March 13, 2017

Evaluating Management

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When evaluating a stock, you will need to make a qualitative assessment of the management team. After all, shareholders don’t manage the day-to-day operations; that responsibility falls on the shoulders of management, who are hired by the board of directors. Assessing management is a highly subjective process, but an important one, since competent managers are able to quickly adapt to changing environments and position the company for future success.


Investors at large institutional funds have opportunities to meet with management at conferences and other venues. Individual investors and investors at smaller funds don’t have that same level of access, so what can you do? Start by reviewing brokerage reports, annual reports, company filings, investment blogs, and whatever else you can get your hands on. As you do, assess management’s track record? For a pharmaceutical company like Pfizer, pipeline success from their R&D efforts is often a good gauge. For an industrial company like Danaher, allocation of capital to the various operating units – and the impact on the company’s overall ROIC – would be a good indicator.


Like many evaluations, properly assessing management starts with asking the right questions. Is the team effectively managing the business for long-term success?  Are they the innovators in the industry or do they simply copy what others do? Innovators have the all-important first mover advantage, which can contribute meaningfully to both revenue growth and operating margins over time. As you assess their ability to manage the business, consider how they rose through the ranks. Managers with a background in operations often times understand the intricacies of the business and the needs of the customer base better than someone from finance, marketing, or legal. They also tend to do a better job empowering their employees and understand the importance of providing those same employees with the authority needed to address client needs.


In addition to managing the day-to-day operations, managers must be effective capital allocators. Capital can be invested in the business (the typical use of excess cash for highly profitable companies), used to make acquisitions, paid out to shareholders in the form of a dividend, or allocated to share buybacks. It’s not unusual for an executive to be good at managing the business, but a poor capital allocator. So look at how they’ve allocated capital in the past to see if it has enhanced shareholder value. For instance, if they’ve used capital to buy back stock, have they been opportunistic – only buying stock at attractive prices – or do they regularly buy stock at fixed intervals? It is also instructive to look at what a manager is doing with the stock  personally. Managers should have “skin in the game,” meaning that they should own stock in the company. Officers and directors are required to file Form 4 with the SEC in advance of purchasing or selling company stock. Look at the number of shares the top executives own, and whether they are buying or selling company stock.


Then, determine if management is shareholder-focused and returns-oriented? To get an idea, look at the company’s profitability metrics. Is the company consistently generating a return on equity or return on invested capital that is above its peer group? How have those same metrics trended over the past 5 years? Is management’s compensation linked to those metrics? If so, this can go a long way toward aligning the interests of managers and shareholders.


The management team is the face of the company. Are they effective communicators? Read the Management Discussion and Analysis (MD&A) section of the 10K filing. Listen (actively) to the Q&A portion of quarterly earnings calls and watch any interviews the management team may have done in the past.  Is the management team transparent, or are they evasive? Do they answer the questions directly, or do they use diversionary tactics to confuse the issues? These are important questions that can tell you a lot about the manager. Some institutional investor like Maverick Capital go so far as to provide their analysts with training in interview techniques and lie detection. A new book, Spy the Lie, is a good resource for investors interested in learning more about identifying deceptive behavior.


Finally, you will need to assess their character. Look at how they have handled adversity in the past – pipeline setbacks, product recalls, employee-related issues, and government investigations are common examples. Did they take responsibility and move quickly to address the situation? Did they learn from their mistakes, or do they have a tendency to repeat them? Management – like everyone else – is going to make mistakes. How they cope with those mistakes will tell you alot about their character.


Assessing management is a critical yet often overlooked component of a thorough analysis of a stock. Hopefully, the questions I’ve outlined above will aid you in this process. Good luck!


Topics such as this are discussed on my Podcasts channel.

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