Evaluating management

The number one criteria which determines the performance of a company is the quality of the management. This is also the most difficult criteria to evaluate and one’s degree of success in evaluating the management determines the eventual success of the specific stock pick and long term returns of the portfolio.

If you are into trading, momentum investing or any other quantitative methods, then management or the nature of the business may not matter. However if like me, your approach to investing is to evaluate the long term economics and performance of a company and purchase the stock at a meaningful discount to the fair value, then management matters a lot.

Although it is easy to state the above point, it is not easy to execute it. There are no fixed formulae to evaluate management. A lot of times I have seen people either completely ignore the issue of management quality or get too focused on it. I will turn to the issue of too much focus later in the post.

I myself do not have any magic formulae to evaluate management. However I have a list of points (in my valuation template) against which I run a check on the company’s management. Let me discuss a few points below. These points are not exhaustive on their own, but may be a good place to start

Capital allocation record: This is the number one responsibility of the management. How does the management invest the free cash generated by the business? Is the management investing it in new opportunities at a high return (preferably more than 15%) or is the management chasing growth for growth’s sake?

A single year of good or bad performance may not be important. One should look at the track record for a number of years to evaluate the performance of the management on this count. A good way to do it is to look the incremental return on new investments. The formulae for calculating this number is simple – (net profit for current year – profit for five years back)/(Fixed asset + working capital for current year – same number five years back).
The above number should give you an idea of how well the management has invested in the last five or more years. A poor record means that the management is failing at its core responsibility.

Management compensation: A good management should be compensated well. However the compensation should be in line with the industry and within reasonable limits. I typically look for compensation to be between 3-5% of profits. Any more than that is a concern for me.

Shareholder communication: Does the management discuss the bad and good openly and with honesty. Do they crow about the good news and hide the bad news? Unfortunately in India shareholder communication is almost non-existent. Even companies doing well give a one page write up of the performance. Except for IT companies and a few others, shareholder communication is joke.

Accounting practice: Is the management conservative in accounting. Look for how the management is accounting for investments and hedge losses. Are they conservative in accounting for old debt (more than 6 months). Does the management have reasonable pension accounting?

Conflict of interest : related party transactions is the place to look for this point. I am on a watchout for any large transaction between affiliated companies (sister companies owned by management).

Past reputation: Has the management been reprimanded by SEBI or any other bodies? Do they have a past reputation of taking the investor for a ride?

I use the above list and more to evaluate the management. There is no formulae or wieghtage for any criteria and the eventual decision is bound to depend on past experience and a subjective assessment of all the factors. At the same time, if the management has a serious negative on any of the above points such as shoddy accounting or poor capital allocation record, I will just avoid the company and move on.

In the end ,there are a lot more companies to choose from and I would rather hold the cash than take grief from investing with a crooked management, not matter how good the numbers.

Over focus on the management
The other extreme I have seen is when investors fall completely in love with the company and follow each and every word and action of the management.

During the bull run of 2006-2007, I saw a lot of investors discuss and dissect every interview and utterance of the management on stock boards. I am all for tracking a company and reviewing the quarterly numbers and conference calls (if the management does that), however I find it silly to read every possible interview and press release and try to make sense out it.

I think companies which are over communicative and share every small scrap of information are focused too much on their media profile and may in some cases, be losing focus on the running their business. Investor who track every twist and turn of the company, risk missing the big picture as they convince themselves that they now understand the company much better as they have been following it very closely.

Getting fooled by management
Even if one is diligent in the analysis and evaluates the management from all aspects, it is possible to get fooled by the management – aka satyam.

So should one stop investing ? By that measure, one should not drive as you can have an accident.

My answer to reducing the risk is diversification. You do not put all your money into a single company. If one does a decent job of evaluating the management, the chances of getting cheated by a crooked management are reduced if not eliminated. The entire idea of investing is to manage risk with appropriate returns to compensate for it.

A quick note on the paid service
First, my apologies to all of you who have written to me. I have not responded to anyone.

I grossly underestimated the response. My initial plan was to respond to each email personally, but after a day or so I dropped it as the numbers went way above my estimates. A lot of you have expressed interest, but have also asked for the details of the service (rightly so !).

I am in the process of setting up an email service and would recommend anyone who is interested in the paid service to subscribe to it. I plan to use this email message service to discuss more details about the service and also share some exclusive content on it (the carrot for subscribing:)).

Some of you have raised the point on what will happen to this blog after I launch my service. Will it undergo a change? I have no plans to change the nature of the blog. It will always remain free and I will continue to share some of the ideas on the blog as before.

I however do not want to use this blog to broadcast about the service too much (though I will have occasional updates) as there are a lot of readers on the blog who would not be interested in it and I don’t want to spoil their experience with such posts.

As always, my thanks to all of you for reading and following my blog.