Last week, a friend at B.A.T. (British American Tobacco) in London complained that he does not have enough time to read my weekly email. I cannot believe that he is not willing to set aside the business of one of the largest companies on the planet for my newsletter. It just serves as another example of how some people have their priorities totally mixed up.

So, for my overworked friend at B.A.T. and all you other time-starved workaholics out there, just read the following two quotes from Warren Buffett. However, that's only if you haven't got time for the whole mail! These two quotes capture the essence of this week's newsletter:

'I choose to work with every single person that I work with. That ends up being the most important factor. I don't interact with people I don't like or admire. That's the key. It's like marrying.' And 'Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence and energy. And if they don't have the first the other two will kill you. You think about it: it's true. If you hire somebody without the first you really want them to be dumb and lazy.'

This week I am discussing an extremely important issue - management. When you invest in equities you are investing in a company. The two main components of the company you are purchasing are its physical/non-physical assets and its management. The assets are usually visible on the balance sheet, while the management is not.

One could say that valuing companies is similar to evaluating a racehorse for the Kentucky Derby or a racecar for Formula One. With the latter two examples you should be keenly aware that you cannot ignore the skill of the jockey/driver when it comes to figuring out who has the best chance of winning. This will be especially true if you have money on the race. Let me explain it slightly differently. Let's suppose we were going to bet on the winner of a special Formula One race, involving all the drivers and teams of last season. However, in this race drivers are going to be allocated cars randomly. So tell me, would you place your money on Ferrari or Michael Schumacher? The vast majority of people I put the question to chose Schumacher, and usually with little hesitation.

My follow-up question was usually confirmed by about the same percentage of people: 'I bet you know very little about the people who run the companies you are invested in, right?'

I find this situation quite bizarre. You wouldn't dream of starting a small business without investigating your prospective partners thoroughly or, at least, knowing them very well, would you? You would do your homework before gambling on Formula One, wouldn't you? However, when it comes to publicly owned companies the landscape supposedly changes so drastically that people completely dispense with the need to investigate their prospective business partners.

A growing economy, expanding industry, liberal capital markets and a company firing on all cylinders create a very forgiving environment for incompetent management and business partners of dubious character. If you are a long-term investor, reality dictates that the business you invest in will experience periods when the economy is in recession or the industry is shrinking or demand is falling. This happens to be the harsh reality of business and the rational long-term investor accepts it. It is frequently only dedicated and competent management that will pull you through the bad times.

My Father had a saying, which unfortunately doesn't translate well into

English, but means something along the lines of "if you disguise yourself as pig's food, you shouldn't complain if pigs eat you". Basically, if you hang out with the wrong crowd it will have its consequences. Ditto for incompetent management. Buffett preaches something similar when he says that you should only do business with people you respect and admire. However, as evidence to the contrary I quoted Carol J Loomis in a recent post on the Motley Fool (US) board. In a 1998 Fortune article, titled 'The Classic Buffett Mistake', she wrote: 'But he
[Buffett] believes that over the years his largest mistakes in investing have been the failure to buy certain "good business" stocks just because he couldn't stomach the quality of management. "I'd have been better off trusting the businesses," he says. So in the stocks he has sometimes held, though not in the businesses he owns directly, he has on occasion gritted his teeth and tolerated a fair amount of management inanity. A few years ago when he owned many more stocks than now, he complained to a friend about the absurdities of an annual report he had just read, describing the content as misleading and self-serving of management and "enough to make you throw up." The friend said, "And yet you're in the stock". "Yes", was his answer, "I want to be in businesses so good that even a dummy can make money."

So, clearly my comments about partnering with management you trust and admire shouldn't be taken out of context. Buffett also states that, 'When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that stays intact.'

I feel the odds of achieving my investment goals (above average returns) are firmly stacked in my favour when I invest in an outstanding company that is run by outstanding management, at a rational price. These are the gold plated investment opportunities I wait for.

Is it important to check whether you and the management of your investment are in the same boat and rowing in the same direction? Personally, I refuse to invest in a company in which management does not have a substantial shareholding. I am a strong believer in incentive systems. In life and in business I have found that my interests are best served if I ensure that those who have the most control over a particular situation (in this case management) have the same incentives as I do. If I only get paid if my horse wins the race, then I want the jockey that will only get paid if he wins the race. I believe the incentivized jockey will put in a bigger effort than a jockey that will get paid no matter what the outcome of the race is. It's a simple case of human nature.

The single most important investment quality I continually focus on is staying rational. This is also a quality I look for in management. I try and determine whether management stays focussed and clearheaded when it comes to operational and financial decisions. The existence of this quality can usually be determined by ascertaining how candid management is. It is as simple as checking whether the story told by management concurs with that told by the financial statements of the company. No company in the world ever has the privilege of a year in which everything goes according to plan. If I only get good news from management I tend to get worried, especially if the story told by the financial statements bears plenty of bad news.

On the operational side, you commonly find that management focuses on short-term growth at the expense of long-term growth. Today's culture of focussing on quarterly profits is obviously conducive to this. Philip Fisher explains that '...the company worthy of farsighted investment will give priority to curtailing maximum immediate profits when there are genuine worthwhile opportunities for developing new products or processes or for starting new product lines or for any one of the hundred and one more mundane actions whereby a dollar spent today may mean many dollars earned in the future.' On the financial side, I want to see that management has allocated capital rationally. If the company produces cash, is the cash thrown at less profitable ventures or is it returned to shareholders?

Although I have much more to say on the matter it would be most inconsiderate of me to keep you guys from more important things. We don't want your companies (e.g. B.A.T) to grind to a halt due to this letter :-)

However, I can't leave you without quoting Father Benjamin:

'The appraisal of management is considered an essential - perhaps the essential - factor in determining whether an investment should be made in a given business and often whether holdings in a business should be disposed of.'

-Benjamin Graham, p.668 Security Analysis 1962

Equally important:

'...poor managements produce poor market prices.' - Benjamin Graham, p.269 Intelligent Investor 4th Ed

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2002/11/04 10:22 View Archive