What to buy: Quality of Management

In order for a stock to be a huge winner in the long term, one of the most important aspects is the quality of the management. They should have unquestionable integrity and competitive management ability.

Without breaking any laws, there are infinite ways in which those in control can benefit themselves at the expense of shareholders. For example, in the presence of stock options as a compensation package, they can retain a big portion of earnings for unattractive projects and investments for the purpose of boosting up stock price. In this case, shareholders would be better off getting a dividend. Another is to adjust estimates and assumptions on the financial statement to meet the expectation of Wall Street and get rewarded for their “performance”. With complex accounting rules and operations, some of the misconducts are literally impossible for investors to detect. Therefore, if management has any history of misconducts and crimes, the investors had better stay away from the stock regardless of other matters.

In terms of the management ability, there are three main areas that should be focused on. First, you need to know how well the management runs their day-to-day operations, compared to their competitors. A good manager doesn’t get up one day and say, “I will improve the condition of my firm”. Truly outstanding managers are the ones who do it on a daily basis without even realizing that they are doing it.  They should be able to break down its overall costs into small pieces (e.g. costs of different products and divisions) so as to know where they need to pay attention the most.  The worst case is that management may not be aware that some of their supposed-to-be-profitable operations are run at a loss, which results in decrearsing rather than increasing the overall profits.

Second, management should be long-term oriented. As mentioned above, many managers are compensated for their short-term performance, which makes them short-term oriented. Outstanding firms are the ones that deliberately hold back maximum immediate profits if it has greater overall profits over a period of years. If you are a long-term investor who seeks for more than 1000% long-term profits at the expense of 20% short-term increase, the management should also do the same thing.

Third, management must be equipped with excellent capital allocation skills. In many cases, outstanding managers climb up the hierarchy with little knowledge about investing. Over many years of experience under their belts, they are the experts of running the firm, but not managing money. Thus, they leave what they earn from the operation to institutional investors, hire a CFO, etc. If those in charge of the capital allocation decisions are incapable, it is the same as pouring water into a basket that has a hole at the bottom. One day, you might scratch your head and wonder why it takes so long for the basket (i.e. stock price) to be full (i.e. rise).

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