We like to fully understand the history of a particular management team. Can management be trusted? This is a simple question that we always ask ourselves. Where have they worked before? What is the history of their capital allocation decisions? Is there a history of value destructive merger and acquisition (M&A) activity?
It is also important that we understand the incentive structure for management. What are the key metrics they have to focus on to get paid? Do they own lots of equity in the company? Do they care if the share price goes up or down? This area of analysis highlights one of the reasons why we see meeting management teams on a regular basis as a crucial part of our job. It enables us to look them in the eye, question them over capital allocation policy and get a feel for their temperament and motivation.
Fundamental challenges for managers
“Two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders” – William N. Thorndike
In his book The Outsiders, William Thorndike teaches us through eight examples how the capital allocation of a company’s managers can make a significant difference to shareholders over time. As Thorndike explains, a company’s management team have five fundamental choices when it comes to allocating capital. They can reinvest in the business, acquire other companies, pay down debt, issue dividends and repurchase their own shares.
Equally important to the choices made are the way they are financed. Issuing debt, raising equity capital or using cash generated by the business – each option will have a different impact on the shareholder. Capital allocation is not a trivial issue and must be given the attention it deserves as part of a sound investment process.
Through reading historic financial statements we try to assess whether capital deployment has been value accretive or destructive. Not surprisingly, what we have found out as we conduct our research is that alignment of interests goes a long way into predicting whether management’s actions will be value creative or destructive.
“What matters isn’t what a person has or doesn’t have; it is what he or she is afraid of losing” — Nassim N. Taleb
‘Skin in the game’ is a concept recently popularised by Nassim Taleb, an author we closely follow, in his book Skin in the Game: Hidden Asymmetries in Daily Life. However, it is not a new concept in the world of investment. Warren Buffett has advocated for years that managers should be shareholders of the companies they represent, investing their money alongside other shareholders. In this way, they will have a clear incentive not to make decisions that destroy value.
For this reason, when looking for companies with appropriate capital allocation, we often find companies in which the management team has a significant stake, in many cases the founding family. This is not possible for the entire set of opportunities we consider, hence why we often focus on management incentives.
"Show me the incentive and I’ll show you the outcome" – Charlie Munger
The business world is no stranger to the power of objectives or incentives. A management team with an incentive system based around generating value for its shareholders will tend to allocate capital sensibly. A good remuneration system should have long-term incentives aimed at maximising shareholder returns.
This can be achieved by establishing direct incentives, such as variable remuneration based on movement of the company’s stock price – either in absolute terms or by comparison to its peers. However, we prefer indirect incentives focused on long-term ROIC, profitability, cash generation, etc. In the end, if the business performs well operationally, the share price will end up reflecting this. Indirect incentives should also stop managers from focusing excessively on the evolution of the share price in the short term.