"Berkshire Hathaway is our largest holding because of Warren Buffett. Leucadia National is a large holding because of Ian Cumming and Joseph Steinberg. We think Eddie Lampert at Sears is a young member of that group."
When investing in a business, Bruce Berkowitz tends to pay more attention to the jockey than the horse because if a company has the assets and management to do well in tough times, the seeds for exceptional performance is already planted.[1] Even Mohnish Pabrai has expressed, in his recent 2008 shareholders meeting, that he is now focusing more on management.[2]
Evaluating management is not easy. The key here is to make sure management has integrity, intelligence and energy. "But the most important is integrity, because if they don't have that, the other two qualities, intelligence and energy, are going to kill you.", as Buffett pointed out. Remember, when you invest, you are entrusting your money to management. In The Intelligent Investor, Benjamin Graham tried to tell us that, in theory, the shareholders are the most powerful people at a company. We are capable of bending any management to our will. But he gave up after realizing that, in practice, many shareholders simply surrender their rights to management by voting according to management recommendations.
So unless you have the resources to secure a controlling interest at a company, you will have to rely on your ability to pick capable management you are willing to get in bed with. Here are four points to remember when evaluating management.
Annual reports and company websites often have colorful photos of the executive team because someone must have figured out that putting a face next to a name makes the company more credible. That someone must have never read Leucadia annual reports. Try searching for photos of Ian Cumming and Joseph Steinberg and you'll see what I mean.
When reading executive bios, always take it with a grain of salt. Guess who controls what goes into the bios? The executive backgrounds allow management to enhance their credibility by peppering names like Harvard and Yale. Not all information provided in the executive profiles is useless. For management who just took over the helm, the profiles hint at where management previously worked and how they fared. Also important here is how long has management been with the company. I tend to favor management who founded the company and stayed on.
Shareholder letters offer insights into how management communicates with investors. The tone of the letters are almost always positive and upbeat. The worst adjectives you could find in a letter are "challenging" and "difficult". But they are commonly followed by a vote of confidence by management to calm the nerves of shareholders. This is understandable. But watch for management who draws attention to better looking but less important numbers to distract shareholders from focusing on the current problem.
Some investors advocate talking to management to get a better feel of their characters. I don't think this is necessary. The danger here is management tend to have excellent oratory skills that might charm you into believing everything they say. In fact, some management thinks frequent communication with shareholders is all but a waste of time. Leucadia never holds quarterly conference calls.
Many investors tend to glean over proxy statements because annual and quarterly reports are already long enough. But what they don't realize is the proxy statements contain crucial disclosures that could make or break an investment such as self-dealing. This is most evident in the Enron debacle. Had Enron investors read in the 1999 proxy about how CFO, Andrew Fastow, borrowed Enron funds to purchase energy related assets from Enron via his two partnerships, they would have balked.[3]
Another juicy tidbit offered in the proxy statement is management compensation including grants of stock options and restricted stock. It is important to pay attention to how management is compensated and how the pay compares to similar sized companies in the industry. Bonuses preferably in stock options or restricted stock should be awarded only if management hit a reasonable performance target.
Finally, the proxy statements also provide information about how much stock insiders own. Management should eat their own cooking. I expect management to have their substantial net worth invested in the company they run. Couple your analysis with the Form 4 filings to find out if management has been adding or reducing their stake. Recent significant open market purchases indicate a strong vote of confidence while significant selling by multiple executives and directors could be a sign of trouble.
To gauge the intelligence of management, observe how management act during tough times. Management that can keep the ship afloat when things go south will tend to do phenomenally well when the tide changes because weaker competitors would have faltered. Take AmeriCredit for example. Management has survived a credit crisis once back in 1998. Then CFO, Daniel Berce (currently CEO), made the right decision to reduce volume to conserve capital and came back roaring when the crisis subsided.[4]
Since the job of a CEO is to allocate capital wisely to maximize shareholder benefits, investors need to analyze deals made by management. The general rule of thumb as, Buffett always emphasized, is every dollar retained should produce a dollar or more in value. If not, the money must be returned to shareholders. Some CEOs, unfortunately, think they are paid to act. So in the interest of making themselves look busy they strive to make say five acquisitions a year. This is just plain stupid. If the deals are not going to produce a decent return for shareholders, the acquisitions are nothing but what Peter Lynch calls deworsification.
