Saturday, December 15, 2012

Assess the Quality of Management-Summary of Chapter 7 Investment Checklist

Note: Most of the summary below are derived from Mr. Michael Shearn's book "The Investment Checklist". You can find the information on this book from I will not personally take any credits for the summary below. 

Great management can create tremendous value for the business as well as shareholders as long as the business itself is not in permanent decline (think of Warren Buffett and Berkshire Hathaway's Textile operation). Bad management can definitely destroy a great business (Enron, Worldcom).

To Appreciate how essential sound management is to the long-term success of a business, consider that top managers typically:

  • Are responsible for designing the business. 
  • Determine the future growth rate of a business. 
  • Are in charge of choosing the right people and providing the right environment for these people to perform at their highest potential. 
  • Determine how to allocate the firm's capital. 

It is best to evaluate a management team over time. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore flaws or warning signs. The more familiar you are with how managers act under different types of circumstances, the better you are able to predict their future actions.

Gather information about managers through Factiva or Lexis Nexis, Wall Street Transcript or the Charlie Rose show etc. Pay particular attention to what motivates the manager and why they are where they are professionally. As you read articles, look for evidence in four basis areas: passion, honesty, transparency, and competence. Look for the ability of a manager to recognize and learn from mistakes and also try to see how quickly they are able to recover from mistakes.

I. What types of manager is leading the company?

  • Owner Operator (1)-Ideal, founder or at least long time partner of business. Dave and Sherry Gold of 99Cents Only Stores, Joe Mansueto Founder or Morningstar, John Mackey, Cofounder of Whole Foods market. 
  • Owner Operator (2)- Also passionate about the business but typically more interested in his or her own personal benefits. These managers typically receive higher compensation packages than OO1. Leslie Wexner, founder of the Limited Brands (owner of Victoria Secrets)
  • Owner Operator (3)- Primarily run the business for personal benefit and do not take shareholders's interest into consideration. You can identify these types of managers by viewing the Related-Party-Transaction found in the company's proxy statement, where you might find such items as personal use of company aircraft, estate planning, personal or home security, and real estate that is owned by the CEO and then leased to the business.  Be Careful with these managers and pay attention to their long term track record in terms of creating value for shareholders. 
  • Long-Tenured (1)- Been with the business for at least 3 years and promoted from within. Risk is they are the wrong manager for the position. (e.g a CFO or COO may not be a good CEO, such as Kevin Rollins of Dell in 2004, Kevin was COO of Dell but led Dell to the wrong direction). 
  • Long-Tenured (2)- Been with the business for a long time but joined the business from the same industry. 
  • Hired Hand (1)-Jump from business to business in a related industry. Tend to make short-term decisions and most of them are cost cutters. 
  • Hired Hand (2)-Join from a completely different industry and typically has no experience with the customer base? 

As you move down from OO to HH, the less information you will have and the more risk you are taking on. There are some industries where specialized knowledge of the business is especially critical : for example, pharmaceuticals, chemicals, and insurance. It is difficult for an outsider to successfully manage these types of businesses.

II. Management Characters:

1. Lions or Hyenas (Lions hunt together while hyenas group hunt only hunting is easy). Hyena characters include:

  • The manager value people more highly because of power, influence, or what they can do for them. 
  • The mangers consider themselves to be better than those around them.
  • They are nice to people that they consider to be important, but disrespectful to others whom they consider beneath them. 
  • They think short-term and just want to win the game. 
2. How did the manager rise to lead the business:

  • Build a 10 year chronicle. 
  • Does the manager have any operation background or just financial background? Ideally you want a CEO that has some operational background. Merck's greatest return came from the leadership of Roy Vagelos who was a scientist and worked in Merck's research department before ascending to CEO. GM's best year was with Harlow Curtice who was involved in sales and designing of GM's car. 
  • What is the managers track record in operating a business? 

III.Management Compensation:

1. Look for CEOs who have low salaries and high stock ownership. Robert Kierlin, founder of Fastenal and his successor as CEO, Willard Oberton. Kierlin earned $63,000 in 2001 but owned 5.87% of the business. Dave Gold was paid $62,000 and owned 40% of business. Joe Mansueto of Morningstar. Russel Gerdin of Heartland Express.

2. Be wary of mangers who hold stock options because stock options often reward managers for things that they are not responsible for such as broad economic gains or industry growth.

3. Be wary of companies that offer Mega-Equity grants to CEOs or other managers.

4. Look for managers who don't monopolize stock options but offer options to all employees: You need to determine if the stock option plan of a company is geared for top executives only or widely distributed to employees as well. Go to proxy statement and find the list of total number of options awarded to the top 5 executive officers and add them up and find the total number of options awarded to all employees. Calculate the %. Exemplary management such as Whole Foods Market's all top management only get 8% of all stock grants.

5. Look for compensation plans that reward long-term performance:

  • Exxon Mobile-half of executive officer's restricted stock vest over 5 years and the other half must be held for 10 years until retirement, whichever is greater. 
  • The ideal compensation structures are those that award for long term creation factors, such as operating income or book value per share,  or economic value created, instead of stock price. 
  • Expeditor International bases its bonuses on operating income by paying its top executives from a pool of 10% of pre-bonus operating income, furthermore, the compensation system is also based on cumulative operating income so if any operating losses are incurred then these losses must be recovered before the executive team can earn a % of of operating profits, and these bonuses make up the majority of executive officer compensation. 
  • Reckitt Benckiser Group links performance based compensation for all executive officers to economic value added, measuring net sales growth, profit after taxes, and net working capital. The long-term incentive program requires that EPS has to grow by 30% over 3 years for the options and the shares to fully vest. 
  • Markel Insurance uses growth in book value per share over a five-year measurement period to base its total compensation package. 
6. Look for restricted stock awards because they reward long term value creation and the longer the vesting period for RSAs and RSUs, the better.

7. A big plus if a company requires stock ownership.

8. Beware of companies that use compensation consultants.

9. A red flag is raised when you find employment contracts in the proxy statement that guarantee that a manager will be paid a certain amount in total cash compensation.

10. Has management been buying or selling the stocks which represent a meaningful ownership %?

  • If you see a stock whose price is continually dropping yet insiders are selling, this is a warning sign. 
  • A cluster of senior executives sell a considerable amount of stocks during a short amount of time (a quarter or two quarters)
  • Aubrey McClendon of Chesapeake has to sell 94% of his stocks for $569 million because of margin call. 

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