In addition to researching the backgrounds of senior managers, so that you’ll know more about their careers, how they were promoted, what functional experience they have (or don’t have!), and the corporate culture of the companies they worked at previously—all of which Chapter 7 focused on—it’s also helpful to assess how managers actually operate the business, which is the focus of this chapter. Here, we’ll look at management styles; strategic planning and day-to-day operations; organizational structures (i.e., centralized versus decentralized); how managers treat their employees and whether they know how to hire well; whether management knows how to intelligently manage its expenses; and whether management is disciplined or undisciplined in making capital allocation decisions.
By looking at how managers actually operate, you will be better able to assess how competent they are. Competency matters for many reasons, but one of the most compelling is that truly competent managers are able to quickly adapt to changing environments. For example, during the stock market downturn in 2008, when the S&P 500 dropped 37 percent, my firm strictly maintained its commitment to investing in proven and competent management teams. With so much uncertainty in the economy, there was very little visibility into the future earnings power of many companies. Therefore, we partnered with management teams that had the ability to adapt their businesses to the changing economic environment. And we avoided investing in management teams that had a limited track record running their business.
For example, we did not invest in an online retailer of diamonds and fine jewelry, because the founder had recently passed the chief executive officer (CEO) title to the chief financial officer (CFO) (February 2008). Even though the CFO had been at the business since 1999, we could not judge her competence in running the business in her new role.
In contrast, we had strong conviction in regard to the competence and abilities of the management team at Whole Foods Market, because that team had operated successfully together since 2001. Faced with declining same-store sales, which the management team had never encountered before, management strengthened the balance sheet and increased free-cash flow.
Another less direct but substantial benefit of partnering with proven and competent management teams is that it frees your time to focus on other investment opportunities. If you partner with incompetent management teams, you have to spend a lot of time monitoring their actions.
I once invested in a business because the stock was cheap, but I knew the management team was somewhat incompetent. I continued to hold the stock because I believed it was substantially undervalued. Each time the business issued a press release, my stomach churned, as I anticipated bad news. The CEO never let me down and continually reported bad results. This investment failed to create any value for my fund.
In contrast, when I have partnered with competent managers such as Bruce Flatt, CEO of asset-management-holding company Brookfield Asset Management, I do not have to scrutinize each management decision in detail. I know that if the top managers make a mistake, they will quickly recognize the mistake and correct it. By investing in proven and competent management teams, you will rarely be disappointed. This will help you maintain an opportunistic attitude.
Now let’s take a look at questions that will help you determine if the management team is competent.
39. Does the CEO manage the business to benefit all stakeholders?
If you were to ask investors whether shareholder value is more important than customer service at a business, most would answer that it is. What they fail to consider is that shareholder value is a byproduct of a business that keeps its customers happy. In fact, many of the best-performing stocks over the long term are the ones that balance the interests of all stakeholder groups, including customers, employees, suppliers, and other business partners. These businesses are managed by CEOs who have a purpose greater than solely generating profits for their shareholders.
In the book Firms of Endearment, David Wolfe, Rajendra Sisodia, and Jagdish Sheth studied 30 companies that view success as more than just maximizing shareholder returns. These companies instead try to maximize value for all stakeholders. Interestingly, these companies outperformed the S&P 500 over the 10 years that the authors tracked them. The companies returned an astonishing 1,026 percent for 10 years ending in 2006—the S&P 500 returned only 122 percent.
It is surprising how few CEOs manage the business for the benefit of all stakeholders. The reason is that it is harder to do. It is easier to focus on one constituency, such as stockholders, rather than many.
John Mackey, co-founder and CEO of Whole Foods Market, has coined the term conscious capitalism to describe businesses designed to benefit all of their stakeholders, such as customers, employees, investors, and suppliers. Instead of subscribing to the theory that the only purpose of a business is to maximize profits, conscious capitalism proponents believe that increases in shareholder value are the by-product of helping customers, employees, and vendors reach their highest potential.
Mackey compares profits to happiness to illustrate his point. Just trying to be happy doesn’t usually work. Instead, we’re happy due to a host of other reasons: a strong sense of purpose, meaningful work, good friends and good health, loving relationships, and the chance to learn, grow, and help others. Like happiness, profits are also the result of other things, and aren’t achieved by making them the primary goal of the business. “Long-term profits,” says Mackey, “come from having a deeper purpose, great products, satisfied customers, happy employees, great suppliers, and from taking a degree of responsibility for the community and environment we live in. The paradox of profits is that, like happiness, they are best achieved by not aiming directly for them.”1
Some examples of businesses that manage the business for customers and other stakeholders instead of maximizing profits are below:
At Costco, CEO Jim Sinegal says that by treating employees fairly and making sure that customers receive a good value, shareholders will benefit over the long haul.