At some companies, the CEO is the key asset to the company. Study the deals the guy at the helm makes. We are all familiar with the dynamic duos Warren Buffet and Charlie Munger, and Ian Cumming and Joseph Steinberg. But there are some lesser known smart cookies such as Michael Ashner of Winthrop Realty who has consistently made some pretty amazing deals in real estate.
Apart from allocating capital, management is also responsible for maximizing efficiency. Days sales outstanding is a good measure of how quickly management can convert sales to cash. For financial companies, you would want to look at efficiency ratios, which is non-interest expense divided by net interest and fee income.
Don't forget to look for signs of overspending in office buildings and unnecessary fringe benefits. Remember former Tyco CEO, Dennis Kozlowski's $6,000 shower curtain and $2-million birthday party for his wife? Of course, these are hard to detect. But generally expenses should be in-line with same-size competitors.
Responsible management always act in the interest of the shareholders. Ask yourself "Is the action in the best interest of the shareholders?" If not, sell your shares and stay away. The reason is simple: As a shareholder, the management team works for you. If you don't like them, why let them manage your hard-earned money?
Good management would pay dividends when they couldn't find a better use for the cash generated by the business. After all, as a shareholder, the cash belongs to you. If the stock is trading at a discount, they would repurchase shares to maximize shareholder returns. Of course, not all share buybacks are equal. But that's a topic for another day. As mentioned earlier, look for management who eat their own cooking. They are more inclined to take the side of the shareholders.
References
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
When investing in a business, Bruce Berkowitz tends to pay more attention to the jockey than the horse because if a company has the assets and management to do well in tough times, the seeds for exceptional performance is already planted.[1] Even Mohnish Pabrai has expressed, in his recent 2008 shareholders meeting, that he is now focusing more on management.[2]
Evaluating management is not easy. The key here is to make sure management has integrity, intelligence and energy. "But the most important is integrity, because if they don't have that, the other two qualities, intelligence and energy, are going to kill you.", as Buffett pointed out. Remember, when you invest, you are entrusting your money to management. In The Intelligent Investor, Benjamin Graham tried to tell us that, in theory, the shareholders are the most powerful people at a company. We are capable of bending any management to our will. But he gave up after realizing that, in practice, many shareholders simply surrender their rights to management by voting according to management recommendations.
So unless you have the resources to secure a controlling interest at a company, you will have to rely on your ability to pick capable management you are willing to get in bed with. Here are four points to remember when evaluating management.
Take Management Communication with a Grain of Salt
Annual reports and company websites often have colorful photos of the executive team because someone must have figured out that putting a face next to a name makes the company more credible. That someone must have never read Leucadia annual reports. Try searching for photos of Ian Cumming and Joseph Steinberg and you'll see what I mean.
When reading executive bios, always take it with a grain of salt. Guess who controls what goes into the bios? The executive backgrounds allow management to enhance their credibility by peppering names like Harvard and Yale. Not all information provided in the executive profiles is useless. For management who just took over the helm, the profiles hint at where management previously worked and how they fared. Also important here is how long has management been with the company. I tend to favor management who founded the company and stayed on.Shareholder letters offer insights into how management communicates with investors. The tone of the letters are almost always positive and upbeat. The worst adjectives you could find in a letter are "challenging" and "difficult". But they are commonly followed by a vote of confidence by management to calm the nerves of shareholders. This is understandable. But watch for management who draws attention to better looking but less important numbers to distract shareholders from focusing on the current problem.
Some investors advocate talking to management to get a better feel of their characters. I don't think this is necessary. The danger here is management tend to have excellent oratory skills that might charm you into believing everything they say. In fact, some management thinks frequent communication with shareholders is all but a waste of time. Leucadia never holds quarterly conference calls.
