3 Critical Mistakes Investors Make When Assessing Management Teams
Stop buying the "story" of an investment and start assessing the investment itself.
Note: This is a part of our 101 series designed to introduce newer investors to topics that are likely to be relevant to them or which may be non-intuitive to those who are relatively new in the investment space.
It’s an all too common story in investing—an investor conducting research or just perusing the news comes along a splashy article profiling a C-level executive of a company (let’s say Company Z). The profile is typically gleaming, of course, with lots of praise heaped on the executive both by the journalist and a few carefully curated old friends and colleagues.
Intrigued, the investor checks out the stock of the company run by the executive. The stock, he finds, is down. Like way down. But not to worry, this was addressed in the profile of the executive: he’s going to turn the company around.
The investor turns to a few conference call transcripts and likes what he hears. Lots of optimism about the future. Analyst questions at the end of the call fielded perfectly. And perhaps best of all, the executive and his team have announced a new, named turnaround plan, full of goals and milestones.
It sounds like a new day at Company Z. The investor decides to buy.
Fast forward a few years or months. Company’s Z’s stock has not only gone nowhere, it’s gone down even further. The investor may or may not be concerned or frustrated at this point, but he knows one thing for sure: management is still saying that things are right on course, the turnaround plan that remains ongoing, there’s lots of optimism for the future, the analyst questions are still being fielded perfectly, etc.
At this point, most investors will either hang it up and sell in frustration or remain doggedly loyal to the story being pitched by management.
Unfortunately, this story plays out many, many times each quarter with management teams crafting slick promises and developing plans for corporate transitions, most of which will never come to fruition.
How can one avoid this trap?
A key factor that we’ve noticed among investors—especially newer investors, but trust us, many people who have been doing this a long time can still be snookered—is a propensity to place much, much more confidence in management than is warranted.
The purpose of this article, therefore, is to outline our philosophy and approach to management teams and, hopefully, to impart some wisdom along the way. Let’s explore some common mistakes that we see investors making when it comes to assessing management teams and investments.
Mistake #1: Believing The Pitch
Make no mistake: investing in a company is an adversarial affair. It’s our opinion that shareholder and management interests are rarely, if ever, truly aligned, and we believe that investors can avoid a lot of heartache with their investments if they simply approach them with this idea in mind.
When buying stock in a publicly traded company, it’s easy to lose sight of what you’re actually doing—buying a fractional ownership interest in a business interest. You wouldn’t likely dive right into a business venture after hearing a five minute pitch from a random guy on the street, but buying a stock instantaneously through your phone or computer can be easily done on a whim. Avoid this temptation at all costs.
Management teams often talk a big game about what they plan to do with the company: grow revenue, increase profits, expand market share, etc. But how often do these plans actually work and how often are promises like these just blowing smoke? While we don’t have definitive data (failed corporate growth plans are usually just replaced with newer, shinier corporate growth plans), we would hazard a guess that it’s a lot more of the latter and a lot fewer of the former.
When assessing “the pitch” of a management team—whether that’s a turnaround story, a growth story, or any story at all—we find the following questions helpful.
Has this management team delivered in the past on promises, or do they consistently move the goalposts? If a management team is new to a company, how did they perform at their last company?
How much of management’s plan can be controlled by them, and how much is reliant on external factors? (I.e., favorable macroeconomic conditions, etc)
What does the management team stand to gain if the plan succeeds or if the plan fails? Is there compensation tied to the successful execution of the plan? If so, have you read the compensation agreement and does it seem reasonable?
What sort of oversight does this management team have? Does the board have a history of responsible stewardship?
Of course, there are more questions to ask but we think these are particularly helpful. Question 4 in particular leads us to our next point…
Mistake #2: Not Digging Into Governance
Have you ever seen a kid behaving badly in public, only to see a lackadaisical parent (perhaps mindlessly scrolling on their phone) completely fail to correct the behavior? Well, in a corporate setting the parent role is played by the board, and the behavior of the management team (the crazed child in our example) is a direct reflection of the board’s involvement. Not understanding whether a board is functional is a key mistake often made by investors.
Understanding the board of a publicly traded company and its effectiveness can be a little like reading tea leaves or trying to divine the will of the gods. Much of what the board does is out of the public view, so it’s important for investors to generate as solid opinion as possible about a company’s board and how effective or ineffective it will be in holding management accountable.
The board, after all, approves executive compensation and large-scale plans for company transformation and growth. Are they likely to be lenient with executives who miss the mark, or will they decide enough is enough and move on to someone new that can generate a better return for shareholders. Here are a few of the questions that we ask ourselves when assessing board governance.
How big or small is the board? While size alone is not a determining factor of efficacy, we tend to believe that bloated boards with many members collecting $175,000 a year to attend a few meetings tend to err on the ineffective side.
Do a majority of the board members have business experience that is relevant to the running of the company? Do the committee assignments make sense, or is the CEO’s college roommate running the compensation committee (spoiler alert: that’s probably bad)?
Has the board ever moved the goalposts for management in terms of compensation? For example, has the board ever adjusted stock option rewards downward so executives can cash in even though the stock price has tanked?
We note that the bar for assessing boards can be flexible. Sometimes red flags are immediately apparent; sometimes it can be quite difficult to get a read. It changes board-to-board, but we encourage investors to not skip this step when conducting their due diligence.
Mistake #3: Not Assessing Capital Allocation
Let’s go back to the kid example for a moment. Say you give your child $30 with instructions to do something productive with it. The kid could buy a toy, books, something educational, fun, or he could just blow it all on candy and pass out in a pile of sticky chocolate wrappers.
The point is, management teams have capital to allocate, and it’s the job of shareholders to assess how effectively that money is deployed. Generally speaking there are only a few ways to deploy capital: reinvested into the business, or returned to shareholders. These two modes of deployment can take many forms, whether it be acquisition of a new company, capital expenditures, stock buybacks, dividends, etc.
What we often see from newer investors is—if the take the time at all to look into how capital is being allocation—a failure to form an opinion on the quality of the capital deployment.
In other words, is the management team you’ve invested in passed out in a pile of sticky candy wrappers?
Here are a few questions one can ask when assessing capital allocation.
Is the management team buying back stock when it’s expensive or cheap?
Is the management team selectively tapping the equity markets to raise capital when the stock is expensive, or are they diluting existing shareholders when the stock is already scraping the bottom of the valuation barrel?
Is the company acquisition happy? If so, how successful have those acquisitions been and were they funded with debt or with cash?
We understand if readers may wonder why capital allocation would be on this list, but we stress that understanding how a management team spends a company’s money is one of the only concrete ways to assess management efficacy. Do they put the company’s money where their mouth is, or are they all talk while the way they deploy capital tells a different story?
Wrapping It Up
It can be easy to get caught up in the high-flying promises of management, especially when they tell a compelling story about the prospects for their company and what they plan to do. Most people who rise to the C-level are quite charismatic, after all. We caution investors, however, to not be sucked in by slick pitches, slide decks, and promises of a golden future. A little due diligence can go a long way.
We’ll leave you with a quote by the great physicist Richard Feynman, “The first principle is not to fool yourself, and you are the easiest person to fool.”
Happy investing. If you enjoyed our article, please consider subscribing for more content in the future!
Disclaimer: Nothing in this article is intended as investment advice. The writing herein is our opinion and nothing more. Investments come with a risk of loss. Consult the appropriate resources before making any investment.