This article appeared in the March 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Roger Montgomery, Montgomery Investment Management
We are fortunate at The Montgomery Fund to be able to meet personally with the management of companies we invest in. Yet despite being in this privileged position, I often wonder if the meetings add a lot of value or only a little.
It is true that when we do not understand some aspect of the accounts or how the cash received flows through the company, a meeting with the CEO or chief financial officer tells us not only how the accounting works but whether the boss has a handle on these issues as well.
But when we have a good grip on the accounting, and the prospects and the quality of the business, I do wonder whether a meeting with management helps or hinders our investment process.
Nevertheless, we and many other fund managers insist on meetings. Some even boast to their investors about how many they have during a year: 200, 300, 600 or even more.
However, it is not true that outperformance against the market or even good returns rely on these meetings. Even though Phillip Fisher, founder of the highly successful Fisher & Co, said in the 1930s: "I have stressed management but, even so, I haven't stressed it enough. It is the most important ingredient."
There were other very successful investors who thought the opposite. Ben Graham, the intellectual dean of Wall Street, the father of security analysis and Warren Buffett's mentor, noted that meetings with company management were over-rated; management themselves were likely to be highly biased.
The fact is, managements can and do have an impact on businesses, much as the driver of a car determines its direction. But it is also true that the business boat you get into will have a bigger impact on your returns than who is rowing.
When Peter Switzer asked me many years ago whether the appointment of John Borghetti as CEO of Virgin Australia would change my view about the airline, I said that irrespective of who was rowing that boat - even if it were an Olympic rower - the boat would be leaking and management would be constantly distracted by having to bail it out.
Warren Buffett noted that if management with a reputation for brilliance became involved with a business with a reputation for poor economics, it would be the business's reputation that remained intact.
So perhaps a poor business will only rarely be turned around by great management.
Obviously, the combination of a great business and exceptional management can only lead to great returns. But how do you assess management? And irrespective of whether you can or do meet management, is that a reliable way to assess competence?
There are a few ways that any investor can adopt to assess management's effectiveness, and often all that is required is a little time and conviction.
Management tells you what you need to know
One of the simplest things you can do, and not many investors bother, is read the past five or 10 years of the chairman's and CEO's letters to shareholders in the annual report.
They reveal a great deal about the ability of management to deliver on promises and whether there is a tendency to over-promise or inflate the prospects of the business - are management realists or dreamers?
For example, I read a decade's worth of letters from Pumpkin Patch, a New Zealand-based children's clothing retailer. Without any financial information and only the letters to shareholders, I worked out that new ventures were launched with great fanfare but the subsequent disappointments were never discussed. And there was the problem that every few years a different person wrote the letter.
The revolving door of authors was a clear warning sign that the company and its board or management were not able to deliver the returns that shareholders might have expected. The Montgomery [Private] Fund and The Montgomery Fund decided not to invest. Since 2007 the share price has fallen from $4.90 to 20 cents.
Few if any private investors have been able to tell me they regularly perform this simple reading task. As Warren Buffett noted: "The best judgment we can make about managerial competence does not depend on what people say but simply on what the record shows."
Return on incremental capital
There is one number that can help tell you whether the combination of management and the business is delivering: the return on incremental capital (the return on a dollar of shareholder funds invested). At meetings with management we look for indications they know how important this is.
It is the only number that matters when it comes to creating shareholder value. A company cannot increase its intrinsic value unless return on incremental capital is maintained or growing. Surprisingly, some management teams tell us about revenue or earnings-per-share growth, with little or no reference to how much capital has been employed to achieve it.
A business owner cares not only about how many dollars comes out of a business, but also how many dollars were put back into it to generate that dollar of earnings.
Be very wary when management cannot demonstrate an appreciation for this important metric. If you can't meet with management, look for the number in the letters to shareholders.
Always be alert to changes at the board level, especially when they involve the chairman, the CEO or the CFO. Of course, executives retire, resign and take a new job elsewhere. But almost as often as this occurs for legitimate reasons, there are problems in the company, the best is in the past, or the share price has reached a level that insiders believe will not be achieved again for a very long time.
It is important, however, not to be too prescriptive. I have seen many instances of management selling shares only to see them rally significantly for many years.
Managers are often not experts at company valuation and they are prone to selling early. But after a founder or a CEO resigns, if he or she owns less than 5 per cent of the issued capital, they are permitted to sell their shares without any notification to the market.
Agency risk is not something regularly discussed but it is something that should be considered when investing. It is the risk that the management of a company will use their position of authority to benefit themselves at the expense of shareholders.
I can imagine you waving your fist at the computer. I wrote to The Montgomery [Private] Fund investors some years ago showing, with the benefit of a spreadsheet, how the issue of options and the use of buybacks could ensure that managers that made only mediocre improvements in the performance of the business, made tens of millions of dollars for themselves.
Space prevents me from explaining the details, but something you can do easily is track the shareholdings of the directors over the past decade or so. Has their wealth tracked the fortunes of a passive shareholder in the company? If not, ask whether it makes sense to be a passive shareholder in the company at all.
Management who continually reward themselves through the issue of options or "executive shares" are transferring the performance of the company to themselves. You need to determine whether it's a justifiable quantum.
There are many other tools you can use to assess management but the most important is the ability to read: the letters of management and the tables of shareholders; measure the delivery of promises and the delivery of self-serve shares. If they are out of whack, so is the policy towards minority and passive shareholders.
About the author
Roger Montgomery is the founder of The Montgomery Fund. Performance statistics and application forms can be found at The Montgomery Fund.
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