The Investment Checklist

by Michael Shearn

  For example, Fannie Mae and Freddie Mac bought billions of dollars’ worth of sub-prime mortgages. Instead of focusing on the true needs of the customers, they helped banks lend money to customers who could not afford the loans. Later, as these sub-prime mortgages defaulted, both of these businesses had to be bailed out by the government.

  Do Not Confuse Strategic Plans with Long-Term Planning

  Do not confuse a strategic plan with goals or long-term planning. You can think of long-term planning as a vision that is always in the head of the CEO as he or she builds the business. For example, a CEO may have a long-term plan to become the highest-rated business in customer satisfaction or to have the lowest employee turnover rate in its industry.

  Highest-Risk Strategic Plans: Setting Financial Goals

  The strategic plans that are most prone to failure are those that have an overly narrow focus, such as those that set a financial target. Many CEOs often make such announcements as “the business will generate $100 million in revenues in three years” or “we will sell 1,000 units per week by the year 2012.” However, what happens in most of these cases is that when the CEO focuses on a specific financial target, they neglect other areas or take on more risk. The single plan will dominate all of the activities of the business at the expense of other important areas.

  For example, in 2003, General Motors executives wore lapel pins and buttons with the number “29” as a reminder of the company’s goal of obtaining a 29 percent U.S. market share. To meet the number that year, GM even offered rebates of up to $5,500 and 0 percent loans over 6 years on some of their cars. Six years later, GM’s U.S. market share was below 20 percent, and the company was bankrupt. Why?17

  The reason GM failed is because it focused on market share, and it had built a cost base structured for at least that level of market share. In other words, it was locked in. To try to make that number, the company burned through billions of dollars, launching new models in many market segments. By 2005, their U.S. share was at 26 percent—which was the lowest since 1925. By 2007, they were down to 23.7 percent, only barely ahead of Toyota. Furthermore, GM’s cash losses during its high-growth years had left few cash reserves for years with declining car sales, and little or no cash to deal with the downturn of 2008 to 2009. By competing in too many market segments, and not leaving the segments where they couldn’t adapt quickly enough to make money, GM lost the gamble it had made to try to gain market share from Toyota and the other import companies.18

  Paul Larson, editor of Morningstar StockInvestor, offers a great analogy of why it is dangerous to set specific financial targets: “It’s like you’re driving somewhere and you tell yourself you will drive to a certain destination at an average speed of 63 mph. Instead, the way you should do it is to go as fast as road conditions will allow. If you have a set projection, you might go too fast and crash, or maybe it is a wide open road and you can gun it.”19

  When a management team sets specific financial goals, it may resort to such actions as managing earnings to meet those goals or making costly acquisitions. Some examples of CEOs who have failed after setting specific financial targets are:

  Hugh Grant, CEO of agricultural biotechnology company Monsanto, once declared that his goal was to double profits within five years. To meet this goal, he needed to shift the businesses focus away from herbicides to its more profitable biotech seed business. By 2010, Grant announced that they were unlikely to meet such a goal and that he was abandoning those plans. Grant later declared, “I’ll tell you from the school of hard knocks, I don’t think you’re going to be seeing us laying out long-term targets.”20

  In 1976, Continental Bank was the eighth-largest bank in the United States. The chairman of Continental announced that within 5 years, the bank’s lending would match that of the other largest banks. To reach this goal, Continental shifted its strategy from conservative corporate financing to aggressively pursuing borrowers. Continental did become the largest commercial lender in the country, and it became a much larger bank, but in the process, it made several critical mistakes. Continental took in more volatile foreign deposits, loosened lending criteria, and sent the wrong message to its employees, who relaxed documentation standards. The bank also lost its historically conservative discipline and cut its pricing on loans. By 1984, Continental was in trouble, and it needed the largest bailout in U.S. history up to that time.21

  In the late 1960s, Ford had begun to lose market share to its competitors who were making small fuel-efficient cars. Ford CEO Lee Iacocca decided to challenge his engineers to produce a car that would cost less than $2,000, weigh under 2000 pounds, and complete it by 1970. Talk about specific goals: This was a trifecta! The result was the Ford Pinto, best known as the car that could ignite on impact. Not only was the car design defective, lawsuits later revealed that Ford’s top managers knew that the car could ignite. So committed were Ford’s managers to their strategic plan that instead of fixing the faulty design, they decided to go ahead and manufacture the car. They figured the costs of the lawsuits from the Pinto fires would be less than the cost of fixing the design.22

  41. Do the CEO and CFO issue guidance regarding earnings?

  Guidance is when management predicts earnings per share or other business metrics over the next quarter or next year and shares this information with investors, either through a press release or a conference call. Wall Street analysts then tend to fixate on whether a business will meet or beat these quarterly earnings estimates. The majority of businesses that are publicly traded give guidance. The National Investor Relations Institute (NIRI) compiles responses from more than 500 public companies regarding earnings guidance and reports that 60 percent of companies provided quarterly earnings guidance in 2009.23

