Some of the best sources of information are trade journals and local newspapers where a business is headquartered. Subjects often reveal more information to industry journalists than they will to a national publication such as the Wall Street Journal. Local journalists also have experience in covering the company and may ask questions that reveal deeper insights. The articles also tend to be longer because the local company is important to the community where it is based.
As you read articles, look for evidence in four basic areas: passion, honesty, transparency, and competence. Look for the ability of a manager to recognize and learn from mistakes and also try to see how quickly they are able to recover from mistakes. Look for articles that talk about how a manager helps employees become engaged in the business or keeps customers happy. If there are not many articles written, you either have to rely more on other sources or simply admit that you do not have enough information to assess a manager.
The questions in Chapters 7, 8, and 9 will help guide you in collecting the evidence you need to determine whether a management team is competent and proven.
The first set of questions, in Chapter 7, helps you learn about the background of the managers and how to classify them.
The questions in Chapter 8 help you understand how the CEO and other managers manage their business, which will help you determine if they are competent.
The questions in Chapter 9 help you understand the personality and character of the manager.
Let’s begin by exploring the background of the management team and how they are compensated.
33. What type of manager is leading the company?
It is important to classify the type of manager you are partnering with at a business. This way, you will be in a better position to gauge potential execution risk. If you are investing in a manager who has a long track record (i.e., more than 10 years) of successfully managing a business, the odds that he or she will continue to manage the business successfully are in your favor. On the other hand, if you are investing in a new management team that has limited experience serving the customer base of the business, the odds are not in your favor. Here is a simple classification system you can use:
This is a continuum, from left to right; here’s a quick overview of what each means, followed by a more detailed description:
OO is an owner-operator, typically the founder of a business.
LT is a long-tenured manager or one who has worked in the industry for at least 3 to 10 years.
HH is a hired hand, a manager who has limited experience serving the customer base of the business and has worked at the business for less than three years.
For example, on the far left side are owner-operators such as the late Sam Walton, founder of Wal-Mart. On the far right-hand side are hired hands who did not have any prior experience at the business before joining as CEO, such as Robert Nardelli, who joined Home Depot in December 2000 from General Electric. Most managers of publicly traded businesses fall into the long-tenured or hired-hand category, and these are the most difficult managers to evaluate. Let’s take a closer look at each type, which is further broken down into sub-categories shown below.
Owner-Operator 1 (OO1)
These are the ideal managers to partner with in a business. An owner-operator is a manager who has genuine passion for their particular business and is typically the founder of that business, for example:
Sam Walton, founder of Wal-Mart
Dave and Sherry Gold, co-founders of 99 Cent Only Stores
Joe Mansueto, founder of Morningstar
John Mackey, co-founder of Whole Foods Market
Warren Buffett, CEO of Berkshire Hathaway
Founders of most family-controlled businesses
These passionate leaders run the business for key stakeholders such as customers, employees, and shareholders alike, instead of emphasizing one constituency over the other. They typically are paid modestly and have high ownership interests in the business. For example, according to the Berkshire Hathaway 2010 proxy statement, Warren Buffett earns $100,000 in salary and directly owns 37.1 percent of the stock. These managers take a long-term perspective when making business decisions and identify their personal success with the survival and growth of their businesses. Much like a parent who will do anything to save a critically ill child, these CEOs will go to great lengths to ensure the survival of their businesses.
Owner-Operator 2 (OO2)
This is an owner-operator who is passionate about running the business but is in between the two extremes of being completely stakeholder oriented and operating the business for his or her own personal benefit. These managers typically receive higher compensation packages than OO1 managers. For example, Leslie Wexner, founder of the Limited Brands (owner of Victoria’s Secret), earned more than $10 million in total cash compensation in 2009, and he owns 17.7 percent of the business.
Owner-Operator 3 (OO3)
OO3 managers are owner-operators who are passionate about the business but primarily run the business for their own benefit. They do not take shareholder interests into consideration and will often siphon off profits to themselves through egregiously large compensation packages. You can usually identify these types of managers by viewing the Related-Party-Transaction section found in the company’s proxy statement, where you might find such items as personal use of company aircraft, estate planning, personal or home security, and real estate that is owned by the CEO and then leased to the business.
For example, in one business, the company’s founder received a loan from the business that bore an interest rate of 1 percent over prime to buy a personal aircraft. Another CEO was reimbursed more than $2.6 million a year for security expenses. Both CEOs of these firms could easily afford to pay for these luxuries out of their own pockets, but they used the company to pay for them. You should be careful investing in companies with these types of CEOs because they typically fail to create a lot of value for shareholders over long periods.
