It is critical for a business to attract the right employees. Businesses attract employees to a degree because of the culture they offer. Employees who enjoy and excel in collaborative environments pick those types of companies, whereas other employees may choose to work in more structured environments. The type of employee a business attracts depends on the type of business. For example, in retail, you must have a strong customer-service culture. If you visit retail stores and find that the employees are not customer oriented, then this is a clear indicator that they are not hiring well.
The only way a business can hire employees who will be enthusiastic about their work and loyal to the business is by clearly communicating the values and attributes of the business to potential employees. This way, employees can self-select into the business if they believe that their values and preferences fit with the business. Some businesses excel at expressing what makes them unique. For example, at Whole Foods Market, potential employees are told that they will have a four-week trial period of working in a team; after that trial period, two-thirds of the team must accept the employee in order for him or her to join the company permanently. Potential employees who do not like team environments will most likely not want to go further in the interview process. Therefore, potential hires at Whole Foods Market self-select into the business.
Employees who thrive in clear-cut, well-defined work environments do not want to work in uncertain environments where there are no hierarchies or predetermined channels of communication. For example, Exxon Mobil does a good job of explaining to employees that it has a highly structured environment and that it will take a long time in order for an employee to be promoted. It expects its hires to remain at the company for long periods of time. Employees who become frustrated with their progress may leave, but those who remain are more likely to make their careers at the company.
One type of employee isn’t necessarily better than another, but the business does need to do a good job of communicating what type of firm it is. If you note that the business has high turnover or disengaged and unproductive employees, then this is a sign it is not clearly communicating its values to potential hires.49
Do They Hire Managers or Employees Who Are Candid?
You want to determine if the manager hires employees who are candid or those who are not afraid to challenge the top management team. Candid employees will speak up when they think the manager is pursuing a flawed strategy, whereas an employee with a different personality or outlook may just assume the manager knows more than the employees.
Candor is, in essence, the willingness of employees to express their real opinions. Perhaps you have been in a formal meeting where another manager is making a presentation that you know will not work, but you wait for the boss’s response before proceeding to question the plan. If the boss approves, it is highly likely you will not speak up. An open CEO encourages others to be open and not agree to things that they have no intention of acting on, or consider poor ideas. Formality thus suppresses candor, whereas informality encourages it. One way to learn if a business hires candid employees is to learn about the type of workplace it has. Ask the employees if the meetings they attend are full of presentations that are prepackaged, well-orchestrated, or stiff. If the meetings are instead open, employees will probably be more comfortable providing valuable feedback.
For example, at DaVita, which operates dialysis treatment centers, CEO Kent Thiry encourages employees to bring him bad news. Thiry regularly surveys employees, and he makes it a point to act quickly on the feedback he receives. He uses the information to avoid mistakes.50
Similarly, Motorola was recognized as a great business in the 1980s when it was run by CEO Robert Galvin. During that period, the only way managers got ahead was by challenging existing assumptions and not supporting the status quo. Galvin encouraged his employees to tell him the truth and to challenge him. A story often told is that a young middle manager once approached Galvin and said, “Bob, I heard that point you made this morning, and I think you’re dead wrong. I’m going to prove it: I’m going to shoot you down.” Galvin’s response to a companion was proud: “That’s how we’ve overcome Texas Instruments’ lead in semiconductors!”51
However, as Motorola’s top management changed, these employees no longer felt comfortable being candid. As a result, Motorola developed fewer innovations, and its stock price (even after accounting for spin-offs) increased only marginally over the last 20 years, from 1990 to the end of 2010.52
If the top managers are hiring employees who are not encouraged to speak their minds, it is likely the business will encounter problems down the road, making it a bad investment.
What Type of Board Members Does the CEO Choose?
Typically, the CEO plays an important part in bringing board members in, especially if the CEO has been running the business for a long period of time. Is the CEO bringing in cronies, board members with prestige, political figures, friends, consultants, or lawyers? If they are bringing in, say, politicians, many will lack business experience, and this could be an indicator that the CEO is bringing in people because they are loyal to him or her. Viewing the types of board members that have come to the business during the CEO’s tenure will alert you to whether the CEO is using the business as a personal vehicle to benefit him- or herself, or if the CEO is running the business with shareholder interests in mind.
Most of the largest frauds in corporate history involved board members whose interests were more clearly aligned with management than shareholders and the business.53 For example:
Enron’s board was known for rubber stamping the company’s deals. Board members didn’t often challenge management on the financial reports or any other matters. And why would they? A board member doing so would be risking as much as $380,000 received as an annual board retainer.
WorldCom, the telecom business embroiled in accounting fraud, had a board almost entirely aligned with CEO Bernard Ebbers: Most were insiders, and even those who were outsiders had strong personal and financial ties to Ebbers.
At cable business Adelphia Communications Corporation, family members made up the majority of the board. The founders of Adelphia were charged with securities violations.
