Aug 15, 2014 Investment Education: Evaluating Management
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; after all, competent managers are able to quickly adapt to changing environments and position the company for future success.
Institutional investors typically have opportunities to meet with management at conferences and other venues. Individual investors don’t have the 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.
Look at how they manage the company’s operations. Do they take a long-term perspective when making decisions or do they manage the business day to day? Are they the innovator in the industry or do they simply copy what others in the industry do? Innovators have the all important first mover advantage, which can contribute meaningfully to revenues and margins. 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 them 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 (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 a manager to be a good at managing the business (what we refer to as “blocking and tackling”), but poor capital allocators. Look at how they’ve allocated capital in the past, and 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 the management team is doing with the company’s stock. Managers should have “skin in the game.” By that, I simply mean 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 these metrics? If so, this can go a long way toward aligning the interests of managers and shareholders.
Are they effective communicators? Remember, the management team is the face of the company. Read the Management Discussion and Analysis (MD&A) section of the 10K filing. Watch any interviews the management team may have done in the past. Listen (actively) to the Q&A portion of quarterly earnings calls. 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 (http://www.amazon.com/Spy-Lie-Former-Officers-Deception/dp/1250029627/ref=sr_1_1?s=books&ie=UTF8&qid=1407507552&sr=1-1&keywords=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 – bad press from product recalls, employee-related issues, or government investigations are common examples. How did they handle the adversity? Did they take responsibility and move quickly to address the situation? Do 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. The questions I’ve outlined here, however, should aid you in this process.
Topics such as this are discussed on my Podcasts channel.
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