Robert Wilmers, CEO of M&T bank, lived a business philosophy that could be a primer for sound banking: “Know your markets and employees, watch credit quality relentlessly, don’t gamble with interest rates, and focus on serving your community.”2 You will note that none of the goals were to increase shareholder value. Even Warren Buffett, CEO of Berkshire Hathaway, held a long-term stake in M&T.3 Under Wilmers’ tenure, the stock appreciated from less than $3 per share when he joined the bank in 1983 to $87 per share on December 31, 2010,4 making it one of the best-performing bank stocks in the last two decades. Wilmers did not focus on the profits of the bank, but instead focused on those things that generated the profits.
David Packard, co-founder of Hewlett Packard, was also known for taking a broader view of stakeholders. One story describes the 37-year old Packard in 1949 listening to a group of business leaders who were apparently focused solely on profits. Uncomfortable with their views, Packard told them plainly, “A company has a greater responsibility than making money for its stockholders!” Of course, Hewlett-Packard went on to become the premier technology company under Packard and Bill Hewlett.5
Similarly when Robert Silberman took over as CEO of Strayer Education in 2001, he said he was not going to focus on any of the metrics that generally drive public company valuations, such as revenue growth, operating income growth, and margin expansion. In an interview, I asked him why he focused on academic outcomes instead of profits, and he said, “It evolved from looking at the asset of the enterprise. It was pretty clear to me that the only thing that was going to drive real sustainable long-term value to my owners was the intangible value of Strayer University. So then I sat back and said, how do you increase the intangible value of Strayer University? And the answer to that is, you increase the level of learning outcomes.”6
40. Does the management team improve its operations day-to-day or does it use a strategic plan to conduct its business?
Most investors seek out superstar CEOs who can s
eemingly change the business overnight with a well-planned strategy. In essence, the investor believes that business transformation is the result of brilliant ideas and clever plans. One reason investors think great performance results from brilliant strategy is that it is often reported to seem that way in the popular business media. These stories are popular for a couple of reasons: First, they are easy to write; second, people enjoy stories about flash and charisma far more than stories about CEOs who grow their business through continuous improvement. These articles often contribute to increases in the stock price as investors buy into the hopes and dreams of the charismatic CEO. Investors tend to have short memories, and they forget that many of these businesses eventually derail in dramatic fashion later on.
Beware of the CEO who believes that one strategy or a single stroke will transform their business. These CEOs typically make big announcements, such as they will take their business from the number-three position to number one in five years, by revolutionizing the way they conduct business, by making a transformational acquisition, or by leaping into a hot new market. These ambitious plans hinge on making rapid, sizable market-share gains.
For example, Nortel’s strengths had traditionally been in voice transmission when CEO John Roth decided that he would transform the company into a much bigger data networking company. He did this by quickly acquiring 19 new businesses from 1997 to early 2001. Nortel’s stock price rose, reaching a market cap of $277 billion in July of 2000. By the end of 2001, the stock price had fallen 90 percent from its peak the previous year. Most of the 19 acquisitions were eventually sold for less than Nortel originally paid or were written off entirely.7
A strategic plan is a detailed roadmap to success, such as a five-year plan that sets specific targets that must be met. As a result, a strategic plan can also be an inflexible plan that outlines how a business will operate for the next 2, 5, or 10 years. If a project or product does not meet the goals of the plan, then it is dismissed. Therefore, seizing opportunities becomes less of a priority for the business.
Contrary to popular belief, most successful businesses are built on hundreds of small decisions, instead of on one well-formulated strategic plan. For example, when most successful entrepreneurs start their business, they do not have a business plan stating what their business will look like in 2, 5, or 10 years. They instead build their business day by day, focusing on customer needs and letting these customer needs shape the direction of their business. It is this stream of everyday decisions over time that accounts for great outcomes, instead of big one-time decisions. These businesses don’t attempt new initiatives until existing ones are thoroughly absorbed by the employees of the company. For example, Apple’s approach is to put every resource behind just a few products and make them exceedingly well. Can you even imagine Apple making a cheap, poorly made product?
Another common theme among businesses that improve day by day is that they operate on the premise that it is best to repeatedly launch a product or service with a limited number of its customers so that it can use customer reactions and feedback to modify it. They operate on the premise that it is okay to learn from mistakes and that it is critical to obtain customer feedback to shape their strategies.
