An example of a business whose management team has made many opportunistic purchases in the past is AutoZone, an automotive-parts retailer. AutoZone’s earnings per share (EPS) grew at a rate of 15.7 percent from August 2002 to August 2010, while its net income grew at a rate of 6.23 percent over the same period. The main reason for the difference was due to the share repurchases that AutoZone made, which reduced the number of shares outstanding from 104.4 million shares to 48.5 million, or by 53 percent.62 The share repurchases have clearly added value: EPS grew 15.7 percent during the eight-year period. Had AutoZone not bought back any stock, then the EPS would have grown only 6.23 percent, which would have resulted in a lower stock price.
Table 8.2 examines further how AutoZone’s stock repurchases have added value over eight years (with August as year end).
Table 8.2 AutoZone Stock’s Repurchasing History, from 2002 to 2010
Source: AutoZone 10K 2002 to 2010 August 25 year end, Basic EPS data is Capital IQ
You can use a similar table when you are assessing whether a management team has added value through stock repurchases. The amount and number of shares repurchased are found in the 10-K in a separate section titled Stock Repurchases.
Similarly, when a business issues new shares (e.g., stock options), it destroys value. For example, General Motors reported a 4.82 percent growth rate in net income from 1985 to 1995. However, its EPS over the same period grew at an annual rate of only 2.68 percent because GM increased the number of shares outstanding during that time.63
Offsetting Options Dilution
When determining whether the stock repurchases add value, disregard those repurchases made to offset options dilution. Most investors don’t think of repurchasing issued options as capital allocation, but this is an area that management controls, and it is another form of capital allocation. You can create a table that includes the number of stock options issued in a given year compared to the number of shares bought back in order to understand what percentage of stock buybacks are used to offset options dilution. In the 10-K, there is a section titled Stock Plans, where you can find the total number of options that are issued by the business. Table 8.3 is an example for Microsoft.
Table 8.3 Microsoft Option Issuance and Buybacks
64
As you can see from Table 8.3, the amount of stock buybacks to offset options dilution averages 25 percent, leaving 75 percent of repurchases to potentially add value. When evaluating how effectively management is using buybacks, use this percentage rather than all the repurchases.
Key Points to Keep in Mind
The best-performing businesses over the long term, as measured by shareholder returns, are managed by CEOs who have a purpose greater than solely generating profits.
Most successful businesses are built on hundreds of small decisions, instead of on one well-formulated strategic plan.
Good management teams work on proving a concept before investing a lot of capital. They are not likely to put a lot of money in all at once hoping for a big payoff.
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 (e.g. guidance).
Businesses that are decentralized attract independent thought and a diverse workforce, which encourages innovation.
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.
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.
If managers are committed to employee training, this is a great sign that they have a long-term orientation.
Avoid investing in those management teams that quickly announce layoffs the moment their business encounters a setback.
If a business culture is admired and respected, the business is able to attract great employees.
Few management decisions are as important as selecting the right people for the right positions. Good hiring indicates sound judgment.
The best capital allocators are those who are removed from the day-to-day operations of a business.
1. Mackey, John. “Conscious Capitalism: Creating a New Paradigm for Business.” In Michael Strong, ed., Be the the Solution: How Entrepreneurs and Conscious Capitalists Can Solve All the Worlds Problems, Hoboken, N. J.: 2009.
2. Horowitz, Jed. “Buffalo’s First Empire: Enigmatic Profit Machine Series: 5.” American Banker, September 14, 1993.
3. Davenport, Todd. “Wilmers: Profitability Plus Community Involvement.” American Banker, December 1, 2005, pp. 22–27.
4. Standard & Poor’s Capital IQ.
5. Collins, Jim. “The 10 Greatest CEOs of All Time.” Fortune, July 21, 2003.
6. Author’s interview with Robert Silberman, Austin, Texas, May 19, 2010.
7. Standard & Poor’s Capital IQ; Fuller, Joseph, and Michael C. Jensen. “Just Say No to Wall Street: Putting a Stop to the Earnings Game.” Journal of Applied Corporate Finance 22 (2010): 59–63.
8. Slywotzky, Adrian J., and John Drzik. “Countering the Biggest Risk of All.” Harvard Business Review, April 2005, p. 86.
