Finding the right investment doesn’t mean just looking at financial statements and performing discounted cash flow analyses. It also requires making a value judgement on the abilities of corporate management. There have been plenty of cheap businesses that traded at low prices relative to their intrinsic values that nonetheless ended up costing shareholders due to inept management. Clearly, poor corporate governance can create value traps. The question is then: How does one identify good managers? It comes down to having skin in the game.
Good managers have skin in the game (but not in the way that you think)
Nothing sends a better message to investors than an executive team that has a stake in the company they manage. This aligns investor interests with those of management, meaning that even nakedly self-interested executives will act in a way that benefits shareholders. There is, however, an important caveat to this creed. Too often, boards will give executives stock options in order to achieve this goal.
This is not skin in the game. The recipient of a stock option bears none of the downside risk that an investor does, which creates a perverse incentive to juice the stock price in the short term, with less regard for the long-term intrinsic value of the company. This is something that Warren Buffett (Trades, Portfolio) strongly believes, and why he has spoken out against the practice. This is from the 1985 Berkshire Hathaway (BRK. A)(BRK. B) annual shareholder letter:
“The rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift-but I'll never buy one).”
Indeed, the explosion in stock-based compensation that has occured over the last few decades has arguably been one of the most important driving factors behind the boom in share buybacks. This has resulted in managers overpaying for their own stock with corporate money, which is obviously not in the interests of shareholders in the long term.
Managers are the ultimate insiders
What is a sign of skin in the game is when managers purchase their company’s stock with their own capital. This signals that they are confident in its prospects and are willing to put their money where their mouths are. Moreover, since managers have more insight into what is truly happening at the company than anyone else, significant insider buying or selling activity is a very good indicator of whether a company is worth investing in.
Conversely, a company that distributes excessive amounts of stock-based options to management is probably not allocating capital in the most efficient way. This is bad in and of itself, but it can also be a symptom of a deeper problem at the company. Perhaps managers have too much control of the treasury, and the board is too weak to stop them. In this case, it is preferable to stay away.
Disclosure: The author owns no stocks mentioned.
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