For example, Coach conducts more than 10,000 customer interviews every year before it launches new luxury handbag and accessory products. Based on the information it collects, Coach will alter the design of the product or drop items that test poorly. As a result, Coach has a direct line to the pulse of its customers and is able to avoid numerous market misfires. Coach believes that the millions of dollars it spends on customer interviews represent a low-cost form of insurance against getting blindsided by customers’ shifting priorities. Instead of setting up a strategic plan, Coach lets customer input shape its strategies.8
You need to determine if the management team you are investing in works on proving a concept before investing a lot of capital in it or whether it prefers to put a lot of money in all at once hoping for a big payoff. Proving a concept does not need to be expensive. For example, Reed Hastings, founder of movie-rental-by-mail business Netflix, mailed himself a CD in an envelope when he was developing the business. When the envelope arrived undamaged, he had spent only the cost of postage to test one of the business’s key operational risks.9
Similarly, Tom Perkins, founder of Kleiner Perkins, an early investor in companies such as biotechnology business Genentech, counsels, “First, eliminate the risk. Then, grow the business.” Perkins would not make any significant financial commitments to a new venture until certain risks were reduced. This model is commonly used in the Venture Capital (VC) industry where startups are given capital in multiple rounds. After a start-up reaches certain milestones, then the VC investors will invest more money. For example, Genentech outsourced a lot of its work to labs instead of investing in its own lab as it developed its products. As Genentech became more successful and proved its product it then invested in its own lab.10
In contrast, businesses that rely on strategic plans often spend millions of dollars on research data compiled by consultants (instead of customers) over a long period of time before they launch a product or service.
For example, when Motorola launched its Iridium phone, only 50,000 people subscribed to its services instead of the millions of subscribers that Motorola had anticipated. It was one of the largest fiascos in business history, and Iridium declared bankruptcy in 2000. Motorola had devised a long-term strategic plan to develop a service where customers could make cellular phone calls from anywhere on earth. This technology took more than 10 years to develop and Motorola invested more than $5 billion in the project to launch 66 low-flying satellites.
Unfortunately, when the company was ready to launch the service, the phone needed to receive the satellite signal was the size of a brick and users had to be outdoors to get reception. Both of these were major stumbling blocks that Motorola had not fully considered when it was developing the service.11 Motorola had focused so much on achieving its strategic goal that it neglected the basics of getting good customer feedback early on.
Here are a few examples of businesses operated by CEOs who do not follow well-formulated strategic plans but instead improve the business day by day.
Henry Singleton, CEO of Teledyne Inc. from the 1960s through the 1980s, believed the best plan was no plan. Under his tenure, Teledyne’s stock compounded at more than 20 percent for more than 20 years. He believed it was better to approach an uncertain world with an open mind. Singleton once remarked at a Teledyne annual meeting, “. . . we’re subject to a tremendous number of outside influences, and the vast majority of them cannot be predicted. So my idea is to stay flexible. I like to steer the boat each day rather than plan ahead way into the future.”12
Dave and Sherry Gold, co-founders of 99 Cent Only Stores, started the business in 1982 and grew it to more than $1 billion in sales in 2005. Dave Gold said, “The people who are making long-term projections usually do not have accountability, and people often forget what they said years before. If you have a strategy for growth for the next 5 or 10 years, it gets changed so much in that time period. I don’t think you can plan out more than 2 years from now. I don’t think that far ahead. If you do, you just get into dreaming.”13
Thomas Stemberg, founder of office retail chain Staples, said, “I don’t get hung up on business plans. I read them, of course. But whatever the plan says, the company will end up looking different. When we started Staples in 1986, for example, our business plan proclaimed we would never deliver. Delivery added costs; we figured we couldn’t afford it.” Today, a large portion of Staple’s profits are derived from its delivery operations.14
Bob Graham, co-founder of AIM Management Group Inc., one of the nation’s largest mutual fund companies said, “When we started AIM Management Group Inc., we never had a plan. We followed opportunities as they came along. Our plan changed along the way, depending on what opportunities presented themselves. We had no idea tha
t we would be in the money market funds business or in the equity funds business, nor did we have an idea of how big they would get.”15
Why Do Strategic Plans Fail?
When CEOs set a strategic plan, they risk becoming committed to it and may fail to consider other alternatives. In the book Influence, author Robert Cialdini writes about “the commitment and consistency principle.” After making a commitment or taking a stand, people are more willing to agree to requests that are consistent with their prior commitment. In other words, once you make a public statement, it makes it difficult for you to change your mind. Setting strategic plans has the same effect: A CEO is very likely to do things to remain committed to meeting his or her stated plans because the consequences of not meeting them are that the stock goes down, thereby reducing the value of stock options or tarnishing the reputation and credibility of the management team. The management team thus becomes committed to only one way of doing business.
Strategic plans fail because they often shut out other opportunities. When an opportunity comes up and it does not fit into the strategic plan of a business, then the management team will likely pass it up. The truth is that most management teams often stumble upon their best ideas.
For example, in the 1990s, Pfizer stumbled upon one of its best-selling drugs, Viagra. The company was developing a treatment for angina (the painful heart condition caused by constricting or clogging of heart arteries), when the users of this drug began to report that it improved their ability to have erections. So Pfizer made a very smart move and refocused on the newly discovered opportunity.16
Another reason they fail is that a business may focus on strategic targets instead of on what the customer wants. This is the same as telling a customer “That’s not how we do things,” instead of asking “How do you want it done?”
The Investment Checklist Page 26