Finding the right fit

A financially stable business that also has a good management team is a sound investment, especially if it’s trading lower than what it’s worth.

But getting a handle on management is one of the most difficult tasks when evaluating companies. We know we want “good” management, but how do we determine what’s good?

Each investment should be viewed as more than the simple acquisition of shares. Instead, view it as purchasing part of the underlying business where you become a partner. When taking this approach, you ought to choose carefully who will be managing your assets. Partner with honest and competent managers that you admire and trust.

A great place to start the search is by reading a company’s annual reports. It should provide you with information to determine how much a company is worth, if it can meet its future obligations and if management is doing a good job.

Here’s how you can tell.

Candid communication

Good management will go beyond the minimum reporting requirements to shareholders. This means admitting mistakes and disclosing what course of action will be implemented to remedy the situation. The absence of such candour should be considered a red flag when choosing where to invest.

Management’s attitude and behaviour have a great effect on a company’s culture and the creation of shareholder value. It takes more than words and policies to promote ethical behaviour within a business. A dedicated management team should lead by example.

3 warning signs of bad management

• Poor accounting practices

• Poor capital allocation decisions

• More concerned about quarterly gains, rather than long-term value

Management for the long term

Running a good business requires management to have a long-term view. When reading annual reports, don’t stop at the most recent year. Going back in time will determine if there is a consistent operating history. Steer clear of management who appear to use an ad hoc strategy or concern themselves with quarterly results—they’re likely focused on managing numbers rather than business.

Good economic performance is a process, not a number. Investors are better served by a wealth of information, including corporate details, industry issues and business conditions. Look for weak accounting standards, such as the non-expensing of stock options, the use of pro-forma financial statements and unintelligible accounting footnotes.

A long-term view is essential when it comes to compensation. Companies should have incentives that motivate managers. They should be tied to the same variables that determine value for shareholders. Be wary of managers who are less concerned with the long-term stock price—they may be more interested in grabbing perks than creating value. Managers ought to act like owners, and strong insider ownership is a good sign.

3 ways to spot good management

• They go beyond minimum reporting requirements

• They have a long-term vision with a strong and consistent operating history

• They only reinvest earnings if they can produce returns above the average cost of capital

Allocation of capital

Look for managers who act like owners. They won’t lose sight of their prime objective—to increase shareholder value. The most important act of management is the allocation of capital. This is where rationality and good judgment come into play.

Once a company generates more cash than it needs for development and operating costs, there are two choices: reinvest in the business or return the money to shareholders.

Both options may sound great, but it’s only wise for management to reinvest if they can produce a return above the average cost of capital. In fact, it would make sense to retain and reinvest all of the company’s earnings if this were the case. Berkshire Hathaway has earned high returns, retaining all its earnings and never paying dividends. The test is whether Buffett can produce incremental earnings above those available to investors, because if a dividend were paid, it will be up to shareholders to find reinvestment opportunities.

Often we see management destroy shareholder value by retaining earnings to produce sub-par returns, or using earnings to chase growth with overvalued business acquisitions. In those cases, investors are better served with the issuance of dividends or the repurchase of shares, but only when they’re trading below their intrinsic worth. Managers who have a record of poor capital allocation decisions and careless corporate expansions should be avoided.

Assessing management is a subjective process, because numbers don’t tell the whole story. Choosing strong management is also linked to the advisor-client relationship. A client is diligent in choosing whom to entrust his dollars with, so his advisors and managers should also pay careful attention to whom they invest with on their client’s behalf. After all, they’re the ones doing the heavy lifting.

Susy Abbondi is an equity analyst with Duncan Ross Associates.