2 Management

The quality of management is one of three key evaluations that an investor has to make. This is extremely difficult to do. And even if you do find a company which you think has outstanding management, ensure that it also satisfies the other two evaluations of economics of the business and valuation of the shares.

The difficulty of judging the quality of management is illustrated by the numerous instances in which chief executives who were once lauded as brilliant have later been proved to be quite ordinary or worse and that their “success” was due to taking big risks (e.g. Northern Rock) or even outright fraud (e.g. Enron).

Stephen Lofthouse discusses the problem of trying to select bargains based on insights into the quality of management:

“There are three reasons why one might suspect that high quality management does not lead to abnormal returns. First, good management should already be reflected in earnings, sales, etc. Second, even if good management is a separate factor (because today’s earnings represent yesterday’s management whereas today’s management will generate tomorrow’s earnings) why is this not already reflected in a share’s price? Third, what is good management, and who would recognise it?”

He describes a study by Michelle Clayman of the companies judged as excellent in Peters and Waterman’s “In search of excellence”. The list of excellent companies was compiled in 1981. Of the original 36 publicly traded, the study covered 29 companies as only these had complete data. Over the period 1981-85, 11 of the 29 companies outperformed the S&P500 and 18 underperformed. She then looked at 39 companies that were regarded as dogs and found that 25 outperformed the S&P500 and 14 underperformed. [Michelle Clayman. "In Search of Excellence: The Investor's Viewpoint." Financial Analysts Journal 43, no. 3 (1987): 54-63. www.jstor.org/stable/4479032. ]

Occasionally you may get an opportunity to invest in a company that has been brought to its knees by poor management, when that management is replaced by high quality management. For example, this was the case at Asda at the end of 1991 when Archie Norman was brought in to sort it out. Investors who invested in Asda then would have made a lot of money through his success in turning around the ailing supermarket culminating in its sale to Wal-Mart in 1999.

Unless such a change in management is imminent, it is best to avoid companies with bad management. It is easier to identify bad management. Some of the symptoms are:

1 Where there are doubts about its integrity. Warren Buffett: I learned to go into business only with people whom I like, trust and admire.

2 Ostentatious lifestyles, e.g Kozlowski of Tyco

3 More than one member of the family on the board, due to nepotism.

4 Who habitually blame political and economic conditions and other outside forces for poor results.

5 Who build plush offices. Northcote Parkinson observed that fountains sprouting in the foyer are the first sign of decline. Nigel Lawson advised avoiding companies that have just moved into a lush new head office. Peter Lynch: Rich earnings and a cheap headquarters is a great combination…. Other bad signs include fine antique furniture, trompe l’oeil drapes, and polished-walnut walls.

6 Where management remuneration is excessive in relation to peers in the competing companies or the incentives are too generous and easy to achieve. Lynch: I thought to myself: If I make money in Televideo, this guy is going to be worth $200 million. That didn’t seem realistic either. I declined to invest and that stock went from $40 in 1983 to $1 in 1987. Buffet: Most managers employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free).

7 Autocratic Chief Executive and a weak Chairman and servile Board.

8 Big acquisition made to increase the power and status of management though it would result in deceasing shareholder value. A good example of this was RBS's acquisition of ABN Amro. ABN was already in advanced talks with Barclays for a friendly merger when a consortium led by RBS entered into a bidding war during which it was obvious that Fred Goodwin was determined to show how powerful he was by outbidding Barclays without regard to the price. The price paid for ABN Amro left the bank with too low capital levels.

9 Over-sensitivity to criticism by analysts or the media, e.g. Robert Maxwell who was  litigious against those who would speak or write against him.

10 Ostentation, e.g. from an Amazon review of a book by Judi Bevan about Marks and Spencer "It was evident to journalists visiting Baker Street ... Visitors would be escorted along seemingly endless corridors, with their closed doors on either side, by a uniformed female minder who would transport them into the care of the white-gloved waiters on the seventh floor. The atmosphere reeked of imperial Britain."