CHAPTER7 Assessing the Quality of Management—Background and Classification: Who Are They? Most investors overlook the human aspect of operating a business, yet, in most cases, the future success of a business is directly tied to the quality of its people. Instead of focusing on management, many investors spend their time determining whether a business has a competitive advantage or if it is trading at a low valuation, because they believe that products or operational strengths are what set the most successful organizations apart, such as Microsoft’s ubiquitous Windows operating system. The truth is that, over time, these advantages can be imitated, and if the talented managers who created these advantages leave the business, then the business will struggle to continue to innovate and create value. In fact, Microsoft did lose many talented people who either called in rich or joined new businesses, such as Google. This is one reason that Microsoft has created fewer innovative products. Microsoft’s stock price peaked during the tech boom at $60 per share on December 29, 1999, dropping to $22 per share only a year later. Since then, it has appreciated to $28 per share as of December 31, 2010—not exactly a great rate of return over a 10-year period. As an outside investor, you cannot know every detail of what’s going on inside a business. There are too many variables that impact the future valuation of a business. You must trust management 173 c07.indd 173 9/2/11 10:38:10 AM 174 The Investment Checklist to make the right decisions. More important, you must know that management can recover quickly from setbacks. In order to trust managers, you need to gain insight into their character and their ability to execute. This will help you improve your forecasts for the business going forward. Think about how many great businesses of the past have faced ruin due to mismanagement—for example, energy business Enron. Early on, Enron held many high- quality assets, including pipelines. Over time, management transitioned the business into a trading fi rm, and Enron spun off or sold these high- quality assets. While Enron went bankrupt, many of these spin- offs, such as pipeline business Kinder Morgan Energy Partners (operated by highly capa- ble chief executive offi cer Richard Kinder), went on to become extremely successful. To appreciate how essential sound management is to the long- term success of a business, consider that top managers typically: • Are responsible for designing the business. • Determine the future growth rate of a business. • Are in charge of choosing the right people and providing the right environment for these people to perform at their high- est potential. • Determine how to allocate the firm’s capital. Knowing the type of management team you are partnering with will help you forecast the future of the business, because the most logical predictor for the future success of a business is its management. A business does not need to have every manager be an allstar, but at the very least, the managers in key positions need to be allstars. Give yourself plenty of time to understand the quality of the management team running a business. This topic is so important that I’ve devoted three chapters to it: Chapters 7, 8, and 9. It is best to evaluate a management team over time. By not rushing into investment decisions and by taking the time to under- stand a management team, you can reduce your risk of misjudging them. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore fl aws or warning signs. The more familiar you are with how managers act under different types of circumstances, c07.indd 174 9/2/11 10:38:10 AM Assessing the Quality of Management—Background and Classification: Who Are They? 175 the better you are able to predict their future actions. Ideally, you want to understand how managers have operated in both diffi cult and favorable business environments. Your overall strategy should be to develop a working picture of a manager and the management team. You can start learning about management by gathering all of the historical and current articles written about each manager. These articles serve as a trail of evidence as to the past accomplishments of the management team, the type of people they are, and how they have dealt with different types of situations. You can answer a great number of questions in this book just by reading articles. You can use aggre- gated news archives, such as Dow Jones Factiva or LexisNexis, which archive historical articles as far back as the 1980s from publica- tions including the Wall Street Journal, the Financial Times, the New York Times, and various trade journals. Look for articles that reveal how the top managers run the business and the type of people they are. Interviews are especially useful, because managers tell you a great deal about their business philosophy or how they operate the business. Use interview sources such as the Wall Street Transcript or the Charlie Rose show, which often feature round- table discussion or lengthy interviews. Pay particular attention to what motivates the managers and why they are where they are professionally. Some of the best sources of information are trade journals and local newspapers where a business is headquartered. Subjects often reveal more information to industry journalists than they will to a national publication such as the Wall Street Journal. Local journalists also have experience in covering the company and may ask ques- tions that reveal deeper insights. The articles also tend to be longer because the local company is important to the community where it is based. As you read articles, look for evidence in four basic areas: pas- sion, honesty, transparency, and competence. Look for the ability of a manager to recognize and learn from mistakes and also try to see how quickly they are able to recover from mistakes. Look for articles that talk about how a manager helps employees become engaged in the business or keeps customers happy. If there are not many articles written, you either have to rely more on other sources or simply admit that you do not have enough information to assess a manager. c07.indd 175 9/2/11 10:38:10 AM 176 The Investment Checklist The questions in Chapters 7, 8, and 9 will help guide you in collecting the evidence you need to determine whether a manage- ment team is competent and proven. • The first set of questions, in Chapter 7, helps you learn about the background of the managers and how to classify them. • The questions in Chapter 8 help you understand how the CEO and other managers manage their business, which will help you determine if they are competent. • The questions in Chapter 9 help you understand the person- ality and character of the manager. Let’s begin by exploring the background of the management team and how they are compensated. ❒ 33. What type of manager is leading the company? It is important to classify the type of manager you are partnering with at a business. This way, you will be in a better position to gauge potential execution risk. If you are investing in a manager who has a long track record (i.e., more than 10 years) of successfully manag- ing a business, the odds that he or she will continue to manage the business successfully are in your favor. On the other hand, if you are investing in a new management team that has limited experi- ence serving the customer base of the business, the odds are not in your favor. Here is a simple classifi cation system you can use: Most knowledgeable and Least knowledgeable and passionate about business passionate about business OO LT HH This is a continuum, from left to right; here’s a quick overview of what each means, followed by a more detailed description: • OO is an owner- operator, typically the founder of a business. • LT is a long- tenured manager or one who has worked in the industry for at least 3 to 10 years. • HH is a hired hand, a manager who has limited experience serving the customer base of the business and has worked at the business for less than three years. c07.indd 176 9/2/11 10:38:10 AM Assessing the Quality of Management—Background and Classification: Who Are They? 177 For example, on the far left side are owner- operators such as the late Sam Walton, founder of Wal- Mart. On the far right- hand side are hired hands who did not have any prior experience at the business before joining as CEO, such as Robert Nardelli, who joined Home Depot in December 2000 from General Electric. Most managers of publicly traded businesses fall into the long- tenured or hired-hand category, and these are the most diffi cult managers to evaluate. Let’s take a closer look at each type, which is further broken down into sub- categories shown below. Owner- Operator 1 (OO1) These are the ideal managers to partner with in a business. An owner- operator is a manager who has genuine pas- sion for their particular business and is typically the founder of that business, for example: • Sam Walton, founder of Wal-Mart • Dave and Sherry Gold, co- founders of 99 Cent Only Stores • Joe Mansueto, founder of Morningstar • John Mackey, co- founder of Whole Foods Market • Warren Buffett, CEO of Berkshire Hathaway • Founders of most family- controlled businesses These passionate leaders run the business for key stakehold- ers such as customers, employees, and shareholders alike, instead of emphasizing one constituency over the other.