Long-Tenured 1 (LT1)
LT1 managers are those who have a long tenure at the existing business. These are managers who have been promoted from within the business and who have worked there for at least three years. The biggest risk with these types of managers is that sometimes they are the wrong manager for the position. Perhaps they were a great chief financial officer (CFO) or chief operating officer (COO), but once promoted to CEO, they fail to execute.
For example, when Kevin Rollins took the management reigns from company founder Michael Dell and became CEO of Dell computers in 2004, most investors believed that this would be a smooth transition, because Rollins had been Dell’s COO since 2001. Yet Michael Dell took back the CEO role in 2007 after Rollins mismanaged the business and inflated Dell’s cost structure. In April of 2008, Michael Dell spoke to analysts in Texas and explained how the company was going to regroup. He outlined the challenges he saw1:
Declining market share. They had missed being in the fastest growing parts of the industry.
The wrong cost structure, both in COGS (cost of goods sold) and OpEx (operating expenses).
Eroded profitability. The result of the combination of the wrong cost structure, inefficiencies in the system, and missed execution.
Too many priorities. The list of things to do was too long and the company needed focus.
Incomplete product coverage. They were “trying to do too much with too limited a product line.”
How could this have happened? Rollins had made enormous contributions at Dell, including implementing the negative working capital business model that Dell is so well known for today. Simply put, Rollins made a great lieutenant to Michael Dell, but he was not equipped to be CEO of Dell. He was the wrong manager for the position.
Long-Tenured 2 (LT2)
LT2 stands for a long-tenured manager who joined from outside the business but who has worked in the same industry. The manager may have been recruited from a competitor or a business that serves a similar customer set.
Hired Hand 1 (HH1)
An HH1 is a manager who joined the business from a related industry. Hired hands tend to jump from job to job. These managers typically make short-term decisions because they are not accountable over the long term. Most of these managers are cost cutters rather than revenue builders.
Hired Hand 2 (HH2)
An HH2 is a manager who joined the business from a completely unrelated industry and typically has no experience with the customer base. HH2s have steep learning curves in the new business. Think of CEOs such as Robert Nardelli, who was CEO of Home Depot from December 2000 to January 2007: Prior to joining Home Depot, Nardelli worked at General Electric, an industrial conglomerate.
The Importance of Managers’ Tenure in Operating the Business
As you move down the continuum from OO to HH, the less information you will have on how a manager will choose to operate the business. For example, if you invest in an HH with a limited track record operating the business, this increases your potential downside risk because when a new management team enters a business, the company’s past results provide less insight into its future prospects. You will take less risk partnering with managers who have a proven track record of running a business because you can give more weight to the historical track record. These established management teams understand the intricacies of running the business day to day and most important of all, they understand the customer base. Outsiders typically do not have this depth of knowledge.
It is difficult to find CEOs who have operated their businesses for a long period. For example, consider these two statistics according to an analysis conducted by recruiting company Spencer Stuart for the Wall Street Journal:
Out of the 500 businesses in the S&P 500, only 28 have CEOs who have held office for more than 15 years.
The typical CEO has held the title for only 6.6 years.
As confirmation that tenure improves stockholder returns, consider this: Of the 28 long-term CEOs above, 25 of them had total shareholders returns during their tenures that beat the S&P 500 index (with total shareholder return calculated as stock price change plus reinvested dividends).2
34. What are the effects on the business of bringing in outside management?
Many investors will bid up the stock price of a business when an outside manager or CEO enters the business. These investors believe that management skills are transferable and react positively when a new management team enters a business, especially one that has been mismanaged. These investors think outside managers can instill changes and improve underperforming companies, because the outside managers are objective and not married to the culture. If this person was a great manager at The Coca-Cola Company, the thinking goes, then he or she will be great at operating any other business. This is similar to saying that a great value investor would make a great trader because both are in the investment business. Obviously, these two styles of investment require different types of expertise and experience to execute properly.
Investors also often make the mistake of underestimating the importance of the support networks these managers had at their prior company that helped make them successful in the first place. When these managers then enter a new business, they often run into problems because they don’t have that support network, and many fail to perform.
In addition, most of these managers are great cost cutters but fail when it comes to growing the business. There are very few cases where a manager is good at both cutting costs and building the business such as Steve Jobs, founder of Apple. When he returned to Apple in 1997, Apple was on the brink of bankruptcy. Jobs was able to cut costs to keep Apple out of bankruptcy and then rebuilt its entire product line and organization.
