Getting the most out of management meetings and visits to company headquarters
“I want to know what motivates people. The problem is not that they won’t tell me, because they will. The problem is that none of us know the truth, even about ourselves. The only thing to do is watch someone over a very long period of time and try to piece it together.” – Brent Beshore
“Incentives are the strongest force in the world. They cause otherwise good people to do awful things, and vice versa. They’re the most misunderstood and counter-intuitive force in business.” – Morgan Housel
Often times, as investors who evaluate, not operate businesses, we take for granted how difficult it is for a particular company to execute its strategy in the face of competition, and earn even one dollar of revenue or increase one basis point of margin. Investors get the luxury of internalizing management guidance and making projections, while often overlooking each additional employee needed, man-hour required, and blood sweat and tears needed to be put forth in order to deliver positive results.
I know I’m certainly guilty of this line of thinking, at times having arrogantly projected aggressive growth metrics, been disappointed with missed guidance or results below my expectations, and questioned management’s every move behind the scenes.
Although some businesses and management teams can occasionally make growth look easy, the business world is often linked to such things such as knife-fights, war between competitors, and battles for market share, all indicating that some form of combat is required just to stay competitive in a particular industry or market. While I’m not one for superlatives, competition is real, the business world can be ruthless, and I’ve learned that there is truly no such thing as a free lunch when it comes to earning profits or increasing margins.
To that point, I’m often amazed at what most managers are able to accomplish when it comes to running their companies, public or private, and the skill displayed in operating a business, a great management team’s ability, among many other things, to increase per share business value is nothing short of remarkable when it happens.
I don’t consider myself the entrepreneurial type, nor do I think I could operate a business half as successfully as the worst CEO out there, so I’m happy to watch and evaluate from the sidelines, and try to ride the coattails of great managers operating quality businesses.
In line with the phrase, ‘if you can’t do, teach’…..‘if you can’t operate, invest.’
When evaluating a new business, especially in the small and micro cap spaces, I find it incredibly important to dig into the management team, and do an incredible amount of due diligence surrounding their past experiences, capital allocation history, knowledge of the industry, and current business strategy. In addition, I find it incredibly important to have a thorough grasp on the incentives set up to guide a CEO’s decision making, and reward the management team for executing on what should be the important key drivers of a business.
While I’ve broken down some of my research process in a separate post, I find it necessary to devote an entire section or time frame of company research to management alone. It’s crucial to have a solid understanding about the person or people to whom I’m entrusting my capital before, during, and after making an investment. I try to accomplish this by reading, speaking on the phone, and if possible, making in-person visits to company facilities or headquarters. It should be no secret that up to this point, I’ve found the in-person visits to be the most beneficial.
Meeting with management teams can often be an overlooked area of investing, and many investors share different views about management due diligence. I’ve heard many investors talk about choosing not to visit with management teams or CEOs out of fear that liking the person may create some sort of behavioral bias – notably described as the ‘Halo Effect’ which can be broken down into the following: ‘I like this person, therefore they are also smart and good at allocating capital.’
I’ve definitely felt this strong behavioral and psychological pull to be a bit more lenient in evaluating a manager if he or she is a nice person, and while it can be hard to separate subjective and objective evaluation of a business, meeting with management teams and getting an up close and personal look at the inner workings of a business can be invaluable, so much so that I’ve made it a mandatory part of my research and investment process.
Famed value investor and founder of Third Avenue Management, Marty Whitman, had the following to say about assessing management teams or CEOs. He said that management ought to be appraised looking at least, at three factors:
Management as operators
Management as investors
Management as financiers
I agree wholeheartedly with the above list, and can add one more. Is management incentivized appropriately to do the above three things in a way that will create economic value for the company?
One of the hardest things about active investing is making sure the management incentives of a business are aligned with those of the company’s shareholders. It’s even harder in the small and micro cap spaces, an area I prefer, where corporate governance is often less sophisticated and occasionally mismanaged. Like many things in investing, there is no precise science to quantify the benefits. However, ensuring that the incentives of shareholders and management are aligned through direct ownership or compensation structures is a significant way to limit the investor downside risk. In the past, I’ve favored companies where the CEOs and board members either own a substantial amount of shares, or can create a substantial financial windfall for themselves through successfully increasing the value of the company they manage.
Unfortunately, it’s been my experience so far where I’ve found that after a certain financial threshold of ownership, the psychological motivations of wealth creation start to change, and may not align as much with shareholders. In other words, for some CEOs and operators, after a certain amount of money is made, there may be less worry about more money and more worry about things such as control, notoriety, or legacy. While an argument can be made that having substantial wealth (and reputation) tied to a company creates an additional margin of safety where management is also motivated by good decision making and is unlikely to take on risks that may destroy company value, I have yet to see a perfect solution to this problem. To sum it up, finding a way to align management incentives with those of shareholders is incredibly challenging. This illustrates the importance of thoroughly vetting a management team before, during and after making an investment, and how evaluating both quantitative and qualitative factors plays a large role in ensuring an investor is committing capital to a talented, conservative and smart manager.
When evaluating management incentives, I’ve found it helpful to try and answer some really basic questions, such as “What is management’s motivation to make this event happen?” or “Is this person going to get rich if he/she does what is best for the business?”. I believe this approach can shed some bright light on figuring out the likelihood of certain events. Unlike in large caps, where most of the time, management has usually already accumulated significant wealth and is likely more concerned with ego and reputation than earning an extra few million, I’ve found that most management teams of small-cap companies are still very much in the wealth accumulation stage and are hungry to grow it. When you find the exception to this with a small cap company (a CEO who has made or created his wealth elsewhere) it’s even more important to dig into management’s motivations to succeed.
