It’s Hard to Measure Management Quality (Revisited)

I have written on this topic sometime last year.

https://themosspiglets.com/2019/06/19/the-importance-of-assessing-management-quality/

Last week, we received news about a corruption case involving a former LTA staff and directors from several construction firms.

https://www.businesstimes.com.sg/companies-markets/former-lta-deputy-group-director-charged-with-corruption

I was surprised at this news especially with the people involved. Mr Henry Foo was once touted as one of the more promising LTA management staff. I mean, being a deputy group director in the early 40s is not an easy task to achieve in the public sector. There were also 2 SGX listed construction companies that were mentioned in the news article, Tiong Seng Holdings and Tritech Group. I had the impression that the management at Tiong Seng Holdings were astute in their acquisitions of construction technology firms.

The Importance of Assessing Management Quality

This brings me to the topic I want to emphasize again. Most of us often overlook the human aspect of a business, me included. Even if we think that assessing the quality of the management is relevant in our due diligence, it is hard to do a good job out of it.

According to Warren Buffett, assessing the quality of management is important. Especially when making decisions on either acquiring a controlling shareholding or making a minority investment in a business.

Of course, in the long run, the quality and underlying economics of a business holds a greater relevance than the quality of management. However, you wouldn’t want to be a investor of an enterprise that is run by incompetent and/or unethical people.

However, in my opinion, assessing management quality easier said than done.

What’s so Difficult?

For starters, it is not as straightforward as looking through a company’s financials This is because you cannot put a numerical value to a company’s management. You cannot create any specific metric to measure its quality. The process of evaluating a management is not only very subjective but very qualitative in nature.

I admit that I myself sometimes tend to ignore management quality when I see a business that I really like. A good example would be one of my holdings TOMZ. I received information that a few investors have tried contacting the investor relations and directors of the company and they have received a rude reply, stating that they are not interested in dealing with the investors. But I treated it as a one-off and stayed vested in the company.

(read: https://themosspiglets.com/2020/05/18/tomi-environmental-solutions-tomz-explosive-growth-incoming/)

Also, it is a lot of hard work.

5 Points To Assess Management Quality

How should we put value on the management when evaluating stocks? Here I have listed 5 important factors in terms of assessing the management quality for your stock analysis.

1. Company’s Financial Performance

Good and stable growth usually implies good management. If done over a long period of time, say 10 years, it shows the management’s ability to steer the company well through good and bad times.

2. Clean Balance Sheet

Clean balance sheets, which are low on debt, suggest that management is not willing to risk the business’s future by borrowing more than the business can sustain. On the other hand, too much debt (D/E > 1x; and higher than industry peers) on a continuous basis is a sign of too much aggressiveness on the part of the management and that could imply that they are focused on short term performance.

However, this plays out differently from company to company. Some business nature requires them to have very high leverage (eg. shipping, material suppliers, construction).

3. Capital Allocation Decisions

Capital allocation means distributing or investing the excess free cash flows (FCF) that the business generates. It’s the management that decides when and where the money should be invested or distributed. The management should always allocate capital in way that maximizes shareholder returns.
There are five actions management can take with FCF:

1. Reinvest the capital back in the business – capex and working capital;
2. Hold cash on the balance sheet;
3. Pay dividends;
4. Make acquisitions; and
5. Stock buyback.

You can look at a company’s past capital allocation decisions to determine their capability. (Eg, looking at SingPost’s poor track record of acquisitions, I am not confident when they recently said that they are looking to capture the e-commerce boom)

Some of the better capital allocators I like are John Malone of Liberty Media, Prem Watsa founder of Fairfax Holdings and Oracle of Boston Seth Klarman.

4. Compensation of Management

When reading through annual reports, I would always try to understand how the management are compensated. This is because by looking at their compensation package, you can determine if it drives short term or long term performance (eg share compensation, bonuses for achieving profit targets etc).

Opining on management remuneration is a very subjective area. It has to be assessed on case to case basis. If a management has managed to steer the company away from dire straits and turned deep losses into healthy profits, then I am okay with them taking a higher salary. However, a management that maintains or even increases their compensation while the business dwindles or stagnates, then I would wish to avoid it.

5. Ethical Management

I believe that this is the most relevant to the news article referenced at the start of this post. This part of due diligence requires a lot more effort besides reading annual reports and company press releases.

We can do this by communicating with the management during Annual General Meetings, getting information on management day to day decisions from their employees or asking for opinions from the public.

Personally I do not think that you can get 100% information on whether the management is ethical or not. If this can be achieved, then we would not have seen these news creating headlines and investors would know about it way beforehand. Hence, in my opinion, we should focus on the analysis of publicly available information about the company, management’s decisions and their outcomes to create an opinion about the competence and shareholder friendliness of the management.

Closing

Management assessment should not be ignored as an aspect of stock selection. Even if I am confident about the financial, business and valuation analysis of any company, if I am wary of the management’s skills and abilities I would definitely rethink my investment decision.

The two key takeaway from this is that;

1) We can assess a management by looking at how well they have ran the business and allocated capital over time.

2) We should also seek management that is shareholder friendly and has the minority shareholders interests at heart.

It is not easy to determine the quality of management when it comes to investing since the assessment include qualitative aspects that cannot be shown in numbers and we can never have 100% of the information. However, your investment success hugely depends on the management quality and I urge my fellow investors to spend enough time in this area.

Cheers