What is a Roadrunner Stock? Part 2: Honest and Competent Management
A Roadrunner Stock is a one of the select minority of small-cap stocks primed to outperform the general stock market by a significant margin over a long period of time. Last week, I discussed the most important attribute of such elite small-cap stocks: sustainably high profit margins resulting from a sustainable competitive advantage.
Another important attribute of a Roadrunner Stock is honest and competent management. Management steers the business and you don’t want your CEO to be drunk as Titanic Captain Edward Smith allegedly was the evening when the state-of-the-art cruise ship crashed into an iceberg. Similarly, you don’t want your CEO to be a crook who embezzles money from the company like John Rigas of cable company Adelphia Communications or Dennis Kozlowski of Tyco International.
Competitive Advantage Trumps Management
But if I had to pick between the strength of a business’ competitive advantage and management quality, the strength of the business would have to more important. As legendary Fidelity Magellan mutual fund manager Peter Lynch wrote on page 130 of his 1989 book One Up on Wall Street :
Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communication satellites or in motel chains than in fiber optics. The simpler it is, the better I like it. When somebody says, “any idiot could run this joint,” that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.
If it’s a choice between owning stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter.
Warren Buffett has voiced similar sentiments many times. In Berkshire Hathaway’s 1989 shareholder letter, Buffett said “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Similarly, in Berkshire Hathaway’s 1995 shareholder letter, Buffett compared a retailer – which faces no barriers to entry and has no sustainable competitive advantage – with a TV station owner that faces very limited competition as part of a regulated oligopoly of broadcast-frequency licensees. According to Buffett, he would rather invest in the TV station – even if headed by a moron – than a retailer headed by a genius:
Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.
In contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business. For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades. You’d do far better, of course, if you put in [ABC’s] Tom Murphy, but you could stay comfortably in the black without him. For a retailer, hiring that nephew would be an express ticket to bankruptcy.
Public companies that are involved in monopolies and oligopolies are usually limited to the slow-growth public utility space. So, an investor being able to ignore the competence or integrity of management is the exception rather than the rule. Most businesses face significant competition and investors consequently must consider both the company’s business model and management quality as important factors. Buffett uses medieval imagery to illustrate the dual-criteria goal of stock picking:
It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord.
Integrity More Important Than Intelligence or Passion
How important is honest management? In a 2009 meeting with business-school students, Buffett was asked what he considered the three most important attributes of corporate managers. Interestingly, Buffett put integrity at the top of the list — ahead of intelligence or energy:
Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. All you have is a crook who works hard and finds lots of clever ways to make all your money theirs. If a person doesn’t have integrity, you want them dumb and lazy.
In his 1989 shareholder letter, he said that investors can “accomplish wonders” by going into business only with people that they “like, trust, and admire.” Buffett emphasized that he had “never succeeded in making a good deal with a bad person.” Nine years later in a 1998 talk with MBA students at the University of Florida, Buffett again emphasized the importance of character in choosing corporate managers:
Think for a moment that I granted you the right to buy 10% of one of your classmate’s earnings for the rest of their lifetime. Will you give them an IQ test and pick the one with the highest IQ? I doubt it. Will you pick the one with the best grades? The most energetic? You will start looking for qualitative factors, because everyone has enough brains and energy. You would probably pick the one you responded the best to, the one who has the leadership qualities, the one who is able to get other people to carry out their interests. That would be the person who is generous, honest and who gave credit to other people for their own ideas.
Who do I want to go short? You wouldn’t pick the person with the lowest IQ, you would think about the person who turned you off, the person who is egotistical, who is greedy, who cuts corners, who is slightly dishonest.
Capital Allocation is the Primary Function of Management
Most investors do not have the personal access that Warren Buffett has with management, nor do they plan on investing in a company owned by one of their school classmates. In other words, it is not realistically possible for most investors to get a good sense of a corporate manager’s personal integrity. So, how does the average investor evaluate management? The answer is to look at how management treats the average shareholder through its capital allocation decisions. Is the manager a good steward of shareholder capital? The five key actions a manager can take with shareholder capital are the following:
- Executive compensation
- Share buybacks
- Re-investment in the business (including acquisitions)
- Assumption of debt (leverage)
With regard to executive compensation, Buffett looks for managers who aren’t greedy and are willing to work for long-term incentives based on performance rather than demanding large sums of guaranteed, up-front cash:
I think people taking compensation have a moral duty not to take it; a moral duty to be underpaid. If generals and archbishops can do it, why can’t the leaders of a large enterprise take less than the last dollar?
In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls. When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.
It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many “alignment” plans flunk this basic test, being artful forms of “heads I win, tails you lose.”
If oil goes from $30 to $60, there’s no reason to pay an oil company executive for that. If they have low finding costs, which they can control, I’d pay them like crazy for that. That is the job you hire them for. To hand them huge checks for something they have no control over is crazy, and it’s equally crazy to penalize them if oil prices go down.