Brief examples (among many) of an already-financially secure manager can take the form of:
A CEO brought in to operate the business, but spent his career working for a large cap company and has already done well for him/herself (and maybe owns no equity in the current company)
A non-operating chairman who was granted a chunk of options, influence over the management team, but owns no equity
A CEO hired by the board using an outside consultant or head-hunter (a mercenary)
So in line with my research process, before speaking with management, I will have already dug into the company’s annual and quarterly reports, read all of the conference call transcripts, and every interview/article on the internet that I can find involving management. I’ll have done this paying special attention to the company’s proxy statement, management compensation, and how top executives and decision makers are rewarded for performance. Above all else, these incentives will drive 99% of CEO decision making, and serve as a solid foundation from which to judge how aligned management is with the shareholders (along with management owning a large amount of company stock).
This preliminary research process helps provide a solid view into the window of historical company performance, and how compensation policies reward or punish (they rarely punish) for that performance. Some early and initial red flags include:
Egregious compensation for management and the board relative to competitors, the company’s market cap, and earnings
Poor historical performance rewarded by higher compensation
The destruction of shareholder value through the frivolous issuance of stock options
High levels of SBC (for non-software companies especially)
Management never purchasing stock in the open market during periods of volatility or undervaluation
No clear strategic discussion surrounding buybacks/dividends
After the initial due diligence stage, I’ve found there is no replacement for an in-person meeting with the management team and key operators, especially if that visit includes a tour of the company facilities or operations. This up close and personal look to ‘how the sausage is made’ provides an incredible amount of perspective about how easy or difficult (it’s never easy) it is for the business to compete. In addition, piecing together what you’ve read in the filings with what you’re seeing up close can really help drive a better understanding of a business and aid in one’s evaluation of a competitive advantage. Seeing machinery, factories, goods, employees, processes, and many other things has always helped to crystallize everything I’ve read or researched.
During in-person meetings, the most important things I am trying to figure out (aside from honesty) include how management views their capital allocation decisions and policies, both historically and moving forward, and how they view their place in the competitive landscape. Tougher to assess is trying to uncover their primary motivations for doing the job (I’ve found owner operators to be much more enthusiastic about their businesses than hired mercenaries). I can weight these conversations and the responses against my historical analysis of the company and how often management has delivered on guidance, targets, and whether they admit when making/having made mistakes. I always have to ask myself – is what they’re saying, and what they’re doing, lining up?
While each company, industry and management team (and thus meeting) will vary, I make an attempt to approach these meetings with the same framework, utilizing a quantitative and qualitative approach in order to stay open minded and frame my questioning to get the maximum benefit from my time with the management team.
I’ve developed a list of questions that I will review ahead of time, along with my checklist, and based on the particular company, I’ll be able to make some notes and use that framework to guide my chat. I’ll then note the responses, and add them to my analysis, write-up, and thesis to further see how my story lines up with what I’ve learned.
Below is a sample of the types of questions I have asked/will ask CEOs/CFOs during management meetings:
Could you reiterate your core business strategy?
Compare it to what the CEO has said in transcripts/letters/annual reports and make sure the strategy is still the same or closely aligned with what was originally laid out. i.e. if you thought you were investing in a car company and the CEO starts talking about handbags…
Who is making the bulk of your investment decisions if not you? Who is the most important person on your team?
Speak to them if the answer is not him
What sort of criteria or philosophy do you follow in regards to reinvestment in the business? How has that philosophy worked for you so far in terms of decision making?
Let’s go over your investment strategy and capital allocation policies as it pertains to the remainder of 2018, and into 2019. Do you anticipate any changes from your original guidance? Have you run into any unpleasant surprises so far?
During periods of business challenges, what has typically been the catalyst? Is that things still keeping you up at night?
AKA what makes your good years good?
How much of your own personal net worth is invested in company stock? Do you anticipate buying more? Why?
This is an absolutely crucial question, but I have yet to figure out a suitable way to ask
If you raised prices 10% tomorrow, what happens?
What are your options for organic reinvestment, are they getting better or worse, how much longer will this window exist, why is that the best use of overall capital
Which one of your competitors are you most scared of?
What happens to your company if the top five most important people leave tomorrow?
What happens if you get by product or service failure, will you be able to survive for another two-three years?
What keeps you up at night?
What are your most aggressive accounting disclosures compared to the standard in your industry?
Why do you report quarterly earnings?
What few processes or couple of processes need to be fixed in your company or back office? What is your plan for fixing them?
If you were told you’d be stranded on a desert island for 20 years and could only invest in one of your competitors while you were gone, which one would it be and why?
Why are you doing this? (building/operating this business)
What is your biggest concern about your business which would cause it lose 50% of it’s value?
What are you excited about that other investors don’t understand?
How do you make decisions?
How do you set goals?
What would cause you to change your mind regarding your current strategy? What is something your company values highly that your competitors don’t?
What would you do differently if your salary were replaced with company stock that you weren’t able to sell for the rest of your life?
I don’t always get to all of these questions, and as mentioned above, haven’t found appropriate ways to ask some of them, but my lists provides a good starting point for over the phone or in-person due diligence.