When you learn that an outsider has joined to lead the business, respond with extreme caution. RHR International, a Chicago-headquartered management consultant, states that 40 percent to 60 percent of high-level corporate executives brought in from outside the company will leave within two years. Many have problems and leave in just a few months.3
A manager with a lot of organization-specific knowledge is critical to generating long-term growth at a business, whereas an outsider needs a significant amount of time to learn the business. Jeffrey Immelt, CEO of General Electric, said, “You see that the most successful parts of GE are places where leaders have stayed in place a long time. Think of Brian Rowe’s long tenure in aircraft engines. Four or five big decisions he made—relying on his deep knowledge of that business—won us maybe as many as 50 years of industry leadership. . . the places where we’ve churned people, like reinsurance, are where you will find we’ve failed.”4
In addition, relative to managers who have been at the business for long periods of time, outside managers have a more limited understanding of a business’s resources and constraints. The risk you take as an investor is that instead of building on an existing business’s capabilities, they deviate from them. Therefore, a new management team creates unpredictability.
There are some industries where specialized knowledge of the business is especially critical: for example, pharmaceuticals, chemicals, and insurance. It is difficult for an outsider to successfully manage these types of businesses, and you should probably avoid investing in them if an outsider does become CEO.
For example, it is critical for the CEO of an insurance firm to have spent a lot of time in the insurance industry because there is a long learning curve in this industry. An insurance firm is insuring against risks that may occur in the future, and managers who have been in the industry for a long time have lived with the fallout of their mistakes. This helps them understand how to properly underwrite insurance. Without this experience, managers are likely to make many more mistakes, which you, as a shareholder, will pay for.
There are a few cases where outside managers tend to be good hires: For example, when a business needs to break from past strategies or needs to cut costs quickly. If the industry changes very quickly, this will also improve the odds that an outside manager will succeed, but if the industry is stable, then industry knowledge is more important. Most of these new managers tend to do well early on in their tenure as they cut costs, but later they start to do badly when it comes time to build the business. In other words, they are good at doing the rapid cost-cutting and divestment, but when it comes to building and sustaining long-term growth, they fail.
For example, Al “Chainsaw” Dunlap created a lot of value for his investors by quickly turning around and selling such companies as American Can, Lily-Tulip, Crown-Zellerbach, Diamond International, Consolidated Press Holdings, and Scott Paper. Dunlap’s strategy was slash-for-cash, where he would take a floundering business and make it profitable within a year. He did this at Scott Paper, which had just lost $227 million in 1993: During his 20 months at Scott, Dunlap increased the company’s market value by 155 percent, from $2.9 billion to $7.4 billion. He accomplished this turnaround by firing 11,200 employees (which consisted of 70 percent of its head-office staff, 50 percent of its management, and 20 percent of its blue-collar workers) and by cutting the research and development (R&D) budget in half, suspending corporate philanthropy, and deferring plant maintenance. He succeeded with this strategy for a few years and was lauded as a legendary turnaround artist and a role model for many managers.
So when he became CEO of appliance maker Sunbeam in 1996, the stock price promptly rose 60 percent, as investors anticipated that Dunlap would quickly turn around the fortunes of the bus
iness. At that time, this was the greatest jump due to a CEO change that had ever occurred in the history of the NYSE. Unfortunately, the techniques he used to turn around other businesses in the past—such as slashing expenses—worked against him at Sunbeam, and the company declared bankruptcy in 2001, two years after Dunlap was dismissed as CEO. In fact, after all the dust settled, Dunlap had to accept a lifetime ban from serving as an officer or director of any public company because the SEC alleged that Dunlap engineered a massive accounting fraud.5
When an outside manager enters the business, closely monitor his or her actions. The best types of outside managers are those who don’t make changes quickly and make an effort to understand the business and its customer base as well as solicit the opinions of employees before they implement major changes. This way, they gain the support of the employees whom they will need to execute their plans; just as important, they avoid the problem of under- or over-estimating the capabilities of the employees. If instead, the manager joins the business and starts to make changes immediately, without getting buy-in from the employees or understanding their limitations, it is likely he or she will fail, and you should avoid investing in this company.
35. Is the manager a lion or a hyena?
Another simple way to categorize management is to classify management teams as either lions or hyenas. This idea was created by Seng Hock Tan, CEO of Aegis Group of Companies, a Singapore-based investment management organization, who came up with this classification while watching a Discovery channel program about lions and hyenas. As he learned about how lions and hyenas interact in the wild, he felt that their behavior was very similar to that displayed by managers.6
The Investment Checklist Page 22