Mike:
Sorry this took so long: it's amazing what piles up in 10 days!
I've extracted some of your post and will try to envelope your points in italics as I try to address them one by one.
Re: my comment on Moore's mistake (?) in firing Scott at Columbia/HCA:
I could not agree more. While I may disagree with you on the Richard Scott ouster -- he is a man not tuned into the finer points, much less the gross points, of ethical medicine -- I certainly understand the importance of management.
I am not one to argue with a doctor. <g> My point was poorly expressed. More precisely, I have _no_ confidence that Frist can stand up to the jackals that now surround C/HCA. The impediments to practicing medicine, let alone ethical medicine, in today's environment are so large that I can have nothing but sympathy for everyone involved. My convictions, although very strong, are so far off-topic here that I won't go any further. I would enjoy engaging in conversation about it, but in a different forum, perhaps by email if it interests you.
Take Corel, a company with several significant assets as well as brand-name recognition. Mike Cowpland and the management are suspect at best, however, and the stock has performed poorly due to management's ability to spend up to nearly the level of sales each quarter.
This is right on with one of my central tenets. I put wasteful management in the same category as, for instance, ridiculously high PE ratios. Interesting assets, interesting returns, interesting something, but not an investment, at least right now. Something to watch for a change that would 'unlock' the value (if it doesn't degrade first).
By contrast, take Warren Buffett. He invests only in company's in which he can leave the management in place and relatively unattended. His biggest asset, IMO, is his ability to find brilliant management among undervalued assets. This skill has made him the most successful investor ever.
I too have followed his work very closely (more closely than anyone else, in fact) since I first heard about him in 1973. I read and reread his writings more than all others combined. There are two additional 'policies' he has that are extraordinarily important to excellent investing. First, and in my mind, most important is 'circle of competence', deeply understanding the business of the companies that are investment prospects. Second is understanding what a 'moat' is, how one develops, how one is maintained, and how one is destroyed. These issues are what separate Buffett from Graham and what Charlie Munger was instrumental in getting Buffett to focus on, as I understand it. They are also (and this is really important in my mind) what makes it possible for Buffett to pay higher multiples for securities.
Incidentally, while Buffett is justly celebrated as _the_ oustanding investor, he is probably an even greater insurance underwriter. His judgement in SuperCat is simply awesome.
So where are we to look, and how are we, the smaller investors, to get the level of insight into management possessed by the Buffetts of the world?
Let's look at several means by which we can measure good management.I'm looking for feedback on any of these points.
1) Insider ownership -- Good managers mustn't have a solid chunk of their own fortunes embedded within the enterprise. It simply helps eliminate a portion of the management-shareholder misalignment of interests. Yet insider ownership is not necessarily a sign of good management. Look at Chris-Craft Industries and Herbert Siegel -- he's just sitting on assets worth more than the market cap, despite the fact he owns such a huge chunk. Wouldn't he want to increase his personal fortune? Can it be he is simply not a good enough manager to do it? So, we have no guarantees with high insider ownership. But I'll take it anyday over little to no insider ownership. Ron LaBow of WHX had a large part of his assets in WHX -- a major reason I had faith he wouldn't let it fail or give away the house to the strikers.
Although I get your point, I am confused by your first sentence. Did you mean 'must' rather than 'mustn't'? For a long-term investment, I have to have solid insider ownership. It's a necessary, but not sufficient, condition. When someone like Siegel lets gems lie fallow, I simply don't understand it and so I can't invest in it. LaBow, on the other hand, has had a history of very active, and mostly successful, asset management and value realization, and therefore it was a very interesting opportunity. We have made a great deal of money on it, both realized and as yet unrealized. It's been a nail-biting experience, but has worked out very well. It was a series of securities that were trading at close to break-up value along with an aggressive leader - both the necessary conditions were present, good management and good value.
2) Past/current companies owned/managed/created by the management. Mike Cowpland made his fortune on the backs of Mitel shareholders. Are we to believe he has changed and that he will do right by Corel shareholders? Have the current management of a corporation under consideration for investment ever been unethical or dishonest -- and been found out by the SEC. I will never invest in 3Com, no matter the value or potential, because its management was so incredibly selfish when it sold most its shares in the 70's, before the fall to the 30's. IOW, can management be trusted. Unfortunately, this is more useful as a marker for companies to avoid rather than companies in which to invest.
The adage goes something like, 'it takes a century to build a reputation and a second to destroy it'. As a former Canadian, I have heard the history of Mitel. Beyond the fact that I don't really understand how moats work when it comes to technology, Corel is an absolute non-starter for me because of the baggage that Cowpland carries. I just have to move on. Character has become a non-issue in the entire commercial world during this century. Not even the depression brought it back. Jim Grant talks much more eloquently about character than I can, so I'll just suggest to anyone who has not read his books, particularly _Money_of_the_Mind, to do so. Your final sentence sums it up, Mike. Because most of investing is a process of elimination, it is a tool for avoiding mistakes, along the lines of Buffett's two recommendations: first, don't lose capital; and second, don't forget the first rule.
3) Executive compensation. When Open Text's management repriced its options to reflect the terrible stock performance (26 to 6), I started looking for an exit. Yes, the stock has soared and I believe in the company's product, but what is the primary motivation of management here? Is the focus short-term or long-term? Hard to hold long-term and ignore short-term fluctuations if management doesn't think the same way.