  Guidance can have the most damaging effects on a business when it begins to represent the organizational goals of the whole business. If meeting guidance represents the only goal the business has, then other valued activities will not be prioritized and are often ignored. Meeting guidance will therefore drive the operations of the business, rather than the earnings of the business being a byproduct of the business’s operations. For example, a CEO and CFO who give guidance may be tempted to achieve dependable period-to-period growth by masking the volatility inherent in a business. Unfortunately, in the real world, a business does not grow in a constant fashion. The majority of businesses face a lot of volatility that CEOs and CFOs cannot make disappear. Growth is almost always subject to seasonality, cyclicality, and random events.

  Once a business begins to set guidance, it may also adopt a short-term outlook at the expense of long-term growth. A CEO and CFO may fear disappointing Wall Street analysts because if they do, their stock price plummets. If management falls short of a guidance goal, they may do things that are not in the best interests of the business to make up the difference. Once they start this process, it is difficult to stop it. Then management begins to borrow from the future in order to sustain the present and begins to participate in the earnings game. The game has little to do with running a business and instead becomes a major distraction that detaches the CEO and CFO from the fundamentals of the business.

  For example, a CEO may push more products onto its customers in order to meet the current quarter’s guidance. Or the CEO may refuse to invest in long-term capital projects that do not contribute to profitability in the short term. At some point, it becomes impossible to manage earnings as usual, and the stock price falls. The CEOs and CFOs at such failed businesses as Enron, WorldCom, Tyco, Adelphia, and HealthSouth, which were stellar performers, succumbed to the pressure to meet the numbers.

  Enron is a case in point. At one time, it had strong global assets such as pipelines, but it then sought to transform its business model by becoming a market maker of natural gas and energy. As Enron’s stock price increased due to the company’s ability to continually exceed its guidance, it had to seek new avenues for growth and moved away from its core competence to areas where it had no
expertise, such as broadband, water, and weather insurance. As these operations began to generate losses, Enron’s management began to use off-balance-sheet partnerships in order to continue increasing their earnings per share by taking debt off of its balance sheet. At its peak in August 2000, Enron had a valuation of $69 billion24—yet it declared bankruptcy in 2002.

  You need to be cautious with businesses that issue guidance. Ideally, you should look for managers who promise only what they can realistically deliver and do not bow to analysts’ demands for highly predictable earnings. If management is constantly worried about its stock price, then this is an indicator that management is worried more about managing the perception of the business than operating the actual business. Instead, management should be clear about all of the risks and uncertainties involved and should outline how a business is progressing toward meeting its long-term objective.

  Some businesses have even stopped issuing quarterly financial targets because they no longer want to subject themselves to the unnecessary pressure to meet external goals. Here are just a few examples:

  Gillette: At one time, Gillette promised investors that it would grow its earnings at 15 percent to 20 percent. But after it acquired Duracell in 1996, it began to have problems meeting this goal. Gillette’s management began to resort to such actions as channel-stuffing products to its distributors in order to meet its projections. When James Kilts took over as CEO in 2001, he quickly dropped the practice of issuing earnings guidance entirely.25

  Newell, a global marketer of consumer products: Newell used to state in its annual reports that it aimed for earnings-per-share (EPS) growth of 15 percent a year; however, after Newell acquired Rubbermaid and its earnings fell, this line disappeared from the annual report.

  Unilever, a consumer goods company: As CEO Paul Polman explained, “What mattered far more than goals and targets was consistent delivery over time. Anything more specific only caused trouble.”

  If a business does issue guidance, you need to be careful that managers are not managing earnings. Start by comparing the quarterly or annual earnings estimates to the actual earnings per share of the business. Create a chart that shows the guidance given by management, and count how many times they beat their estimates. If management is consistently beating its own estimates, you can classify these management teams as “dedicated guiders.” This should serve as a warning signal, and you should closely scrutinize its accounting to understand how the business is consistently beating its guidance.

  42. Is the business managed in a centralized or decentralized way?

  It is important for you to determine if top management operates a business using a centralized or decentralized structure. If it is centralized, the business is managed using top-down hierarchies with rigid reporting structures, which create bureaucracies. A centralized management team often tells employees exactly what tasks to do. These businesses also have very narrow decision-making processes, and they mainly get compliance from their employees rather than genuine commitment. This may lead employees to not feel trusted and make them less likely to internalize responsibility. They are afraid to make mistakes and sometimes they will not do the right thing because of that fear.

  Bureaucratic businesses also tend to have difficulty recruiting and retaining competent employees because competent employees don’t want to just take orders without understanding the reasons behind them. Rules and restrictions cause the most innovative people to run from the business or start their own companies. This means that a business’s pipeline of future leadership will often be limited.

