A question came up in this week’s webinar about identifying great CEOs, and how much we should factor management quality into our investment decisions.
I want to elaborate a bit on my answer from the webinar, so this article discusses how to identify good management, particularly for a value stock.
For traders, or investors with small positions, knowing the management of a company is less critical. When investing in a high-conviction core position for the long-term based on fundamentals, however, management quality is extremely important to assess.
Depending on the company, management quality may depend mostly on the CEO, or could be a combination of the company culture including the board of directors, CEO, and other executives.
1) Track Record
Obviously, any company benefits from having superior management.
Unfortunately in many cases, it’s difficult to judge management quality. When it comes to technology companies, for example, the founder/CEO often doesn’t have a long track record. Even if they do, it’s hard to say if their success at one company can tell us anything about their potential success at a very different second company. Tech companies are very much about the creative idea, the disruptive technology that changes the marketplace, which might just be a one-time thing rather than something the founder/CEO can repeat. So, it makes more sense to focus on the qualities of the company in question rather than qualities of the leader.
But when it comes to boring companies, value stocks, where capital allocation is the most important skill for management to excel at rather than creative disruption, management quality is critical.
Capital allocation is deciding what to buy, what to spin off, what to focus on, how to spend money on dividends or buybacks, how much debt to take on, and how to prioritize various alternatives. It's a series of small decisions rather than one brilliant idea.
A key thing to realize is that capital allocation is one of those skills that doesn’t really come and go. A superior capital allocator generally continues being a superior capital allocator. This is a skill for which a person’s track record is highly important.
2) Insider Ownership
The most quantitative way to check management quality is simply to look at their incentives.
CEOs are that have disproportionate high pay relative to the size of their company are maximizing their own short-term gains instead of long-term company value. Whether the company performs well or not, the CEO still gets paid a ton. There are some truly corrupt or borderline illegal cases out there, where clearly management is just trying to skim as much as they can off the top. A higher-than-usual compensation package is a red flag.
In better cases, the incentive structure is based around long-term ownership. In such a case, the CEO does well mainly if the shareholders do well, and suffers if the shareholders suffer. Look for situations where the CEO and other insiders have unusually large insider stakes in the company; lots of skin in the game.
Warren Buffett is an extreme example of this. His salary for running one of the world’s biggest companies is literally less than what I make each year. But of course, since he owns tens of billions of dollars in company stock, his net worth is strongly tied to the long-term performance of the company. Strong performance can make him tens of billions of more capital.
3) Long-term Approach
Does the CEO primarily focus on long-term performance, or do they chase quarterly results? Are they playing chess or checkers?
Many CEOs and other executives are traded between companies like Pokemon cards. They are just passing by, just hitting some quarterly targets for the next few years and collecting a high salary before going elsewhere.
Other CEOs may stay at a company for a decade or two, or more. The company may have a long track record of long CEO tenures, and a history of CEOs that clearly operate the company like a long-term owner rather than short-term management.
This should be clear in presentations, conference calls, and stated goals. What time frame is the CEO and the rest of the company aiming at?
4) Empire Building vs Maximizing Shareholder Returns
What does the CEO frequently talk about wanting to do? Do they seem like they want to be everywhere, doing everything, acquiring everyone? Peter Lynch referred to this as “diworsification”.
Or does the CEO have the humility and self-awareness to correctly identify what their company is great at, what they have the resources to excel at, and focus on that? In many cases, it is better to stay small and maximize per-share returns than to try to be big simply for the sake of being big, and diluting the capital base in the process.
To make matters worse, CEO compensation is correlated with corporate size. CEOs have a personal interest in making their companies bigger, because it will usually result in higher pay. Unusually good and well-meaning CEOs are able to avoid this temptation and focus instead on maximizing shareholder return and only making the company as big as it should be.
Historically, companies with high shareholder yields, meaning companies that pay a high combination of dividends and buybacks, outperform as a statistical group:
I often use the following set of charts to explain this visually. In these charts, a “project” may refer to an internal growth idea or an acquisition.