Again, it's a warning sign. Options, in general, have become abusive but are so widespread that to eliminate securities of companies that have option programs is to practically eliminate all of them. I get relatively more interested if top management (Chair, Pres., CEO, COO) owns their stock outright. (I get really interested if the top people buy in big time when they come on board. This happens more often in smaller companies, obviously.) I also get interested if the head of the company gets paid exclusively in stock.
4) Call the company. Does management place high value on investor relations? Not PR, but IR. Will the CFO call back if I request him/her? Or will an inept IR rep reveal ignorance greater than my own? Does to whomever I am speaking express confidence and logic, or is it rather flash and emptiness? This is the hardest part for me to interpret. And I never know for sure how I am doing. Obviously, this is virtually impossible to do with the large cap big names. E-mail has been a boon. An investor on the Corel thread actually got the CEO to write him re: the company's future.
It is continually amazing to me that the highest correlation here is between frankness in management's discussion in annual reports (not the SEC MD&A which is highly formalized, but the actual annual report) and the quality of information I get when I talk to people at the company. There is no question in my mind that facing facts starts at the top. If the Chairman's/President's letter is filled with bromides, I can pretty much bet on getting nothing but 'flash and emptiness' from everybody at the company. I make it an iron-clad rule to follow the format of [recite a fact, e.g., increased days in receivables], and ask how the company is addressing it, what caused it, etc. The more homework I've done and the more precise my questions, the higher quality the answers are. Follow-up questions, also [fact], [question], earn even more respectful answers. I fully expect that it will take time for the person to whom I'm talking to get comfortable enough to be frank. I _always_ ask for permission to call back in the future and I _never_ complain. Get the facts, develop a conclusion and act.
5) Ratios. Return on Equity. Return on Capital. Gross Margins. Accounts receivable to sales. Inventory to sales. I find the inventory management to be key. Does inventory grow appropriately with sales, or faster, or slower? If a turnkey inventory management program is in place, is the management of it efficient? Unlike ROE and ROC, the inventory/sales numbers are hard for the CFO to fiddle with, especially if one has an eye on AR. How the company expenses and capitalizes its various costs also tells me something about management's long-term fidelity. If they are capitalizing R&D or other costs, look for them to show up in LT assets on the balance sheet -- if these assets are ballooning, I start to look for illicit capitalization that will tip me off to management's time-frame.
This is where duPont ratios are a huge help to me. Particularly when I am considering a new industry, I can only get comfortable when I understand the dynamics of these movements. The central questions to me are: Is the attractive ROE/ROC temporary or permanent?; what makes it better here than in other companies in the same industry?; has management built something unassailable here?; how do they protect it?; what specifically is it that gives rise to the return - is it particular people in the company, or particular practices the company follows, or both? and so on. This is the identification of the moat. It is my experience that dominant companies generally don't have truly superior products. Rather they have superior people, practices and marketing. I see people frequently argue that Intel's chips and Microsoft's software are _not_ superior, but they totally dominate their markets (and their ratios obviously show it.) Likewise, National Indemnity's SuperCat reinsurance isn't superior to that of other underwriters, but it totally dominates its market. What financial analysis leads me to is the why and the how, not to the existence of market domination. Even more interesting are companies who dominate unnoticed niches. Everyone understands who dominates. The gems are the companies not as well known who dominate the side markets, the specialties and so on. The way I have found them is almost always starting with ROE/ROC.
My only solutions to your second point, regarding accounting presentation, is to use cashflow instead of income, as the numerator in the starting ratios. And _read_the_notes. So much dynamite can be buried in the notes, it's amazing that they are so infrequently discussed. When was the last time you saw a post here (or anywhere else that investors meet) where information from the notes was discussed? Whenever I find something unusual in the notes, I make a phone call. If I don't get a good answer, I'm out of there. I also don't understand how anybody can do any decent DCF analysis without taking note disclosure into account.
6) Shareholder rewards. How is the management rewarding shareholders for corporate-wide successes? a) Share repurchases -- is the company following through on its "promises" to buy back shares. b) Dividends -- becoming less relevant thanks to double taxation. I'd rather they actually buy back stock. c) Reinvestment of retained earnings into various corporate uses -- is management obtaining sufficient return from these uses in order to justify the increased risk of spending shareholders' share of the earnings?
When all is said and done, a company's securities have value because of the future, not because of the past. The incremental analysis that I discussed in my earlier post is the most difficult financial analysis I do. In fact, if I get easy answers, I am simply very suspicious. The best I get is a 'feel' for how well incremental cash investments are doing and might do in the future. It's pretty obvious when cash is retained for aggrandizement (new offices, planes, etc.), but it's much more difficult to determine what the incremental yield on expansion of the business is. Most growth faces diminishing returns, but it is very difficult for management to know when there are better things to do with the money. Protection of franchise is, without question, the most widespread rationale (rationalization (?)) for continuing to invest in the face of diminishing returns. The mark of truly outstanding management is knowing the point at which it is better to return the money to shareholders or to use their expertise to find new products or markets.
In the hope I have not been unbearably pedantic, I look forward to hearing your comments. |