  In contrast, if a business has a decentralized management structure, those employees who are closest to the customer are empowered to make decisions. These employees often feel as if they are running their own business. An added benefit is that it’s much easier for front-line employees to convey valuable information about their customers to top managers. Because it’s much easier for information to flow up, managers know more about their customers.

  Many of the best-performing stocks in history—that is, those that have compounded at rates greater than 20 percent over 15 years—have used decentralized operating structures; for example, Teledyne, Berkshire Hathaway, Penn National Gaming, Expeditors International, Fastenal, Capital Cities ABC, and Bed Bath & Beyond. One reason for their success is that this type of business attracts independent thought and a diverse workforce, which encourages innovation. The greatest financial benefit is that decentralized businesses have reduced corporate overhead. For example, Penn National Gaming, a regional casino company, has one of the lowest corporate overheads of any publicly traded casino.

  Let’s take a closer look at Fastenal (another company with a decentralized management structure), whose stock price increased from $0.27 per share on September 1, 1987, to more than $60 per share on December 31, 2010. Fastenal doesn’t operate using strict, top-down corporate hierarchies. Instead, this company treats its branch managers more like individual store owners, giving them wide latitude in decision making. Company founder Robert Kierlin always felt that because most customer interaction happens at the store level that it made sense to transfer the decision making to that level. Branch managers know the customer best, so Fastenal’s store level managers make decisions about what inventory to carry, and what price to charge for their products. In fact, some managers negotiate directly with corporate suppliers. The compensation structure is also matched to the store level, with branch managers receiving commissions and profit sharing from their stores.

  Similarly, Louis Vuitton Moët Hennessy’s (LVMH) stock price has increased more than 10 times in value from 1989 to 2010, under the leadership of Chairman and CEO Bernard Arnault. Arnault attributes much of this success to the company’s management structure, stating, “One key element of management of a group like this (LVMH has 83,542 employees26) is decentralization. You need the right team of inspired managers. I want all of my managers to take charge of their divisions as though they were family enterprises.”27

  How Do You Identify a Business That Is Managed in a Centralized or Decentralized Way?

  First, determine who has the responsibility for selecting and hiring employees. Is it the Human Resources (HR) department or the managers who the employees will be working under? If it is the group where the employee will be working, then it is decentralized, but if all hiring is done through HR, then it is bureaucratic. Ideally, the responsibility of selecting employees should rest primarily with those holding authority over the department in which there is an opening. Herb Kelleher, founder of Southwest Airlines, brought model employees into the hiring process. For example, pilots made hiring recommendations for new pilots because they were in the best position to judge the abilities of potential candidates.28

  Second, speak with the customers of a business. You need to determine how the business solves customer issues. Do employees have to resort to a bureaucratic process to resolve customer issues? Or do they have the authority to solve a customer issue without getting supervisory approval? Think about how frustrating it is when you have to return a product to a store and the manager has to approve the return or you have to fill out lots of paperwork. In contrast, Four Seasons Hotels encourages all of its employees to solve problems themselves, and it rewards employees who go beyond the call of duty in helping a hotel guest.

  Third, note what the difference is in compensation among the top five executive officers by viewing the proxy statement. This will help you determine whether the business is run by a top-down CEO or if it is a flat organization. For example, the proxy statement of one business revealed the following:

  CEO received a salary of $2,164,423; the next highest paid executive received $690,577.

  CEO’s bonus was $7 million; the next highest was $825,000.

  CEO was also given 590,000 stock options, as compared to 90,000 options for the next-highest-paid executive.

  You can clearly see that the CEO had a significantly higher compensation package than the
rest of the management team. This indicates that the business is being run by a top-down CEO.

  By comparison, the 2009 proxy statement for Expeditors International shows that CEO Pete Rose received total compensation of $4,782,892, and the other 4 top executive officers earned similar amounts. This indicates that it is probably a decentralized operation.

  Fourth, talk to salespeople who sell products and services to the business. Salespeople have to determine whether a business is managed in a centralized or decentralized way because they need to identify the primary decision maker in order to make a sale. For example, experienced salespeople will try to determine how important job titles are at a business. If titles are not important, then this is a sign it is decentralized. Salespeople will also look at the environment of the business they are selling to. For example, they look to see if the cubicles or offices of the employees are sterile (centralized) or if they are customized to the tastes of the employees of the business (decentralized).

  43. Does management value its employees?

  Most investors view the CEO as the sole person who operates the business, while the employees are viewed as commodities that can be downsized at any point. Nothing is further from the truth. The primary function of a manager is to obtain results through people. If a manager is unable to achieve results through people, he or she is not a good manager. Try to understand if the management team values its employees because the only way it will obtain positive results is through these people.

  When employees feel they are partners with their boss in a mutual effort, rather than merely employees of some business run by managers they never see, morale will increase. Furthermore, when a business has good employee relations, it typically has many other good attributes, such as good customer relations and the ability to adapt quickly to changing economic circumstances.