How Can You Tell if a Company is Well Managed?

In this article I will be diving into what performance indicators we would like to see from management in a wonderful business. This is article 2 out of 2 about Management. You don’t have to read the first article to dive into this one – both articles are stand-alone – but here the link: How do you know if you can trust the management?

As value investors we have 4 parameters we’re always looking into (the “Warren Buffett way”). We want a company that we’re able to understand, and once we’re over that hurdle we want it to have management we can trust, a large competitive advantage, and then we want to buy it at a reasonable price. Now let’s dive deeper into management and how you can track their performance.

Does the CEO communicate the Strategy?

A company’s strategy is an extremely important component for investors. With this strategy we know where the company is headed, and we can track how well they’re doing year on year – if the CEO shares their strategy! Because it’s far from every CEO that shares the strategy and continuously reports back on it – the wins and the learnings.

A way to track strategy over time is to read the first annual report authored by the CEO. The first business I bought as a value investor (after going through many, many companies I found a wonderful business) had a CEO that was magnificent with a clear and concise strategy. They had a bold expansion goal and every year we shareholders could track progress through communication in the annual reports. When the first goal was achieved, a new and bolder goal was communicated and reported on. When COVID-19 hit, the challenges the business was facing with achieving the strategic goals, was communicated. For an investor it is so gratifying being able to clearly understand what is going on, even in times of struggles.

"When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever."

Warren Buffett 

Management's Performance

Is the CEO thinking long-term or medium-term? Is the strategy clearly communicated - preferably in the annual report. And do they track the performance of the strategy by following up on key metrics in the annual report? As a shareholder of a business we want to ensure that the CEO is shareholder-friendly by communicating this to us.

To measure management's performance, Phil Town - guru investor and investing mentor - recommends to look at ROIC (return on invested capital) and compare the numbers with ROE (Return On Equity). The difference between the two numbers are debt. So if the business have no debt the ROIC and ROE are the same percentage – but with debt the Return on Equity is higher than the percentage of invested capital.

According to Phil Town we also want the ROIC and ROE to be above 10% respectively. The bigger the better. You should track the numbers back 5-10 years – please note that if there was a change in the CEO within this timeframe you can see if there were any changes in ROIC and ROE with the shift.

ROIC indicates how well management have made profitable investments in the past. ROE indicates how much profitability the management adds (but again, watch out for the debt).

ROIC and ROE is a number that you can find multiple locations – for example in the annual reports, on Yahoo Finance, stockanalysis.com and many regional platforms in your own language. To track back you can go to macrotrends.net (or again check the annual reports). In my free investing checklist, there’s a nice table where you can insert numbers and track key management metrics.

Debt

Preferable we want management that doesn't take on long-term debt. And if there's long-term debt we want it to be low - it should take less than 3 years to pay off the debt. The reason this is so important is because if the business have debt when times are prosperous they might be in trouble when times are tough. If the company has debt it's important to understand the reason for the debt and the plan to pay it off.

Is the Compensation Structure Fair?

Another important task is to understand the leader’s compensation structure. The management pay structure is described in the so-called proxy statement that can be found on the company’s investor relations website. How is the CEO compensated?

A good idea is to compare the CEO’s pay. For example, with other leaders in the industry and with the average pay of an employee in the company.

Here’s a scary example of CEO pay. Let’s call the company AB Inc. (fictional name). When looking into CEO’s compensation in AB Inc., I initially found the pay to be ok. The CEO pay was on par compared to other leaders in the industry. However, as I read on in the Proxy statement it became clear that this was only a fragment of the CEO’s salary. The real payment structure was quite complicated because in reality the CEO was hired through his own company – let’s call that company YZ. The way it was structured was that the AB Inc. had a service agreement with YZ, and the CEO was also compensated through this agreement by XY. So, on top of the pay of 30 million from AB Inc. (which was the industry standard including bonuses and options awards etc.), on top was an additional bonus from AB Inc. of up to 24 million dollars, that I only discovered by reading on in the Proxy statement. Further this agreement meant that an important part of employees in AB Inc. was hired from YZ, and it made me wonder what the board was going to do in case they no longer were happy with the CEO’s performance. If the board of AB Inc. wanted to get rid of the CEO, they would have to terminate the service agreement with YZ, loosing talent and key employees with an important knowledge and set of expertise that a business needs. That did not make me feel comfortable as a potential investor.

I hope these examples provide some valuable insights to you as a new investor. Go with simple pay structures and with a manager, who can clearly communicate their goals and revisit them frequently. Look how the management allocate capital by tracking ROIC and ROE and you’re on your way to find wonderful!