Ordinary stockholders have to place a massive amount of trust in the managers of the companies they own. Minority mom and pop investors don't have any control or say over the way the companies in their portfolios are run, and they're unlikely ever to be able to build the resources to take control even if they wanted.
As a result, it's vital that minority investors can trust their managers. They need to be able to believe that managers will produce the best outcomes for all investors, not just the large hedge funds and mutual funds.
According to Warren Buffett (Trades, Portfolio), there are two main yardsticks investors can use to establish whether or not managers will act in the best interest of all stakeholders.
Buffett's yardsticks
Buffett made the following comments at the 1994 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders. Responding to a shareholder who asked Buffett for his thoughts on how to find good managers, the Oracle of Omaha started his reply by saying, "I think you judge management by two yardsticks."
The first, as he went on to explain, was how well they run the business:
"One is how well they run the business and I think you can learn a lot about that by reading about both what they've accomplished and what their competitors have accomplished, and seeing how they have allocated capital over time. You have to have some understanding of the hand they were dealt when they themselves got a chance to play the hand."
The second yardstick Buffett said he liked to use was to try and work out how these managers had treated their "owners," or shareholders:
"And then the second thing you want to figure out is how well that they treat their owners. And I think you can get a handle on that, oftentimes. A lot of times you can't. I mean it β they're many companies that obviously fall in β somewhere β in that 20th to 80th percentile and it's a little hard to pick out where they do fall. But, I think you can usually figure out β I mean, it's not hard to figure out that, say, Bill Gates (Trades, Portfolio), or Tom Murphy, or Don Keough, or people like that, are really outstanding managers. And it's not hard to figure out who they're working for."
Buffett went on to explain that while it's always going to be difficult to distinguish good managers from the bad, how they treat their owners can be a great guide:
"It's interesting how often the ones that, in my view, are the poor managers also turn out to be the ones that really don't think that much about the shareholders, too. The two often go hand in hand."
Like so many parts of investing, there's no set formula for finding good managers, but Buffett's comments from 1994 offer some great guidance. He went on to add that the best way to gain an understanding of management by far is through reading.
Reading company annual reports, competitor reports and reports on managers from outside the organization all help build a picture of a manager. When you have all of this information in front of you, it is not as difficult to establish a manager's quality. The more information available, the easier it'll be to reach a conclusion.
Unfortunately, there's no short-cut to this process. Finding good managers, like finding good companies, takes time. However, if the process is done well, the rewards can be substantial. That's why it's worth spending time reading up on the business and its competitors.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- How to Build a Portfolio According to Charlie Munger
- The Sequoia Fund's Simple Four-Point Checklist
- Why Second-Level Thinking Is Vital for Investors
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