Insiders dominated conglomerate Tyco’s board. CEO Dennis Kozlowski’s board filled 8 of 12 positions with Tyco employees. Kozlowski was convicted of grand larceny related to unauthorized compensation.
Look out for conflicts of interests between directors and the CEO found in the Related Party section of the proxy statement. For example, here’s what you would have found in HealthSouth’s proxy statement (HealthSouth’s CEO was involved in a corporate accounting scandal):
A director earning $250,000 annually for seven years as part of a HealthSouth consulting contract.
A director with a $395,000 joint property investment with HealthSouth CEO Scrushy.
A director whose company received a $5.6 million glass installation contract at a new HealthSouth hospital.
A company owned by HealthSouth employees (Scrushy, six directors, and the wife of a director) that also did business with HealthSouth. The company, MedCenterDirect, was a hospital-supply company that operated online.
Watch also for donations to charities made by the company on behalf of certain directors as this often serves as a red flag. For example, at Enron:
Dr. John Mendelsohn was a board member and member of the audit committee: He received substantial donations for the cancer research center he directed from both Enron and Ken and Linda Lay.
Lord John Wakeham, another audit committee member, was paid $72,000 each year over many years as an Enron consultant.
Wendy Gramm (another audit committee member) received a $50,000 Enron donation for the program she directed at George Mason University, the Mercatus Center Regulatory Studies Program.
These are potential conflicts of interest, and they serve as clear warning signals.
45. Does the management team focus on cutting unnecessary cos
ts?
I used to believe that a frugal manager was a good manager. Over time, I learned that although managers who are habitually thrifty will be able to recognize opportunities to lower costs, they may not invest in important projects. Frugality is bad when the company does not spend money for the benefit of customers.
On the other hand, reducing unnecessary costs while continuing to invest in the core business is good. For example, if you visited the headquarters of retailer 99 Cent Only Stores, you would see stained carpeting, broken file cabinets, folding tables used as credenzas, and front pages of newspapers displayed as art. Clearly, founders Dave and Sherry Gold have chosen not to spend money on the headquarters because customers don’t care what corporate offices look like. As Dave Gold says, “I don’t mind spending money. I just don’t like to waste it.” Instead, 99 Cent Only Stores invests in the things that benefit the customer, spending money on the stores, and making sure its buyers (who find the best products for customers) are well compensated: In fact, the company pays its buyers double what they would make anywhere else.54
Another CEO who believes in investing in his business is David Zaslav, CEO of television company Discovery Communications. Zaslav puts creative leaders rather than a business leader in charge of each channel and prioritizes brand building, audience building, and great content. His thinking is that quality content is always going to be in demand. Zaslav sees the company as two halves: “On the right half is better content, better shows, better characters: Deadliest Catch and Oprah. The left side is everything else. If we can take $2 out of the left side and invest $1 or $1.50 more in our content and brands, that gives the trajectory of our growth a push.”55
Watch also for the type of costs a business cuts. When Starbucks CEO Howard Schultz cut costs during 2009 and 2010, he avoided cuts that would directly affect the customer. Instead, he reduced costs by eliminating supply chain inefficiencies, waste, and certain parts of the support structure. Starbucks also reduced expenses, but at the same time, it kept investing in the things that mattered most: For example, maintaining employee benefits and committing more resources to employee training. During 2010, Schultz said that his customer-satisfaction scores actually rose, reaching their highest levels ever because, “We reinvested in our people, we reinvested in innovation, and we reinvested in the values of the company.”56
Also, think about this: If the management team is continually announcing cost-cutting programs, this is a sign that they are not focused on continually cutting unnecessary costs. These types of businesses are often serial restructurers as well. For example, during his Hewlett-Packard tenure (2005 to 2010), CEO Mark Hurd took $3.2 billion in restructuring charges and $3.3 billion in write-downs for amortization of intangible assets related to acquisitions. This buy-and-restructure strategy helped HP deliver annual revenue growth of 7.5 percent and 22 percent growth in earnings per share during Hurd’s tenure. However, Hurd was constantly restructuring the workforce by increasing the use of contract manufacturing and other cost-cutting measures. He also acquired companies (such as Electronic Data Systems, 3Com, and Palm) to grow markets in services, networking, and mobile devices—acquisitions that, combined with ongoing restructurings, made “one-time charges” recurring. The problem is that once these large costs have been taken so quickly, it becomes more difficult for the business to cut costs further without the quality of the product declining.57
46. Are the CEO and CFO disciplined in making capital allocation decisions?
Capital allocation is the manner in which the management team invests the excess free-cash flows that the business generates. Management decides when and where these excess free-cash flows should be invested or distributed. There are five actions management can take with excess free-cash flow:
1. Reinvest the capital back in the business in new projects.
2. Hold cash on the balance sheet.
3. Pay dividends.
4. Buy back stock.
5. Make acquisitions.
It is difficult to find CEOs who are both good at operating the business and at allocating capital. The main reason for this is that operating a business and allocating capital are two completely different skill sets; being proficient at one of these functions has no correlation to being competent with the other. As a group, CEOs possess varying degrees of competence when it comes to capital allocation.
