its track record.

Oversight

Management compensation is one of those areas where oversight problems sometimes arise. For investors who want to check, search out the annual DEF 14A reports that detail what top earners received. The metric is the compensation ratio, which is calculated by dividing management compensation by the company’s income.

Sharma’s research in 2011 showed Walmart had a compensation ratio of 0.38%, which was comparable with Exxon Mobil (NYSE:XOM) at 0.24%, Johnson & Johnson (NYSE:JNJ) at 0.44% and other large corporations.

Pay structure also matters, specifically how much of an executive’s total compensation comes from salary and how much from incentives (stock options or stock grants). In 2011, the Walmart CEO received 8.72% from salary and the remainder from incentives, which was in line with what other large corporations were paying.

In theory at least, the board of directors supervises management on behalf of shareholders and keeps managers from going astray. Yet, theory doesn’t always work out in practice. That can happen because friends or family of the CEO end up on the board and it becomes a rubber stamp rather than a genuine source of oversight. Family-controlled corporations may end up in this situation too.

Sharma’s assessment of Walmart, which is a family-owned corporation, is a cautious one. He did not argue that this was a disconfirming issue, but he did warn that “long-term shareholders of Walmart must closely monitor the actions of the family members engaged in the oversight and management of the company.”

Conclusion

Managers and their environments were the focus of chapter 20 of “Book of Value: The Fine Art of Investing Wisely.” In it, Sharma argued that managerial issues could also be the basis for disconfirming or refuting an investment thesis.

He provided investors with a list of issues to check as they do their analysis or due diligence. They were grouped into three broad categories: demographics, track record and oversight. A company that failed in any of these areas would suffer a loss in investor confidence.

For Walmart, the company Sharma has been following in this book, confidence remains since none of the tenets of the investment case have failed. However, he did sound a note of caution about oversight, warning that investors should keep an eye on the independence of the board of directors.

Disclaimer: This review is based on “Book of Value: The Fine Art of Investing Wisely" by Anurag Sharma, which was published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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