This simple checklist will help you
1. Is management rational?
weed out companies whose management teams
are NOT committed to building shareholder value
2. Are they candid with shareholders?
3. Do they resist the "institutional imperative?"
Let's take a brief look at each of these attributes…
Is Management Rational?
The most important job management has is the allocation of capital. Allocation of capital to the bottom line, after all expenses and reinvestments into the business has been made, is the biggest factor determining shareholder value.
How Do They Allocate Capital?
Keep an eye on the cash that a company has and how they spend it. If management is disciplined and rational, they will do the right thing and create value. Simply because a company is generating excess cash flow doesn't mean they need to spend it on something foolish.
There are very few managers who have the skill and discipline to acquire other companies. Most of the time managers pay too high a price for the acquired company and let their egos get the best of them.
When you see companies constantly acquiring other companies it should set off an alarm bell. Why does management need to buy growth? Have they run out of ways to expand their business internally? History has shown that acquisitions don't always increase shareholder value. There are some managers who have done an excellent job of acquiring companies, but by and large most acquisitions do not add much to shareholder value.
"When a chief executive officer is encouraged by his advisers to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life. It's not a push he needs."
-- Warren Buffett
Candid with Shareholders: Are they Sincere and Truthful?Simply put, the CEO's annual report letter is written to you – the shareholder – by the chief executive officer or chairperson. Its purpose is to inform you of what happened in the past year and, in many cases, to state their goals for the company for the next year… pat themselves on the back for a job well done…or – not often enough – point out their shortcomings.
This letter also gives you insight as to where management's focus is and whether they treat shareholders like owners.
When reading the annual reports, I look for the number of times the CEO gives praise to others and uses self-effacing humor, which are the hallmarks of good leadership. Conversely, if the word "I" comes up with every great thing the company did over the past year…you should take that as a warning sign.
Someone once told me to go into business only with someone you would feel comfortable giving your house keys to. After reading several years of shareholder letters, I ask myself that same question. I want to feel comfortable with the management running my company.
Resisting the "Institutional Imperative":
I remember when I was growing up and did something wrong, my father would sit me down, give me a stern look and demand an explanation. Often, my reply was, "But Dad, everyone else was doing it."
Are They Lemmings or Leaders?
Doing what everyone else is doing is still the excuse for companies acting like lemmings and jumping off the cliff. "Follow-the-Leader" is not a game relegated to the playground; it is still played in boardrooms across the United States.
Between 1975 and 1982, U.S. commercial banks could not lend money quickly enough to financially aid politically shaky Latin American governments. At one point, the debt to Latin America was more than half of the region's market value of all goods and services (gross domestic product.) Why did banks fall over themselves and continue to lend money to these countries?
Because everyone else was doing it. Look for managers who stand apart and do not lead their companies down the road to disaster.
Why do intelligent managers make stupid mistakes? Warren Buffett has learned, through his many years of experience, that the "institutional imperative" takes over. Simply put, the institutional imperative is doing dumb things just for the sake of doing them.
Keep in mind that when you are buying a share of a business you are really buying a piece of the company. If management appears to be taking the lion's share for itself – or making poor decisions with the company's capital in general – don't buy their shares…there are lots of other companies from which to choose.