There are currently three (3) major buckets in how I measure management’s capabilities, performance, and ethics. These are strategic and operational outcomes, compensation, and intellectual honesty. I will go into further detail in each of these later but for now let me say we evaluate each prospective and existing management team with the following questions:
1. Does the team have the capability of being great management? In this I look for relevant professional experience, training, and background. It’s unlikely we will invest in a security software business run by a PhD in nuclear engineering and no relevant experience in the field. It doesn't rule it out, but it definitely reduces the chance.
2. Does performance demonstrate strategic/operational and governance skills? Here I look for data generally outside of Wall Street’s more normal approach. Are the team great allocators of capital? Do they get the highest efficiency from their organization? Is the organization including the Board fully aligned in their mission? I care less about how the stock price has performed than how they’ve increased intrinsic value over the long term.
3. Are management and shareholders generally aligned? I say generally because a corporation isn’t always about shareholders. Sometimes tough decisions are made (healthcare costs, capital spending) that might effect shareholder returns that are in the best interests of the company and the environment in which it operates. Compensation plays a big part in answering this question.
4. Is management honest with itself, its corporation, and its key stakeholders? In this I look for recognition of learnings and mistakes in the annual reports, quarterly conference calls and communications with shareholders. Senior management that won’t take responsibility or acknowledge failures are fooling themselves into thinking there is nothing left to learn. Intellectual and emotional stagnation are the death knell for industrial performance and competitive advantages.
So how do you go about and measure whether management is someone you want to partner with? At the Nintai Charitable Trust (NCT) we use the following criteria to answer the four (4) questions above.
Strategic and Operational Outcomes
In this category we want to see specific data that management are utilizing a smart strategy and have a great handle on operations. Several items fall under this.
M&A Activity: Most of the data suggests that M&A activity is a long-term detriment to a corporation’s intrinsic value. Any activity on this front I like to be supported by measured milestones and investment metrics. In my career, I’ve generally found great management is far more successful in bolt-on acquisitions than industry/corporate changing events. A holding in the Nintai Charitable Trust – T Rowe Price (TROW) – has done a great job ignoring the demands of investment bankers and steering clear of large M&A deals and taking on large amounts of debt.
Operational Measures: Here I look for long-term management performance with an emphasis on ten (10) year returns. These include Return on Equity, Return on Capital, and Return on Capital vs. Return of Capital. The latter represents management’s view on whether capital can be allocated internally for projects that will generate excellent returns or return the capital to shareholders in the form of dividends or stock buybacks. As Science of Hitting pointed out earlier this week, he looks for buybacks to take place at a discount to intrinsic value. We concur. NCT’s holding Fastenal (FAST) has done a great job focusing on operational returns with an eagle eye. With a 5 year ROE of 26% and 5 year ROC of 25%, management has generated great long term returns for its investors.
Compensation: The last ten years has proven how difficult it is to align management’s needs with shareholder needs when it comes to compensation. Everything from the stock options backdating scandal to the growth of CEO pay has created a rather dismal picture of corporate governance. I’m not locked into any specific policy related to compensation but I do have several criteria I think are important. First, management should not be rewarded for failure. It seems nearly every failed CEO leaves these days with a shocking golden parachute that would make the golden calf itself blush. Second, success should be defined by long-term value creation. Whether it is book value or some other measure, one thing it shouldn't be is tied to the company’s stock price. Long time NCT holding Expeditors International (EXPD) has utilized incentive pay as well as operational margins to give bonuses to all staff. From top to bottom, staff is incentivized to create long-term value to the company.
Perhaps the hardest thing to measure is management’s intellectual honesty. What I mean by this is the acknowledgement of intellectual and emotional learnings gleaned through successes and failures. I look for this in public disclosures such as 10-Qs, 10-Ks, Annual Report commentary, and quarterly conference calls. Second, I look for clear explanations in plain English which lay out the issues faced, options presented, decisions made, and outcomes generated. Third, unequivocal acknowledgements of failure go a long way to building confidence in our investments. Last, it’s great to hear from management learnings they’ve gleaned and how it’s impacted their strategy and management. An example of this is NCT’s Fastenal (FAST) that addresses specific questions about financials in both their quarterly calls and investor meetings. They are open about mistakes they have made and what they’ve learned from these.
When you purchase a piece of a company, you are going into business with a management team chosen by your duly elected representatives (the Board of Directors). We think it’s vital that as an owner you fully understand their abilities, skills, ethics, and goals. More importantly, it is vital you have set criteria on which you can measure their performance. While there is no perfect process that can protect investors against poor management decisions, as investors we can at least choose who we do business with in our portfolio.
 The Wall Street Journal was a leader in coverage of this story. In the end nearly 340 publicly traded companies were investigated. An example was Jeffrey Rich of Affiliated Computer Services (ACS is now part of Xerox). In a total of six grants, Mr. Rich had a 1 in 300 billion chance of receiving grants on the exact dates of corporate stock lows. ACS’ options program was –like many others - a disgrace to its shareholders and the industry in general.