How to evaluate the Management of a company before Investing?
Created on 16 Jul 2021
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Updated on 16 May 2022
“There are no bad companies, only bad managers.”
Consider an example where you purchase a beautiful car, but if the driver does not know how to drive well, your car is going to crash eventually, isn’t it? Similarly, an investment in a company with poor management is like driving a car with a naive driver.
Every successful investor stresses the importance of a company’s management. But it becomes a tedious task for retail investors like us to directly access the management.
So, before diving any deeper, let us first understand why analyzing the quality of management is critical.
Why is analyzing the management’s quality critical?
For most retail investors, investment research is a number-crunching game. Little do they care about the sustainability of these numbers, which depends largely on the quality of management. But again, why do inexperienced investors overlook such an important aspect?
Unlike quantitative analysis, there is no fixed formula to judge a company’s management, and it certainly cannot be calculated using any balance sheet or income statement. The information about any company’s management is not readily available on the internet, and it’s not advisable to simply question someone’s ethics and integrity. That’s basically why so many investors often overlook the management analysis of the company.
Then, how to analyze a company’s management, you ask?
How to analyze the quality of management of a business?
“I think you judge management by two yardsticks. One is how well they run the business, and I think you can learn a lot about that by reading about both what they’ve accomplished and what their competitors have accomplished, and seeing how they have allocated capital over time.” - Warren Buffett
Warren Buffett often emphasizes checking the quality of management by looking at their capital allocation skills and how the company has performed in comparison to its peers over the years.
Analyzing the values of a manager is not an easy task. Because of non-quantifiable parameters, its study and analysis have become more theoretical in nature. But there are several factors that we as investors must see to get a clear picture of the company’s management:
The factors that define the quality of management include the experience and skills of the promoter or the BOD(Board of directors). One can also look at the past track of project execution and the overall culture of the business. A company's culture can have a huge impact on the fortune of the business and its shareholders. It is basically the set of beliefs and behaviors which govern how a company’s management and employees interact and handle external business transactions.
Some management is more flexible, transparent, and open when it comes to decision making while others are more rigid and less adaptable. Most errors in accessing the quality of management happen when we as an investor are too quick to judge their character (like how they have done in the recent past). These errors also occur when we become biased and see only what we want to see (like how management has performed during good times).
One should also look for how long the current managers have been managing the business.
If you are investing in a company whose management has a long track record (i.e., more than 10 years) of managing a business successfully, the odds of them running the business effectively will mostly be in your favor.
An investor should try to insert words like 'Fraud', 'Scam', 'Issues', 'Court', 'SEBI Dispute', etc. as a prefix to the promoter’s name or the company’s name and quickly run a google search to get a proper insight about them. Although not much information is available for retail investors in the public domain, it’s worth giving it a shot.
Executives manage the business in shareholders' interest and may or may not be a part of this ownership model. For instance, ITC has zero promoter holding. So, to motivate these executives, a proper reward system is essential but structuring a reward system that aligns with management’s motivation and the owners’ interests is a challenge.
After analyzing a lot of companies, we have found that the usual salary range for the promoters/ management is around 2 - 4% of the net profit (PAT) of the company. However, a remuneration higher than 4% does not always mean that the management is filling their own pockets. Some promoters do deserve it for the hard work they’ve done for the company.
Management’s salary gives a critical idea about their intention of running a business. The right way to analyze the remuneration drawn by management is by comparing the salary trend with the sales and profit growth. Incentivizing a competent and deserving management team is essential, but one needs to note that rising managerial remuneration is justified only when the company's performance is improving. Otherwise, the chances are high that the company is not implementing proper corporate governance principles.
The primary aim of any company is to generate enough profits and strengthen the business’s value. Hence, whenever an investor invests in a share, they expect the management to utilize that money in the most efficient manner and deliver exemplary returns. But sometimes, the management fails to meet these expectations, and due to this, they end up wasting the investor’s hard-earned money. In business parlance, this is known as ‘poor capital allocation’.
Capital allocation is when the management team invests the excess free cash flow (FCF) that the business generates.
Finding a CEO who is good at both operating the company and allocating the capital efficiently is tough. So, a simple strategy to look for the efficiency of management is to notice the Return on Capital Employed (ROCE), which shows the efficiency of a business with which its capital is employed. The higher the ROCE, the better it gets for the company.
Pidilite, one of the adhesives majors in India, after achieving dominance in the white glue segment through Fevicol, implemented a product development strategy through an inorganic route. Instead of holding cash or paying extensive dividends, the company made enormous acquisitions between 1999 and 2005. Pidilite acquired known brands such as Dr. Fixit, M-seal, Steelgrip, Roff, and Ranipal to widen its reach in the adhesives segment.
After successful acquisitions, the company went to dominate in these newer sub-segments too. As a result, Pidilite delivered a robust ROCE of 34% (average) from 2000 to 2010. Even today, the company delivers an average ROCE of 33%!
Related Party Transactions
This is one of those portions of an annual report that is unavoidable. We’ve already seen a lot of examples where promoters have siphoned the company’s money to outsiders. They take a loan in the company’s name, and instead of using it for the company's welfare, they divert the money somewhere else.
However, related party transactions do not necessarily indicate fraudulent financial reporting. One needs to evaluate the nature of related party transactions within the broader corporate context and see whether these transactions are justified or not.
Whether it be interest-free loans given by companies to the promoters, selling the company’s assets dirt cheap to the promoters or buying promoter assets at a sky-high valuation, the related party transactions section contains an entry depicting the transaction same.
Below are some examples of related party transactions an investor should focus upon:
Transaction between the promoters and the company
Many companies lend money to the promoters in the form of loans and later write them off. So basically, the company has given that loan for free. Apart from writing off loans, the companies also provide loans to their promoters at a negligible interest rate. It becomes a major problem when the money is lent by borrowing funds from the bank.
Another scenario could be where the promoters lend loans to the company at a higher interest rate than the bank. This is a clear sign of them plundering the company.
Buying and selling assets/ stakes between the company and the promoter’s entity
It is often found that the promoters get a higher price by selling their assets to the company than they would have got by selling them in the market. In some cases, promoters make the company buy assets from the market and later purchase it from the company at a lower price.
In such cases, it is usually the shareholders that have to pay the price.
Funding the promoter’s venture
On other occasions, you would find that the company has provided seed capital to the promoters to help them start their personal venture. It is the shareholder’s money that is kept at stake if the promoter does not return the money. Also, sometimes, the company enters into a joint venture with the promoter to start the company, and while that venture is on the verge of failure, the company tends to buy the stake of promoters to save them.
Good management is a factor in the computation of a company's intrinsic value, although it may be harder to quantify it, unlike cash projections or profit forecasts. The above-mentioned factors are key parameters to judge the quality of management, though one must look into other factors as well. These include the pledging of shares done by the management and checking if the shares are pledged for a valid reason. One should also check for the management commentaries and see if they are in sync with the actions taken by them.
Evaluating the management’s quality is an integral part of management analysis. Stressing only on the financial results will never give a complete picture of the company. As a value investor, you must invest in the company, where management puts the shareholder value above their selfish motives.
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