9. Gilbert, Clark G., and Matthew J. Eyring. “Beating the Odds When You Launch a New Venture.” Harvard Business Review, May 2010.
10. Perkins, Tom. Valley Boy, The Education of Tom Perkins. New York: Penguin Group, 2007.
11. Markels, Alex. “The Sky Really Is Falling.” U.S. News and World Report, November 8, 2004.
12. “The Brain Behind Teledyne: A Great American Capitalist.” New York Observer, April 7 2003; Henry Singleton at a Teledyne annual meeting.
13. Author’s interview with Dave and Sherry Gold in May 2010.
14. Stemberg, Thomas. “Treat People Right and They Will Eat Nails for You, and Other Lessons I Learned Building Staples into a Giant Company.” Inc., January 2007.
15. Bob Graham interview by Michael Shearn and Matt Dreith, April 8, 2011.
16. Langreth, Robert, and Andrea Petersen, “Drugs: Stampede Is On for Impotence Pill.” Wall Street Journal, April 20, 1998.
17. Guilford, Dave. “GM Gives Up on Share Gain.” Automotive News, November 17, 2003; general press coverage of GM for the period; Business Monitor International. “Market Overview.” U.S. Autos Report, 2008–2010.
18. More, Roger. “How General Motors Lost Its Focus—and Its Way.” Ivey Business Journal 73, no. 3 (2009).
19. Author’s interview with Paul Larson in November 2010.
20. Frean, Alexandra. “Monsanto hopes the grass will be greener with new crop of products.” Financial Times, January 8, 2010.
21. Bennett, Robert A. “Continental Illinois Challenge.” New York Times, August 2, 1982; “Aggressive Banking Pays Off at Continental Illinois Corp.” Wall Street Journal, October 15, 1981; Bennett, Robert A. “Shaping Chicago’s Top Bank” New York Times, September 28, 1981; Singer, Mark. Funny Money. Boston: Mariner, 2004; Rowe, James L., Jr, “Record Bailout for Continental Bank Launched.” Washington Post, May 18, 1984.
22. Bonamici, Kate. “Ford Decides to Let the Pinto Explode.” Fortune, June 27, 2005; Halpern, Paul. “The Corvair, the Pinto and Corporate Behavior.” Policy Studies Review 1, no. 3 (1982): 540–545.
23. NIRI (National Investor Relations Institute). Guidance Practices and Preferences-2009, May 2009 (“2009 NIRI Survey”); Guidance Practices and Preferences Survey-2008, May 2008 (“2008 NIRI Survey”); 2007 Earnings Guidance Practices Survey Results, July 2007 (“2007 NIRI Survey”). http://www.niri.org.
24. Standard & Poor’s Capital IQ.
25. Schroeder, Alice. “Please Hold for Mister Buffett.” BusinessWeek, March 8, 2010.
26. December 2010 LVMH Annual Report.
27. Adams, Susan, and Hannah Elliott. “Master of the Brand, Bernard Arnault.” Forbes, November 22, 2010.
28. Livingston, Sand
ra. “Being Different Helps Make Carrier a Success.” Cleveland Plain Dealer, February 21, 1993.
29. Lublin, Joann. “CEO Tenure, Stock Gains Often Go Hand-in-Hand.” Wall Street Journal, July 6, 2010.
30. Ignatius, “Mistakes.”
31. “Company Interview-Richard Galanti.” Wall Street Transcript. March 22, 2010, pp. 49–51.
32. Vinnedge, Mary. “From the Corner Office—Herb Kelleher: Beating the Big Boys at Their Own Game.” Success Magazine, October 3, 2008.
33. Pacelle, Mitchell. “Despite Lawsuits, Enron Bonuses Haven’t Been Returned.” Wall Street Journal, November 3, 2003.
34. Nunes, Paul, and Tim Breene, “Reinvent Your Business Before It’s Too Late.” Harvard Business Review, January–February 2011.
35. Wagner, Rodd, and James Harter. The 12 Elements of Great Managing. New York: Gallup Press, 2006.
36. Tindell, Kip (CEO of Container Store), Lecture at 2nd Annual International Conference on Conscious Capitalism, May 2009; Casey Shilling (VP of Marketing Communications) Container Store, April 6, 2011.