The Juice Is In The Proxy Statement
Many investors tend to glean over proxy statements because annual and quarterly reports are already long enough. But what they don't realize is the proxy statements contain crucial disclosures that could make or break an investment such as self-dealing. This is most evident in the Enron debacle. Had Enron investors read in the 1999 proxy about how CFO, Andrew Fastow, borrowed Enron funds to purchase energy related assets from Enron via his two partnerships, they would have balked.[3]
Another juicy tidbit offered in the proxy statement is management compensation including grants of stock options and restricted stock. It is important to pay attention to how management is compensated and how the pay compares to similar sized companies in the industry. Bonuses preferably in stock options or restricted stock should be awarded only if management hit a reasonable performance target.
Finally, the proxy statements also provide information about how much stock insiders own. Management should eat their own cooking. I expect management to have their substantial net worth invested in the company they run. Couple your analysis with the Form 4 filings to find out if management has been adding or reducing their stake. Recent significant open market purchases indicate a strong vote of confidence while significant selling by multiple executives and directors could be a sign of trouble.
Analyze Capital Allocation
To gauge the intelligence of management, observe how management act during tough times. Management that can keep the ship afloat when things go south will tend to do phenomenally well when the tide changes because weaker competitors would have faltered. Take AmeriCredit for example. Management has survived a credit crisis once back in 1998. Then CFO, Daniel Berce (currently CEO), made the right decision to reduce volume to conserve capital and came back roaring when the crisis subsided.[4]
Since the job of a CEO is to allocate capital wisely to maximize shareholder benefits, investors need to analyze deals made by management. The general rule of thumb as, Buffett always emphasized, is every dollar retained should produce a dollar or more in value. If not, the money must be returned to shareholders. Some CEOs, unfortunately, think they are paid to act. So in the interest of making themselves look busy they strive to make say five acquisitions a year. This is just plain stupid. If the deals are not going to produce a decent return for shareholders, the acquisitions are nothing but what Peter Lynch calls deworsification.
At some companies, the CEO is the key asset to the company. Study the deals the guy at the helm makes. We are all familiar with the dynamic duos Warren Buffet and Charlie Munger, and Ian Cumming and Joseph Steinberg. But there are some lesser known smart cookies such as Michael Ashner of Winthrop Realty who has consistently made some pretty amazing deals in real estate.
Apart from allocating capital, management is also responsible for maximizing efficiency. Days sales outstanding is a good measure of how quickly management can convert sales to cash. For financial companies, you would want to look at efficiency ratios, which is non-interest expense divided by net interest and fee income.
Don't forget to look for signs of overspending in office buildings and unnecessary fringe benefits. Remember former Tyco CEO, Dennis Kozlowski's $6,000 shower curtain and $2-million birthday party for his wife? Of course, these are hard to detect. But generally expenses should be in-line with same-size competitors.
Alignment of Interest with Shareholders
Responsible management always act in the interest of the shareholders. Ask yourself "Is the action in the best interest of the shareholders?" If not, sell your shares and stay away. The reason is simple: As a shareholder, the management team works for you. If you don't like them, why let them manage your hard-earned money?
Good management would pay dividends when they couldn't find a better use for the cash generated by the business. After all, as a shareholder, the cash belongs to you. If the stock is trading at a discount, they would repurchase shares to maximize shareholder returns. Of course, not all share buybacks are equal. But that's a topic for another day. As mentioned earlier, look for management who eat their own cooking. They are more inclined to take the side of the shareholders.
References
- Whitney Tilson and John Heins, Buffett: Still The Best Jockey, Forbes excerpt from Value Investor Insight, April 28, 2006.
- Joe Ponzio, Notes from the Pabrai Funds 2008 Annual Meeting, FWallStreet, October 1, 2008.
- Benjamin Graham with commentary by Jason Zweig, The Intelligent Investor Revised Edition, HarperBusiness, 2003. p. 500 - 501.
- Andrew Osterland, Less Business Wanted? It Worked for AmeriCredit, CFO.com, October 22, 2001.
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
