How to recognise outstanding management
I often hear people say, “It’s important that a company has good management” or, comically, “They seem like good guys”.
Clearly, good management is important, but what are its attributes? To evaluate management we can focus on four main areas.
- Incentives – what are management incentivised to do?
- Conflicts – what conflicts does it currently face?
- Are there any omissions being made?
- Skills – what skill set does the company require?
1. Management incentives
From a shareholder’s perspective, we want to know the management team is steadfastly focused on delivering strongly improving earnings per share, using acceptable levels of risk and not using excessive debt or dangerous business practices.
Management’s focus on growing earnings per share needs to be effectively communicated so this growth can translate into share price growth and dividends. The effectiveness of a management team in delivering will be borne out in share price appreciation and dividends. The concept is relatively simple, but the devil is in the detail and it is the subtleties in implementation that bear so much close observation.
What constrains management from delivering growing earnings per share and dividends? Factors include the uncertain nature of business in general, as well as personal interests, alignment of interests and conflicting interests. They play a key role in the entire process.
From our experience the bigger a company is, the more management gets paid. Companies are therefore very often trying to grow. This does not necessarily mean they are incentivised to grow earnings per share, but rather to simply grow earnings. Hence the constant mergers and acquisitions, placements, capital raisings and all manner of complex financial engineering. Depending on whose research you read, over the longer term, studies have shown that less than half of all such transactions are actually earnings per share accretive or create shareholder value.
2. Management conflicts
This peculiar set of circumstances brings us to a second and perhaps even more important issue: alignment and conflict of interests.
In theory, managers should simply get rewarded on share price improvement over long periods of time. Some of the world’s best investors actually take an active role in overseeing the remuneration of management in listed companies. They spend extraordinary amounts of time making sure remuneration of managers is closely aligned to shareholder return.
A closely guarded secret of many micro- and small-cap company fund managers is that they invest solely in businesses where the management are also the founders and large shareholders. This immediately creates an alignment of interests between the manager/founder and shareholders. This one simple fact probably doubles or triples the chance of a shareholder actually making a return. The owner/managers are constantly looking after shareholders’ best interests, and have also already proven their abilities in growing a successful company.
In the evolution of a business, the founder and largest shareholder will eventually hand the business over to “professional managers”. At that moment, new conflicts of interest arise.
The transition from founder to professional manager also carries with it a change in the skill set required to manage the business. So begins the tension between professional managers and shareholders. Management people are no longer the owners, but work for the owners of the business. Each tries to extract their “pound of flesh”. Owners want management to make better returns; managers in turn want to get better pay.
Management is now risking shareholders and founders’ assets, often not their own assets, creating additional tensions and conflict. And all the while the board of directors needs to interface between owners and managers – not an enviable task.
3. Management omissions
As investors, we are faced with these tensions and conflicts on a daily basis and need to evaluate a management team to assess the extent of conflicts of interest, as well as if there are any omissions taking place. We are constantly on the lookout for management omissions.
There are essentially three types of omission: the “good, the bad and the dangerous”. The good omission comes from the experienced and competent manager who attempts always to under promise and over deliver. These managers have experienced the pain of over promising and under delivering and never want to experience the pain again.
The bad omission comes from the manager who is inexperienced and over promises and under delivers. The bad omissions can often be detected in body language and nervousness, and a general inability to deliver over time.
The dangerous omission is perpetrated by a manager who convinces themselves that their lies are true. These are the truly delusional ones and are often difficult to detect, because the person telling the lies believes them. These are the most dangerous lies and lead to the most extreme stories in corporate history, and also very large financial losses. Always be on the lookout for the different types of omissions.
4. Management skill set
Here is some practical advice on what to look for in a good manager. A management team should ideally have experience in the industry in which it is operating and a record of growing and managing successful businesses. This is particularly true of smaller companies.
Management should be “good with people”, or more accurately good at mobilising people to perform the task at hand. Management should ideally have already demonstrated great success in a previous business venture or endeavour, because nothing ensures success quite like previous success.
Over the years, business people tend to fall into two categories: those who can make money and those who cannot. Invest with management teams who have demonstrated an ability to make money for the companies they work in.
In summary, we are looking for a management team that is focused on delivering earnings per share growth, share price growth and dividends, not simply growing the business for the sake of growing.
We are looking for managers whose interests are aligned with ours, ideally as large shareholders in the business, or management whose remuneration is closely tied to earnings per share and share price growth. Where these factors cannot be clearly demonstrated, look closely for conflicts of interest and management omissions.
Finally, look for a depth and breadth of management experience with specific industry experience. When choosing between a good-looking resume and a proven money maker, choose the money maker.
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