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Thomas Macpherson
Thomas Macpherson
Articles (193)  | Author's Website |

Interviewing Management: Core Concepts

At the Nintai Charitable Trust there are 4 major areas of interest when we interview corporate management

June 16, 2016 | About:

Good questions are often far more powerful than answers,” they argue. “Good questions challenge your thinking. They reframe and redefine the problem. They throw cold water on our most dearly held assumptions and force us out of our traditional thinking. They motivate us to learn and discover more. They remind us of what is most important in our lives.” – Andrew Sobol and Jerald Panas[1]

In 2013 during a strategy session reviewing decision making in the Second Iraq War, an officer heard a case study and whistled. “How the hell could we have missed something like that?” he asked. After a long pause, the facilitator said, “Simple. You never asked the question.” Since then the Army War College has spent time developing a course on how to ask the right questions – obtaining information that will affect your decision making and produce better outcomes.

I bring this up because in our article last month (May 25, “Asking the Right Questions”), we discussed the importance of asking the right questions about a possible investment opportunity. In the ensuing discussion, Zejia asked me which questions I might ask management of an investment opportunity. Much like the army officer training, I look for questions to management that can increase the possibility of a successful investment. What follows are the topics I discuss with management as well as specific questions I might ask in the course of our conversation.

Before I get into greater detail, I should make it clear we generally talk to roughly one-half of our investment holdings’ management. Our ability to get on the calendar of Bob Deuster (CEO of Collectors Universe [CLCT]) is far greater than with Intuitive Surgical’s (NASDAQ:ISRG) Gary Guthard. When we can’t actually speak to management we will occasionally send in a questionnaire asking our questions. How (or if) management replies can make or break our decision to invest.

There are four major areas I want to explore with management – capital deployment, compensation, forecasting and corporate responsibility. I look to map management’s responses with the historical record from SEC filings such as the annual 10-K or quarterly 10-Qs.

Capital deployment and returns

Perhaps that greatest role played by senior management is to wisely deploy the company’s capital so that it earns a good return. Wise allocation of capital is harder to find than you might think. Why is that? First is the truly abysmal record of management itself. Of the Standard & Poor's 2000 roughly one-half of the companies’ weighted average cost of capital (WACC) exceed their return on invested capital (ROIC). It is also estimated that roughly 80% of all mergers and acquisitions destroy value. Second, there is no real training to become CEO or on allocating capital. You either learn it on the way up or through on-the-job training. It is no wonder managements have such a poor record. Some of the questions I ask are:

  1. What are your key drivers for return on capital?
  2. What are your key measures in capital deployment decision making?
  3. Does success/failure in allocation of capital impact compensation?
  4. What do you define as long-term thinking?
  5. Do you integrate long-term thinking with allocation of capital?

Compensation and incentives

There really isn’t any best way to align management’s compensation with long -term value creation. We know with some certainty what doesn’t work: free stock options, measuring value by stock price, easily obtainable goals that can be manipulated. The list goes on. I look for management that openly grapples with this issue and isn’t afraid to tinker with the system to improve it. It’s better to try to align goals with some uncertainty than not align goals with a fixed certainty. Some questions I might ask are:

  1. How do you align management and shareholder goals?
  2. Do you try to incentivize management and employees equally?
  3. How often do you measure the impact of incentives?
  4. What changes have you made over the past 12 to 24 months?

Forecasts, mistakes and reviews

Over the course of their tenure, CEOs will make a fair number of predictions, estimates and assessments of their strategy. They do this through investor documents (such as their annual reports), quarterly earnings conference calls and presentations made at industry conferences. I look for managements that openly acknowledge failures and address what went wrong and what they’ve learned. Most of all they must measure and adjust as time passes. A management team that fails to learn and adapt is a prescription for underperformance. Some questions I might ask are:

  1. What predictions have proven correct? Incorrect?
  2. What have you learned from getting predictions wrong?
  3. How often do you review your predictions and assumptions? Quarterly? Annually?
  4. How do mistakes impact your role as CEO? How does it impact the company?

