Most investment research focuses on the quality of a business' operations, competitive position, returns on equity, earnings growth and so on—and rightly so—but far less attention is paid to the quality of the people running the business. Both factors matter. Indeed, Warren Buffett frequently speaks about the importance of evaluating the people who run the businesses he owns.
Here are just a few examples:
"Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value."
"It's hard to overemphasise the importance of who is CEO of a company."
"Charlie and I look for companies that have ... able and trustworthy management."
"You need two things—a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle."
While management itself cannot constitute an economic moat, at Morningstar we believe management’s capital-allocation decisions can lead to the establishment, enhancement or erosion of an economic moat. Put another way, we want to better understand the intersection of management and moat with each company we research.
Our stewardship methodology emphasises management’s record on items such as financial leverage, investment strategy and valuation, and operational execution, among others. We find these factors not only to be universally applicable for comparing stewardship across global markets, but also to better reveal how well management teams are allocating shareholder capital to enhance or establish an economic moat.
We're also keen to evaluate how well a management team has played the hand it's been dealt. Rather than using hindsight as our primary guide in evaluating a management team’s capital-allocation skills, Morningstar analysts bear in mind that some results have more to do with luck than management’s skill—particularly pertaining to short-run results—and instead put themselves in management’s shoes at the time the decision was made.
In other words, we want answers to questions like these:
- What other options did management have at the time?
- How did the timing of the decision fall in the industry’s cycle?
- What were the prevailing industry multiples at the time the acquisition/divestment was announced?
Because one can take all the right steps in evaluating a stock only to have the market fall or have another unforeseen event lead to poor short-term results, we want to learn more about the company's decision-making process for acquiring another company, starting a joint venture, investing in growth capital expenditures, or repurchasing stock. As Michael Mauboussin puts it in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, "When a measure of luck is involved, a good process will have a good outcome but only over time."
Realising that luck is often fleeting, Morningstar analysts want to determine the thoroughness of management's investment evaluation process and whether recent successes and failures have altered that process. This, we believe, will tell us more about the quality of the firm's general capital-allocation decisions than what short-term results might suggest.
Admittedly, outside of sitting in a room with the CEO and CFO as they evaluate investment opportunities, it can be difficult to evaluate management's capital-allocation decision-making processes. That doesn't mean we shouldn't try, of course.
Here are 10 areas that we look into when evaluating stewardship:
Have most investments and acquisitions been in line with the company’s core competencies, or does management like to make diversifying acquisitions? All else equal, we prefer companies to stick with what they know best and strengthen their core businesses rather than engage in conglomerate building. Good stewards of shareholder capital might also have a record of selling non-core businesses at good to fair prices.
Have investments and acquisitions been moat-widening? In other words, have returns on invested capital or profit margins improved as a result of management's decisions? A strong sign of good stewardship is that management's capital-allocation decisions improved the company's competitive position and consequently increased shareholder value.
Does the company have a record of taking large impairment charges? Poor stewards of shareholder capital frequently need to write down the value of previous acquisitions and probably need to improve their M&A decision-making processes. Exemplary stewards consistently pay good to fair prices for their acquisitions.
Is management's investment focus on building long-term shareholder value, or has it engaged in a growth-for-growth's-sake strategy? Investment decisions that provide both short- and long-term benefits are ideal, but exemplary stewards of shareholder capital should be willing to sacrifice short-term results to create long-term shareholder value. Poor stewards, on the other hand, have a myopic focus on short-term results and have less concern for long-term consequences.
Does the firm have a history of cost overruns or expensive operational missteps? Our methodology doesn't punish companies for a string of bad luck. Instead, we're more interested in how management's actions and decision-making process may have played a role in value-destructive events. Poor stewards of shareholder capital will have a habit of not correcting their mistakes, whereas exemplary stewards consistently avoid repetitive and costly mistakes and quickly fix those that they do make.
Does the firm have the appropriate dividend and buyback policy? The common traits of a good dividend policy are consistency, affordability and transparency. All else equal, firms in cyclical and capital-intensive businesses and those with significant value-enhancing investment opportunities should pay out a smaller percentage of earnings compared with firms in defensive industries or those with fewer reinvestment opportunities. As any successful investor would do, exemplary stewards look to opportunistically repurchase shares when the stock is trading at a material discount to fair value. We don't like to see executives using buybacks simply as a means of increasing earnings per share or offsetting dilution related to employee stock options with little regard for the price paid.
Does the firm have an appropriate amount of debt given the cyclicality and capital intensity of its business? We look unfavourably on firms with leverage ratios that are inappropriate for their lines of business. Firms that operate in highly cyclical, capital-intensive industries shouldn't carry a large debt load, as this will serve to exaggerate the inherent volatility in the business. Similarly, firms in mature industries that carry no debt and have few reinvestment needs may not be maximising shareholder value, as issuing debt could lower the firm's cost of capital.
Does the ownership structure serve as a benefit or detriment to minority shareholders? Dual voting structures with unequal voting rights, large family or insider ownership, and large government ownership positions can have a meaningful impact on executive capital-allocation decisions. The big question to ask is, "Are the major shareholders' interests aligned with those of minority shareholders?" and if they are not, "Has the arrangement led to value-destructive decisions?"
Has the board of directors established an appropriate incentive structure that rewards value creation? Exemplary stewards will establish annual and long-term bonus metrics that align management's financial interests with those of long-term shareholders and are appropriate for the line of business. Poor stewards, on the other hand, may not disclose metrics for evaluating performance, have "moving goalposts" when rewarding management, or base incentives on metrics that reward growth without regard to value creation.
Do you think management is forthcoming about strategic missteps and challenges? Exemplary stewards will be communicative with shareholders in both good and bad periods, while poor stewards will look to sweep bad news under the rug or make it more difficult for shareholders to evaluate capital-allocation decisions by rearranging reporting segments or adjusting accounting assumptions.
Answering these 10 questions should help you understand how well management is allocating capital, whether or not management's interests are aligned with your own, and whether management treats shareholders as partners or simply capital providers. In other words, you'll be able to decide whether or not you want to invest in the company for the long term.
