Tuesday, October 11, 2011

From The Mailbag: Evaluating Management-Friendliness

I have recently received a few questions on the order of "How can I tell if management is shareholder friendly? Can you tell me if management at company X passes the smell test?"

The second question is far too difficult for me to answer, for several reasons. First, we all have different standards of just how friendly a manager has to be. Second, "friendliness" can be measured using many different criteria; preferences among investors will vary not only as to which criteria should weigh the most heavily in coming to an overall conclusion, but also as to which criteria should be used at all. Finally, differences of opinion regarding management friendliness will arise between investors even if shown the exact same data; an action one investor may deem friendly may be viewed as unfriendly by another (e.g. a restricted share issue).

As such, rather than state my opinion of company X, it is probably more useful for you (and less time-consuming for me) to discuss what information may be relevant in allowing you to answer the second question for yourself, using your own investment criteria, objectives and opinions.

One of the most important determinants of a management team's friendliness is its track record at allocating capital. Management is entrusted with control over shareholder assets. Given this control, are company resources being deployed in a manner whereby shareholders are benefiting?

As shareholders, we are not privy to the details about whether managers have made good decisions about any individual projects the company has undertaken. However, we do get to see the aggregate results of all of these decisions. To answer the question of whether management is properly allocating capital, it is necessary to look at management's long-term track record with respect to returns on capital.

(Note that this measure is used to judge a lot of different things. For example, it can also be used to help determine whether a firm has a moat, or whether its manager is competent.)

A low or negative return-on-capital number doesn't mean management is unfriendly, however. This data must be used in parallel with other data to determine whether managers are being good stewards of capital.

For example, if returns are low or negative, managers should probably avoid growing the business by investing more shareholder capital after bad. Shareholders can compare depreciation expenses with capital expenditures to help determine if management is indeed trying to grow despite meagre profits. Shareholder friendly managers would seek to return capital to shareholders rather than invest it at low rates of return.

Note that a shareholder-friendly management needn't pay a dividend! Firms with high returns on invested capital may be able to compound profits by re-investing in the business. Furthermore, even for firms with low returns on capital, paying off debt may make more sense for shareholders (reducing risk), or buying back shares may be more prudent (due to the current share price or because taxes on dividends are comparatively worse than taxes on buybacks).

If management chooses to invest in the business despite poor returns, there should be a compelling reason. Shareholders should seek out this reason and use their own business sense to confirm that there is adequate evidence to suggest the future will be better than the past.

Many investors also believe shareholder-friendliness is related to manager pay scales. High pay may signal a weak board that is not doing its part to look after shareholder interests. Furthermore, high expenses related to stock option grants can make managers reckless with shareholder capital. (Options cause their holders to participate in upside rewards, but not in downside pain.) Management is most likely to be shareholder friendly when it is also a shareholder. (Here's how to find that info.)

What are the criteria you use?

1 comment:

Anonymous said...


Thanks for all the tips.