One of the best forms of executive compensation is stock ownership. Fund manager Chuck Akre says that ascertaining management integrity is “the tough question and the answer which often takes us years to discover.” One short cut Akre uses is to favor “owner operators,” which refers to managements that own a lot of company stock. The thinking is that if management’s financial interests are aligned with shareholders, they will do right by shareholders regardless of integrity. He also makes sure that management’s compensation is not excessive. Second, Akre looks for management that is in the hands of the founding entrepreneur, because he finds entrepreneurs to be people with passion and pride in having creating a business, rather than just a business suit collecting a paycheck.
Shareholder Capital Should Be Used to Increase Intrinsic Value
With regard to dividends, share buybacks, and acquisitions, Buffett says the decision should be based on which use of capital increases intrinsic value of the business the most:
Understanding intrinsic value is as important for managers as it is for investors. When managers are making capital allocation decisions – including decisions to repurchase shares – it’s vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious but we constantly see it violated. And, when misallocations occur, shareholders are hurt.
Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value. Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug.
Between paying out earnings in dividends and re-investing earnings into the business (including acquisitions), the decision should depend on which generates a higher rate of return:
A company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas.
Too often, managers engage in acquisitions for egotistical empire building – more concerned with increasing the size of their business than increasing profitability. Buffett has repeatedly criticized value-destroying acquisitions in his shareholder letters (e.g., 1981, 1982, 1994, 1995). Acquisitions can go wrong in at least two different ways: (1) overvalue the assets being acquired; and (2) undervalue the acquiring company’s stock used to purchase the assets. A January 2012 study by Thomson Reuters looked at stock-repurchase activity by S&P 500 companies over the past 10 years. The study concluded that most stock buybacks are poorly timed and destroy shareholder value.
Similarly, share buybacks should only be done if the company’s stock is undervalued. In Berkshire’s1999 shareholder letter, Buffett outlined the criteria management must satisfy before a buyback can be considered “good:”
Repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can’t help but feel that too often today’s repurchases are dictated by management’s desire to “show confidence” or be in fashion rather than by a desire to enhance per-share value.
Debt Can Reflect Management Recklessness
Lastly, Buffett doesn’t like companies that incur a lot of indebtedness. Debt can increase returns if the interest rate on the debt is less than the return available from investing additional capital. But leverage is a two-headed sword. When investment returns don’t pan out as expected, the increased debt destroys value and could potentially be so onerous as to destroy the solvency of the business. Corporate managers who recklessly incur debt are like greedy gamblers, risking the long-term viability of the company in order to squeeze out a few more percentage points of profit – which often help goose the manager’s incentive-based compensation. In his 1982 shareholder letter, Buffett emphasized that he liked to buy stock in “businesses earning good returns on equity while employing little or no debt.” Similarly, in his 1987 shareholder letter, Buffett put it this way:
In its 1988 Investor’s Guide issue, Fortune Magazine reported that among the 500 largest industrial companies and 500 largest service companies, Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.
The Fortune champs may surprise you. Most use very little leverage compared to their interest-paying capacity. Really good businesses usually don’t need to borrow. Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage. Therefore, it seems to us to be both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.
A Failure to Communicate?
A last component of good management is routine and informative communication with shareholders. Shareholders have a right to know what is going on with their investment. Furthermore, communcation forces management to articulate its strategy, which can help it better understand what it is doing, rather than running on autopilot with half-baked ideas. Explaining oneself is not always easy and often requires self-examination and justifiying actions that turn out to be unjustifiable. The Roman philosopher Seneca is famous for the saying: “While we teach, we learn.“
All of Warren Buffett’s annual shareholder letters are great examples of shareholder communiation and he emphasized the importance of such communications at Berkshire Hathaway’s 2007 annual meeting:
We read the annual reports. Charlie and I read an annual report recently – it was very fancy – for an oil company that didn’t talk about finding costs per MCF [million cubic feet of gas] or barrel [of oil]. The most important metric, over time, wasn’t even discussed and when it was touched on, it was in a dishonest manner. That tells us a lot about the individual running the company. If he’s not willing to talk to the owners, even once a year, that makes me question the person.
I’m pleased that the fellows at Google think it’s good for companies to communicate with shareholders. If you read Google Owner’s Manual, you know what they’re like.
It’s like writing a letter to your partner in a business, in which you’d say, “I’d like you to join me as a partner, I’d like you to invest your money, so here’s the information I want you to have and how I will treat you…”
I hope more companies sign on for this.
Summary of Important Management Attributes
To sum up, honest and competent management is a very important component of stock selection, but less important than a strong business model based on sustainable competitive advantage. Because it is difficult to know what lurks inside the hearts of men, evidence of management integrity can be indirectly adduced from the following corporate behaviors:
- Moderate executive compensation, with a substantial component that is incentive-based and paid in stock (integrity)
- High returns on capital (competence)
- Return of cash to shareholders in the form dividends or share buybacks (whichever increases intrinsic value more) (integrity and competence)
- Low debt (integrity and competence)
- Very limited or no acquisition activity (integrity and competence)
- Routine, informative, and respectful communications with shareholders (integrity)