Corporate responsibility

I look for management that realizes it doesn’t work in a bubble. Companies can have an impact on public policy, their communities and their workers’ family lives. This doesn’t mean I’m looking for a not-for-profit socialist haven. Rather I look for a blend of shareholder value with an enlightened approach to corporate responsibility. Treating your employees – and the community you work in – with respect and fairness simply makes business sense. Some questions I might ask are:

  1. How do you help your employees assist their community?
  2. Are any of your employees on public assistance?
  3. How does the company give back to the community?
  4. What is the payroll ratio between the CEO and the lowest-paid employee? The median average employee?

Conclusions

Understanding how management thinks about allocation of capital, compensation, decision making and corporate responsibility can shed light on some of the most important jobs a CEO must master for success. From this give and take an investor should feel comfortable that management is honest in its communication, skilled in the strategic decisions and acutely aware of the power of incentives. By not asking the right questions, investors might focus on topics that will play no role in the long-term success of their investment. To do so – in the parlance of our War College students – would be to win the fight but lose the war.

As always I look forward to your thoughts and comments.


[1] “Power Questions,” Sobol and Panas, Wiley; February 2012

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 4.6/5 (8 votes)

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Comments

Robert Abbott
Robert Abbott premium member - 4 years ago

Great article, Tom! I appreciated your thinking on capital deployment in particular.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Thanks Robert. Appreciate it. Aloocation of capital is one of the most important - and difficult - tasks for a manager. Best. - Tom

Zejia
Zejia - 4 years ago    Report SPAM

Hi Tom, Appreciate your post in response to my query. I haven't had experience of interviewing the Management, but I did have sent questionnaire. I ususally ask the management to elaborate some statements or forecasts that are not explained clearly or sufficiently in their annual report or investors presentation. Unfortunately, most of the time, they are reluctant to answer, which lead me to think whether I have asked the proper questions.

Your thinking on forecasting failure are something I've never thought. But isn't it too harsh- like how the mistake impact your role as CEO? If they can answer such questions frankly, will definitely add credit.

With regard to the management's compensation, since it's determined by the Board of Director, or the Remuneration Committee(here in Aussie), if those questions are asked to the CEO, will you get fair and informative answers?

Just my two cents.

Best Regards,

Zejia

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Zejia. Thanks for your comment. I've found that if management is unwilling to discuss mistakes and their impact then they are unlikely to be growing as individuals. That doesn't mean that every holding in the Nintai portfolio has shared their thoughts. Some have done so such as Fastenal (FAST). What we won't put up with are wholly negative comments such as what we received from Qualcomm (QCOM). We sold the stock shortly after receiving their reply. As for compensation we don't look for specific numbers but answers to our broader questions. Several of our holdings had us talk to the BoD for greater details while others spoke to us directly. Again, we won't invest in a company that disparages or belittles the fact we think this matters. Hope this addresses your comment. Thanks again. Best - Tom

OPM Insights
OPM Insights premium member - 4 years ago

Hi Tom, Was wondering. What specifically did QCOM say to make you short the stock? Also, for the companies where you aren't able to talk to management, how do you evaluate your concerns?

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Nelson. We didn't actually short QCOM. The Nintai Charitable Trust is long only. We sold the stock out of the portfolio because the response from investor relations was rude, demeaning, and unresponsive. I should note the we were on the fence due to the company taking on a significant amount of debt. Their reply was the final straw. For those that don't reply, we have the annual reports,10-K, and 8-K to go on. We also sweep our database for any presentations or speeches that might be helpful. We also use industry boards (like CafePharma) to get a view on employee issues. Hope this answers your questions. Best. - Tom

OPM Insights
OPM Insights premium member - 4 years ago

Thanks for the response. Cheers.

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