37. Buffett, Warren. Letter to Shareholders of Berkshire Hathaway, Inc., 1990.
38. Dade, Corey, and Cari Tuna. “FedEx Joins Other Firms Cutting Pay, Retirement.” Wall Street Journal, December 19, 2008.
39. Schulz, John D. “A ‘Clear Opportunity.’” Traffic World, December 8, 2003.
40. Burke, Monty. “Back to Life.” Forbes, January 20, 2002.
41. Cawood, Scott. “Company Culture: The Intangible Pathway to Profitability.” Employment Relations Today, Winter 2008.
42. Herskowitz, Mickey, and Ivy McLemore. People Are The Product, A History of AIM. Houston: AIM Funds, 2000.
43. Author interview with Lee Valkenar, March 2011.
44. Sisodia, Raj, Jag Sheth, and David Wolfe. Firms of Endearment. Upper Saddle River, NJ: Wharton School Publishing, 2007, pp. 33–34.
45. Hymowitz, Carol, and Matt Murray. “Management—Boss Talk: Raises and Praise or Out the Door—How GE’s Chief Rates and Spurs His Employees.” Wall Street Journal, Eastern edition, June 21, 1999.
46. Standard & Poor’s Capital IQ.
47. Interview with Casey Hoffman December 2010.
48. Herb Kelleher, speaking at the University of Texas at Austin, October 19, 2006.
49. Erickson, Tamara J., and Lynda Gratton, “What It Means to Work Here.” Harvard Business Review, March 2007.
50. O’Toole, Jim. “What’s Needed Next: A Culture of Candor.” Harvard Business Review, June 2009.
51. Ibid.
52. Ibid.
53. Much of the info on board alignment and board conflicts of interest is drawn from Marianne M. Jennings, “Preventing Organizational Ethical Collapse” Government Accountants Journal 53, no. 1. (2004).
54. Holt, Nancy D. “Workspaces.” Wall Street Journal, October 15, 2003.
55. Edgecliffe-Johnson, Andrew. “The Biggest Beat of Non-fiction Television Eyes a Global Prize.” Financial Times, January 10, 2011.
56. Ignatius, “Mistakes.”
57. Jones, Steven D. “In the Money: Hurd’s H-P Grew, But Charges Pruned Earnings.” Dow Jones News Service, August 10, 2010.
58. “The Brain Behind Teledyne: A Great American Capitalist.” New York Observer, April 7, 2003.
59. Time Value of Money, LP free cash flow estimate.
60. Standard & Poor’s Capital IQ.
61. Western Union 10K reports, 2007 to 2009.
62. Standard & Poor’s Capital IQ and AutoZone 10-K reports, 2002 to 2010.
63. General Motors 10-K reports, 1985 to 1995.
64. Microsoft 10-K reports, 2009 to 2010.
CHAPTER 9
Assessing the Quality of Management—Positive and Negative Traits
In Chapter 8, we looked at how management operates the business; this chapter shows you how to evaluate the positive and negative traits of the managers themselves. Many investors rely on the personality, education, and technical knowledge of a management team to assess whether they are capable of leading a business. These are important qualities, but there are far more important qualities. If you are going to invest for the long term with a management team, you’d also better think about the character and values of the people on that team. For example:
Is management passionate about operating the business?
Does the manager have integrity?
Would managers fudge accounting numbers to meet guidance?
Do managers have enough humility to acknowledge when they have made a mistake?
As you begin to evaluate the character of a manager, look for a pattern of behavior that can help you forecast future behavior. When it comes to people, the best predictor of future behavior is past behavior. You want to get an overall sense of what the manager is like. In order to do this, look at what the managers have accomplished in the past and more important, how he or she accomplished them. Published interviews are among the best sources for real insight, as are in-depth articles written about the manager. As you are reading and forming an opinion of a manager, make sure you’re getting more than just quick quotes or a few annotated quotes. If the majority of answers are captured, it’s a much stronger piece of evidence, and it reduces the likelihood that certain comments were taken out of context.
