How to pick businesses run by great managers?
“Bet on the jockey not the horse”
The above saying may be true with regards to horse racing but not necessarily true in picking stocks (businesses). A competent management is an essential cog in the business (cash producing), but it’s not the end all. On the other hand, even if an exceptional management runs a poor business, the results will be poor (reflecting the quality of the business). We take a middle path and analyze the business on the outlook and the competence of the management and try to come up with a framework.
- What is the annual salary of the top level executives?
- What are the stock options provided to the management? Are incentives based on milestones or not? The information about the items 1 and 2 are found in the Proxy statement.
- What acquisitions were completed in the past 5 years? What price was paid in acquiring those businesses? How did those contribute to the earnings of the business? Check if there were charges related to the write down on the goodwill. This will flag an acquisition gone soar.
- What is the growth strategy spelled out by management? Is it organic and sustainable or just relies on acquisitions?
- How much earnings were retained each year and what value did those earnings produce. Famously said by Buffet, each dollar of retained earnings should produce a dollar increase in the market value of the business.
- Is the company buying back its own stock? Especially watch for stock buybacks. I love companies that buy their own stock, but it is very hard to find those that buy their stock when their stock is actually undervalued. The buybacks are announced on the back of good earnings and the growth is already priced into the stock at that point. A premium price is paid for buybacks there by destroying shareholder capital. There is another reason for the buybacks as well. It is to pay for the stock options of the management team. This will not dilute the shares further but achieve no real value for the shareholders.
- Does management return the earnings in the form of dividends? If yes, are the dividends sustainable and do they increase every year? If debt is taken to hand out dividends, run as far as you can from making an investment.
- Is the equity and capital structure of the business sound? If no, what are the reasons for the destruction of equity? Is it too much leverage? Is it due to acquisitions that were written down later?
- What is the return on equity achieved by the business? This is a key measure to see how the management is deploying the assets to produce a return. This takes into measure any capital infused into the business thus giving a reliable yardstick.
- What is the culture of the company? Investigate on linkedin. Try to come up with the employee churn rate. This will be very time consuming for large companies but can be very helpful for small caps.
Some of the above items could be built into a stock screener but others require more work to be done. An easy way to approach this would be to start with the Quantitative ratios, narrow down the stocks that fall within the circle of competence, and then do further research.
An exceptional reading would be the book “The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success”. The book reflects on the Capital allocation brilliance of eight CEOs who took an unconventional path to generate compound returns of over 20% measured over a period of 20 years.
Every company’s management’s capital allocation can be judged and if one finds a good business with great management, that should put one on a sure road to riches.