The best capital allocators are those who are removed from the day-to-day operations of a business—for example, Warren Buffett, CEO of Berkshire Hathaway; Peter Carlino, CEO of Penn National Gaming; and Bruce Flatt, CEO of Brookfield Asset Management. The best capital allocators delegate the day-to-day operations to other managers within the business; for example, Carlino delegates the day-to-day operations to COO Tim Wilmott. This allows these CEOs to see the big picture and not get bogged down in the details.
One of the best capital allocators in corporate history was Henry Singleton, longtime CEO of Teledyne, who cofounded the business in 1960 and served as CEO until 1986. In John Train’s book The Money Masters, Warren Buffett reported that he believes “Henry Singleton has the best operating and capital-deployment record in American business.” When Teledyne’s stock was trading at extremely high prices in the 1960s, Singleton used the high-priced stock as currency to make acquisitions. Singleton made more than 130 acquisitions of small, high-margin manufacturing and technology businesses that operated in defensible niches managed by strong management. When the price-to-earnings ratio of Teledyne fell sharply starting in the 1970s, he repurchased stock. Between 1972 and 1984, he reduced the share count by more than 90 percent. He repurchased stock for as low as $6 per share in 1972, which by 1987 traded at more than $400 per share.58
The best way to determine if managers are good at allocating capital is to review their historical decisions, whether they are buying back stock or making new investments. You can identify a good capital allocator by looking for examples where they are disciplined.
For example, in a fourth quarter 2008 conference call, Penn National Gaming CEO Peter Carlino discussed why the company did not build a hotel next to its successful casino site in Hobbs, New Mexico. A hotel would help the casino generate more cash flow as it would encourage visitors to stay overnight. Carlino said that preliminary estimates to construct the hotel came in at $30 million, yet he felt that it would not make sense to build the hotel until the construction costs came in closer to $20 million. This $10 million difference is not a large amount, considering Penn National Gaming generated more than $300 million in distributable free-cash flow in 2009.59 Even though a hotel would add to cash flows, Carlino demonstrated that he is disciplined in waiting for the right deal before proceeding with any capital investments.
In contrast, the majority of CEOs would probably build the hotel and hope that the extra cash flows from overnight visitors would make up the $10 million difference. But Carlino’s capital discipline has helped Penn National Gaming become one of the greatest compounding stocks in the last 15 years, compounding at more than 27 percent from its May 1994 initial public offering (IPO) to its stock price at the end of 2010 of more than $27 per share.60
47. Do the CEO and CFO buy back stock opportunistically?
Earnings per share is the most important measure in determining what a share of stock in the business is worth. Because stock repurchases decrease the number of shares outstanding, they have the effect of increasing earnings per share. If the stock is undervalued, these stock repurchases can add materially to the value of the business. The timing of buybacks will depend on the value of the stock, on how much cash the business has, and how much cash it needs. Management may decide to buy back stock as a one-time act, or you may see management lay out predetermined amounts each year that it plans to use for buybacks.
There are a couple of common motivations behind stock repurchases:
Management may believe the stock is undervalued, so it takes advantage of the opportunity to potentially add value.
Mana
gement may want to offset dilution from issuing stock options.
Let’s review the two reasons for buybacks in more detail.
Adding Value By Buying Back Stock Opportunistically
By making buybacks when the stock is undervalued, management can materially add to the value of the business. For example, if a business is worth $50 per share and management buys 10 percent of the stock at $25 per share, then management has automatically increased the value of the business to $52.50 per share ($25 per share multiplied by 10 percent equals $2.50 per share plus $50 per share). If it instead pays $100 per share, then it is reducing shareholder value. The lower the price it pays for the stock, the more value management will create for shareholders.
The best way to determine if the management team is opportunistic in its stock repurchases is to examine its history. Western Union, for example, generates a lot of excess free-cash flow, so stock buybacks make sense. When Western Union was spun off from First Data Corporation in 2006, management announced it would invest $1 billion per year in stock buybacks. In 2008, when the stock was trading at more than $23 per share, Western Union repurchased $1.3 billion in stock. However, as the stock price declined to below $14 per share in 2009, management pulled back, saying the recession had limited its ability to repurchase shares, and that it would only repurchase $400 million in stock. With stable cash flows and a strong balance sheet, Western Union had more than enough cash to buy the stock. Instead, as the stock price increased, Western Union began repurchasing stock, announcing it was reinstating its plan to buy back $1 billion in stock each year. Although conserving cash is important, in this case, it was unwarranted given the strong cash flows, and clearly illustrated that Western Union’s management team was not opportunistic in its stock repurchases.61
The Investment Checklist Page 30