Some companies like to invest in all of their ideas, even if some ideas will result in much better returns on invested capital (ROIC) than others:
Smarter companies put money into their best ideas, their core competencies, where they can excel and that will have the best ROIC. They give the money they don’t need back to investors in the form of dividends and buybacks.
Investors can spend those dividends, or they can reinvest back into the company to increase their ownership stake in the company’s best ideas. This is a recipe for long-term outperformance. It maximizes per-share returns.
Of course, many younger growth stocks benefit from avoiding dividends and buybacks and investing entirely in their growth prospects. The problem starts to occur when they become big enough that they should be using capital more carefully, but aren’t.
Many big value blue-chips are prone to this. They frequently make overly-expensive acquisitions because they don’t know what else to do. Often the best thing to do is to invest in your best ideas, and give the rest of the money back and tell your investors to buy more stock so they have more exposure to those best ideas.
5) Personality and Qualitative Assessment
Lastly, just follow the company for a while. Listen to conference calls.
Does the CEO use a lot of buzzwords, sound generic, or seem like a broken record? Or is it clear that they have mastery of what they’re talking about when they speak?
On top of all the objective assessments, use your intuition. Humans take in much more information than they are conscious of. For example, when you drive a car, the vast majority of what you are doing is subconscious. Do you trust the person? Is there something sleezy about them that you can’t quite identify? For any core long-term position in a portfolio, you should feel comfortable with the CEO. Listen to your gut- it’s generally wise.
Many analysts only follow a given company for a couple years before moving to a different position. I prefer quality over quantity; there are many companies I’ve followed for 5-10 years or more, and know the company and their management quality very well.
Rather than constantly looking for new ideas, whenever I am looking to invest new capital, I often look back over my existing holdings or previously analyzed stocks to see if any values have opened up thanks to a short-term problem. Following companies for a long time makes it easier to buy during opportunistic times.
Some CEOs are household names, like rock stars basically. Everyone knows Jeff Bezos, Elon Musk, Bill Gates, and Warren Buffett.
But there are many outlier CEOs with extremely good performance that don’t have any public recognition. They are still under the radar despite crushing the market.
My favorite example of this is Bruce Flatt, CEO of Brookfield Asset Management. He has been with the company since 1990 in his mid-20’s, and has been CEO since 2002 when he was in his late 30’s. Now, he’s still barely in his mid-50’s, and hopefully has a long tenure ahead of him. He’s already a billionaire, and him and other insiders own 20% of the company.
Since he took over, he has been the architect of a massive change in company structure and growth, and has absolutely crushed the S&P 500:
This isn’t an example of one good idea. It’s a case of constantly making good choices for 17 years as CEO. The company keeps cautiously investing in places of distress, buying high quality assets from struggling operators, refinancing them, improving them, operating them, and then selling them years later during times of strength for much higher valuations to recycle the capital back into other opportunities.
Flatt is surrounded by other executives with long tenures as well. And the executive chairman is a separate person than Flatt, rather than a combined CEO and Chairman role, so there is plenty of oversight.
But Flatt is a Canadian accountant. He’s not a rock star. Brookfield Asset Management, with a $46 billion market cap and amazing outperformance, has fewer stock followers on Seeking Alpha than Iron Mountain, a $9 billion records management storage company with worse performance.
When Bruce Flatt gave a talk on investing at Google last year, the audience looked like this:
This poor dude stood there and spoke to a dozen people and a sea of empty chairs for an hour.
Not many people pay attention to quiet outperformance. And that’s a good thing for those of us that do- it keeps the price down.
Getting to know companies well and being able to identify top-tier capital allocators is one of the best ways to identify good value stocks. And it’s one of the few things that factor investing and algorithms don’t do well yet.
It’s important to remain diversified, to not invest too heavily into any one company or CEO. Highly-skilled CEOs with huge insider ownership can still mess up sometimes, like Richard Kinder a few years ago. It helps to factor management quality into your investment decisions, but not follow any one company or CEO blindly.