A manager’s habits and values are among the most important factors that determine whether he or she will be a success or a failure in the long term. The questions in this chapter will help you to identify the traits that are common to the best-performing managers, so that you can invest with them for the long term.
48. Does the CEO love the money or the business?
Most investors spend too much time trying to determine whether management has the right financial-incentive structure to create shareholder value rather than examining if the manager has passion for the business. External incentives, such as a large compensation package, will never be as powerful as internal motivation. Passion motivates more than money. Warren Buffett, chief executive officer (CEO) of Berkshire Hathaway, firmly believes this: When he was asked how he determines which managers to partner with, he said, “. . . the biggest question I ask myself is ‘Do they love the money or do they love the business?’”1
Why Is Passion Important?
Passion is a necessary ingredient for long-term success in business or any profession. If you have ever asked the advice of successful businesspeople on how to become successful, the most common advice you probably received was that you needed to find something you love to do and then do it. By doing what you love and getting very good at it, you’ll be happier, society will likely reward you, and the money will eventually follow. They probably counseled you to not go after a job for the money, and in fact, most people who have made a lot of money didn’t make that their primary goal. For example, when entrepreneurs create a business, they are usually following some passion. They do not say to themselves, “I want to be an entrepreneur” and then look for a business to start or acquire.
The same rule of success applies to public company CEOs and other managers: If they are not passionate about the business they are managing, they will likely do a poor job managing the business over the long term. Steve Jobs, founder of Apple, said it plainly in a commencement address to Stanford University students in 2005, “The only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle.”
The act of building a business over a number of years is slow and can be boring at times. How can CEOs be effective if they are not genuinely interested in what they are doing? CEOs and other managers who are passionate about their businesses throw themselves into their work, constantly learn from their mistakes, and they find opportunities and solutions to problems that others do not see. Passion turns into tenacity, which is a necessary ingredient for success because the rewards are often far into the future.
How Do You Identify Passion?
You can identify passion by answering the following questions:
Is the business a career or just a job for the manager?
Would the CEO refuse to sell the business, no matter what the price?
Is the manager interested in money or motivated by money?
Does the manager focus on appearances instead of the business?
What type of philanthropic endeavors is the manager involved in?
Are the managers lifelong learners who focus on continuous improvement?
Is the Business a Career or Just a Job for the Manager?
Start by asking whether the business is a career or a job for the manager. When you review the backgrounds of managers (which you can find in the proxy statement or articles written about the managers), determine whether they have remained in the same industry for a long period of time or if they jump from industry to industry. If they have remained in the same industry for a long period of time, then the odds are they enjoy their work. Look at previous positions to understand if there is consistency or a pattern in what they do.
For example, the founders of child-care provider Bright Horizons have always been passionate about helping children have the best start possible to their lives. They figured that millions of U.S. parents wanted and needed to work but could not afford high-quality child care. They decided to fill this need with Bright Horizons. A quick check of the founders’ backgrounds tells you that this husband-and-wife team also served as co-country directors in Sudan for Save the Children before founding the company. Because their background was previously in helping children, it was obvious that they were pursuing their passions.2
Would the CEO Refuse to Sell the Business, No Matter What the Price?
If someone else offered to buy the business from the CEO, how would that CEO respond? A truly passionate CEO would say the business is not for sale and would decline these overtures. In contrast, most CEOs would sell if the price was right. What if you were offered $1 billion for a business generating an estimated $50 million in revenues? Would you sell it because it was an extremely high offer?
This was the situation faced by Mark Zuckerberg, founder of online social network Facebook, in 2006 when he was courted by managers from Viacom, Yahoo, and others to buy his company. Zuckerberg continually resisted their offers and realized that he did not want to sell the business. He said he was not growing Facebook solely for the money and that no amount of money would buy his business.3 What is most interesting is not whether Zuckerberg made a good decision or not but rather that such a young person (who was only in his early 20s) was so passionate about his business that he would not sell it for $1 billion, or $10 billion for that matter.4 Zuckerberg prefers to have tight creative and financial control of the business and wants to play the game his way. The money is secondary. Zuckerberg has been quoted as saying, “We are engaged in something greater than getting rich.” This is true passion. Fast forward to 2011 and Facebook is valued between $60 billion and $75 billion.5
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