Tuesday, October 19, 2010

Skin, ROE, Honesty: Ingredients for a great management team

A talented management team can build important, lasting competitive advantages for the company, and   create extraordinary long-term value for shareholders.  A weak management team on the other hand can destroy significant shareholder value and cause permanent damage to what may be a great organization with strong fundamentals.

We all want to invest in companies with a great management team in place. In this article, I will talk about some of the things to look for when evaluating whether or not a company’s management team is good for shareholders.

Having skin in the game

While the ownership of company’s stock might not automatically make a manager great, managers that own a lot of shares in the company or have “skin in the game” are more likely to act in the best interest of shareholders. Insider buying and insider ownership can also indicate that managers are confident in the future prospects of the company (which they should be).

I generally look for companies whose managers own shares that are worth significantly more than their annual compensation. A significant portion of the shares owned by the managers should have been bought with their own money and not acquired through stock options. Managers also shouldn’t have consistently sold their holdings or sold a large part of their holdings.   

Long-term return on equity rate

When judging if management has performed well or not, investors should look at the return on equity and not at the earnings.

Managers can increase earnings every year simply by retaining earnings and buying treasury bonds or other assets (even assets with very low returns) with the retained earnings. It obviously doesn’t take much skill to reinvest a company’s earnings in low return assets.

To see if management has managed the company’s growing assets well, investors should look at the long-term return on equity rates. A good management team should be able to generate above average return on equity rates (compare against the industry average or the long-term return of stock) without the use of significant debt. Preferably, management should help the company achieve ever increasing returns on equity.

There will, however, come a time when the company has grown too big and management can no longer identify large enough investment opportunities that can generate returns that the company is accustomed to. But investors should make sure that the company’s returns on equity are still above average, and that the return on equity rates doesn’t fall faster than the expanding capital (Shareholder equity that has grown from $100 to $150 shouldn’t make return on equity drop from 30% to 5%).

Return on equity can be increased by using debt to invest in assets. Investors should make sure that the additional debt taken on has been compensated with an acceptable increase in return on equity (It goes without saying that management that has taken on too much debt can’t be good for shareholders, regardless of the increase in return on equity they helped the company achieve).

Honesty

More important than being talented, managers need to be honest. I will pick a mediocre but honest management team over a talented but greedy and deceitful management team any day of the week. Even if a talented, dishonest management team can help the company generate better returns on equity, there’s always the risk that the management team will do things like dilute shareholders’ holdings by issuing lots of stock options to themselves, and take on too much risks or engineer earnings to meet their bonus targets. These kinds of things will most likely destroy shareholder value in the long-run and undo management’s past brilliance.  

Here’s how I identify companies with honest management:

Management is open with shareholders and tells shareholders as it is. If the company is experiencing tough times, then tell shareholders that the company is in a rough patch.

The company has good accounting practices.

Managers are paid in line with the company’s performance. If the company is losing money, the CEO shouldn’t be getting a $50 million bonus.

Management does what it says. If management says that they want to increase revenue in India by 50% in 3 years, then shareholders should see a 50% increase in revenue from the company’s Indian operations in 3 years.


When we invest in a stock or company, we are entrusting our money to the management of that company. And if we want to preserve our capital, much less earn good returns, we need to make sure that management is at least mediocre, and definitely honest.    

If you have any questions, or if you have anything that you would like to share, please feel free to comment. Thank you for reading and may you always sustain good returns on your portfolio. Take care.

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