How to assess Management’s Quality …

While the fundamentals of the company could look great, at times, too good to be true (and probably is), it all boils down to shareholder’s return. This is only made possible when the company’s management is honest, able and business savvy. After all, good numbers without management’s good intention is no use to the shareholder.

Hence, judging management of the business is the key to make money, which obviously is not easy. Below are the 4 points which would be useful to determine company’s management/promoter’s honesty, integrity and savviness.

I. Business Vs Management: Taking cue from The Godfather, if you are involved in a business wherein a single mistake can cost life(s), it’s obviously a dangerous business to be in. 

As Warren Buffett succinctly put it;

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

Also, the choice of businesses is equally important; running a retail or a restaurant business is very taxing as compared to running a toll bride business. After all, “You should invest in a business that even a fool can run, because someday a fool will.”

II. Key Jobs: 2 Key Jobs of company management is Widening the Company Moat and Allocating Capital

Widening the Company Moat: Management’s prime duty is to widen the moat, i.e. increase the competitive strength of the business year-on-year.

• This can be made possible by creating brand which has pricing power, i.e. whether the company can raise prices without losing its customers. Well, Jaguar Land Rover (Tata Motors company), BMW and Dailmer all have lost billions of dollars off late – surely brand does not entail reducing recall value for the customers, the management needs to make money from the brand.
• Moats can also be widened if the company has patents/intangible assets, which give exclusive rights to market their products or services, thereby enjoying blockbuster profits till the patent expires. Management of Pharma and Movie companies create moats by getting patents and rights, thereby creating value for shareholders.
• Being the lowest cost producer also enables company management to create a moat for itself, which needs to be maintained on a consistent basis. Management needs to ensure that they are obsessive about reducing costs. During my stint with HDFC Bank, we were not allowed to use fresh envelopes to send internal communication. The envelopes were used multiple times till there was no space left on the cover. This clearly explains why HDFC Bank’s cost to income ratio is one of the lowest in the banking industry.  
• Products or Services with high Switching Costs create barriers to entry in the industry, thereby enabling to widen the company moat. After all, Switching Costs involve time, effort, money, propensity of having a high error rate and Social Proof (all my friends are using it!!). Once a trader or a fund manager has got used to Bloomberg, having spent time and effort, it creates a high barrier to shift to another software.
• Regulatory Licenses provide natural monopolies or oligopolies to the business. Regulatory licenses which are difficult to obtain provide natural barriers to entry for the new entrants. Regulations provide natural edge to the existing players in the industries like, Banks, Casinos, Cigarettes and Alcoholic beverages.

Allocate Capital: Allocating capital is the 2^nd most important job of the company management, 1^st being widening the moat. Allocation of capital by the management can assume the following forms:

• Capital Expenditure: Businesses which requires continuous and large capital expenditure to stay competitive or alive has very little management say. No matter how savvy the management is, it would remain at the mercy of increasing capital requirement of the business.

• Distribution of cash via Dividends or Repurchase of shares: Management can create immense shareholder value by distributing excess cash being generated out of the business either in the form of paying dividends or repurchasing its own stock.

• Acquisition: Acquisitions are usually dangerous, especially from a buyer’s perspective. As Peter Drucker rightly said: “I will tell you a secret: Deal making beats working. Deal making is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work…deal making is romantic, sexy. That’s why you have deals that make no sense.”

III. Skin in the Game: As Charlie Munger has very succinctly put, “Human behavior gets determined by incentives and getting the incentives right is a very, very important lesson.” Management’s skin in the game, i.e. how it serves its own interest gets determined by the Compensation and its Ownership in the business. Higher the compensation (preferably in a staggered manner), and ownership, greater would be management’s propensity to think long-term term, and not get unnecessarily bothered by quarterly numbers which need to be achieved (sometimes, at all cost!!!)

IV. Communication: The two important tenets of communication by management are Transparency and Humility. This can easily be ascertained by reading the Annual Reports. Reading Letters to Shareholders of Warren Buffett’s Berkshire Hathaway Inc. is an absolute treat. He has expressed his mistakes candidly, which clearly indicate his humility and transparency:

• Buying Berkshire Hathaway: The dumbest thing I could have done was to pursue ‘opportunities’ to improve and expand the existing textile operation — so for years that’s exactly what I did.
• Investing in Tesco: An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.
• Purchasing Dexter Shoe Co.: To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. As a financial disaster, this one deserves a spot in the Guinness Book of World Records

Management of Lanco Infra on the other hand in its Annual Report blamed delayed disbursement and / or partial disbursement of loans as the reasons for the company’s woes – It was never their fault anyways (Self – Serving Bias). The company no wonder went into insolvency.

Disclaimer: Please note that these are my personal views. While, I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.