Three Clues for Assessing Management

Assessing management is the most difficult analytical task and requires the greatest amount of humility.

From an early age, successful survivors are artful in hiding both emotions and thought patterns. If it is difficult to scope out one talented person in relation to other people (some of whom are just as bright), it is more difficult by an order of magnitude to do the same for an entire management team.

So Concentrate on the Numbers

I will first focus on the easiest of three clues: the numbers.

As other sports followers know, one thing you learn from “handicapping,” or analyzing at the racetrack, is to be suspicious of long streaks. We know that very good performers have off days. Understanding the reasons for falling off a sustained trend line would help. But those are not always discernible.

Nevertheless, I am comfortable throwing a rare mishap out in my guess as to the future. Unless something major has changed, I tend to accept an 80% compliance with a trend to be useful as an element to future predictions. Also, one of the lessons people should have learned from the Bernie Madoff scandal is that perfection is suspicious.

While reading my comments about financial statement analysis, please bear in mind that I don’t expect every stock in a sustainable growth stock portfolio to completely mirror these filters, but the weighted average of the holdings should. I am not going to comment on every line item in the Income Statement and Balance Sheet. However, each item may color a prudent investor’s decision process much more than the press release of XX% gain in EPS. This is particularly the case if the GAAP accounting earnings are considerably different than the more popular non-GAAP numbers.

Operating Revenues

In the business world, without a consummated sale there is little belief. After I understand how revenue is recorded, I like to see periodic growth that is faster than that experienced in the sector. A fad sale is often like speed dating. While not normally reported, repeat sales demonstrate that in the eyes of the customer, the sale addresses a customer’s problem.

Repeated revenues from the same customer show dependency, which is the goal of the drive for sustainable relations. In addition, growth in market share shows competitive strength, except for the price leader, which may be buying the business by educating the customer to place price over value.

Often it is extremely valuable to be recognized as the low-cost producer. Though it is a critical defensive weapon, it is analogous to eating one’s young. On the other hand, being acknowledged as the low-cost producer can exert some price discipline on a competitor. Good analysts will markdown sales growth if returns and warranty costs are rising.

Gross Margins

The direct cost to growth product companies to produce sales is often about half the revenues received over a market cycle, producing a gross margin in the 40%–60% range. Service companies, where their principal expenses are people costs, can have lower gross margins as they have materially lower plant and equipment depreciation.

Many financial services companies use substantial amounts of borrowed capital (unless it is customers’ float), and have interest costs that bring margins below those of product producers. Analysts become concerned when gross margins contract because it may signal some loss of competitive standing with peers or from substitute products from outside the industry.

Operating Margins

After the cost to produce a current product or service there are other costs which include selling, general, and administration (SG&A). In addition to research and development for new products, there are periodic charges that need to be absorbed as well as depreciation and other costs. Often interest expenses are included.

I prefer to see a net interest item that subtracts from interest earned the interest paid/accrued. If net interest is a significant item, analysts may question whether the company has an adequate capital structure and how it will get one. Overall operating margins can be approximately 20 percentage points below gross margins.

Income Tax Rates

Analysts want to know what income taxes have been paid or accrued. Most importantly, the want to know the source of the differences and the implications for the future. Wise tax management is applauded if it does not constrain the company’s future actions.

Impact of Foreign Sales and Earnings Translation

A long-term investor normally does not want to value currency translation gains and losses highly. However, hedging does tell investors management’s attitude toward short-term results. There are several ways to hedge. The more popular short-term approach is by entering the foreign exchange market through derivatives or local currencies.

A longer-term approach is to balance sales and earnings from various foreign countries with the home or functional currency. One also needs to understand which currencies the bulk of the foreign operation’s expenses are incurred. Further, it is important to understand in which currency profits are measured, including when, where, and at what level taxes are paid.

Reporting on Industrial Conditions

Good analysts will have other sources of information as to the growth in various markets as well as significant price trends. The reporting company should be a source of these critical elements in an unbiased way. The absence of these may show a lack of serious interest in their shareholders’ welfare.

Brief Balance Sheet Concerns

Often a firm will provide three levels of inventory: finished products, work in process, and raw materials. If inventory levels are rising faster than sales, particularly in the finished products and, to a somewhat lesser extent, work in process, it can be a tip off that the company may have to lower its selling prices or improve its terms to bring inventory levels back below the sales rate. If the build up is in the raw materials line item, the company may be speculating as to future rising prices or trying to create a shortage as a competitive device. In any case, changes in inventory levels need to be understood.

Physical fixed assets of plant and equipment are recorded at historical cost, unless written down minus accumulated depreciation. Depending on the industry, the ratio of the remaining un-depreciated assets as a percent of the original cost of the assets compared with peers can be a useful clue as to which competitor has the newest facilities and, possibly, which has the lowest cost of production relative to its sales level.

Intellectual property can be of great value to a company’s barriers to entry or moat. The size of the moat and how well it is defended can be critical in the ability of the company to resist attacks by competitors. To my mind this is of secondary importance compared with the client’s dependency on the company’s products and services and the client’s attitude toward that dependence.

Accrued but unpaid taxes, while they create valuable float, need to be understood and appropriately recorded like all liabilities. One also needs to ensure the full extent of the retirement liability is recorded. (In terms of educational institutions, rarely is there an estimate of the long-term cost of tenure.) One of the jobs of a thorough analyst is to determine the off-balance-sheet contingency reserves. If a company states it doesn’t have one, that can be a problem.

The Second Clue: Process

For a company to have a sustainable growth pattern, it needs a well understood and written process for most of its critical functions.

A thorough research report should be able to summarize the process as well as reports to regulators and shareholders. A series of well-defined processes can aid a company if critical management disappears or can serve as an aid in regulatory inspections.

Far too many institutional shareholders do not fully understand the critical processes that the companies in their portfolios employ. This means that when there is a market disruption, investors will be flying blind until they can get a reasonably full and responsive communication from the company. Often this will lead to the sale of the position due to unfounded but believable rumors.

The Toughest Clue: Management

While past history is never fully complete and never exactly mirrors current conditions, it is a somewhat helpful guide. Still, it doesn’t guarantee anything. In Jason Zweig’s new book The Devil’s Financial Dictionary, he quotes Warren Buffett, “when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Nevertheless, we often have to make a decision as to whether the existing management can carry the company to the rosy future we would like to believe in. The attributes that we look for are:

1. Unquestioned integrity not only in a legal sense, but also in an intellectual sense. We need to recognize that some people lie to themselves and overstate their views of the future.
2. Innovation of both product and process, which are critical to long-term success.
3. How key executives, as well as those at the lower level, treat each other is a good clue as to how they will treat absentee owners of both debt and equity.
4. Good controls of people, finances, and processes will provide the everyday discipline that is critical to the success of the enterprise.

I look forward to discussing these thoughts with you.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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