How to Grade Management
April 10, 2017, 4:28 pm
We’ve talked a lot about the fundamentals and technicals I watch when looking for potential investment opportunities. One factor we haven’t touched on very often is management, and I do get questions about judging management’s effectiveness, so I’d like to share some thoughts on ways to do that with growth companies in particular.
First let me say that I do not have specific criteria when it comes to evaluating management. Almost all CEOs are highly educated, intelligent and have enjoyed a lot of success in life. Since I tend to select stocks that have a solid history of growth, the CEOs have also had some measure of success in their position. In addition, most of the companies are growing while still investing big for their futures, so I do not think management tends to be focused solely on how much they can pocket in the near term.
Strong quantitative data is often a good indicator of the quality of management. However, we know that business is dynamic and not static in nature. Therefore, a good executive must be able to adapt to change. Growth businesses tend to attract more competition over time, and in technology, product obsolescence is often an issue. Given this, I look for management’s plans for future growth in their investor presentations and public filings, and how realistic they are. Companies that are slow to adapt to changing market conditions will at some point see their stock prices take a hit.
I also judge management by how they allocate incremental capital – the cash they take in each year in cash flow. Since they consider themselves as steering growth companies, most CEOs do not want to pay dividends, which is perfectly fine. But what I don’t like to see is a company buy back shares when its stock trades at above-average PEs. To me, this is not investing in growth, but actually a tool used to hide dilution (from issuing stop options). Unfortunately, this practice has become so ingrained among most U.S. companies it is hard to be critical of specific management, as this is an institutional issue.
It’s also important to gauge management’s ethical behavior. For years, Wells Fargo (WFC) was one of the most admired companies, not just in banking but in the market as a whole. In fact, Warren Buffett used WFC as a benchmark when evaluating other potential investments. It took decades to discover that the company’s strong growth in fee income was often achieved by illegal practices. While the bank was able to survive the crisis in decent shape, that may not be the case with smaller companies that do not have a franchise as strong as Wells Fargo.
Due to increased regulations, brokerage firms are spending less on conferences and instead disclosing everything over the Internet, so most investors have much less access to senior management than they did 20 years ago. Still, evaluating where a CEO is taking a company is an important part of determining a stock’s potential.