The Investment Checklist

by Michael Shearn

  51. Does management think independently and remain unswayed by what others in their industry are doing?

  One of the toughest challenges a manager faces is to look at all of the profits that competitors are earning and not be tempted to copy that success. Sometimes these profits may be earned from unsustainable sources.

  For example, Jamie Dimon, CEO of J.P. Morgan, did not follow his reckless competitors as they chased poor-quality mortgage-backed securities in search of higher fees. At the time, most of J.P. Morgan’s shareholders complained that Dimon was being too conservative and that he was passing up the chance to make millions of dollars in profits. However, when the financial crisis of 2009 put some of his competitors out of business, Dimon was one of few CEOs who managed to both weather the storm and strengthen his business during this time of distress.

  Shareholders will often attempt to influence managers to maximize short-term profits. The best managers always maintain a long-term focus, which means that they are often building for years before they see concrete results. For example, in 2009, Jeff Bezos, founder of online retailer Amazon.com, talked about the way that some investors congratulate Amazon.com on success in a single reporting period. “I always tell people, if we have a good quarter, it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.”21

  Another example of long-term thinking is how Howard Schultz runs Starbucks. For many years, investors have said that Starbucks should undo its company-owned stores and franchise them instead, because this would significantly increase the amount of free-cash flow that Starbucks could generate and would improve the return on capital. Although it is a good argument economically, Schultz has continually refused to franchise Starbuck’s stores. He believes that this act would fracture the customer-service culture of the company, which is central to Starbuck’s success. He is therefore managing the business for its long-term interests and has demonstrated the ability to think independently.22

  Another way to determine if managers think independently is to see if they continually benchmark themselves against their competitors or if they try to copy the past success of competitors. It is difficult to copy someone else’s success, and when a business tries to copy what it believes makes a competitor successful, it may be a sign that the management team does not have a sound plan for the business.

  For example, during the tech boom of 1998 to 2000, I remember people trying to come up with tech-based concepts that would make them rich. Most of these people did not think about meeting customer needs; instead, they were trying to copy the success of others. More recently, investors have started hedge funds in hopes of hitting it big. What they fail to realize is that many of the billionaire hedge fund managers today did not explicitly set out to create large funds. It was an unintended consequence of being at the right place at the right time, which is something that cannot be fabricated.

  Similarly, when a Las Vegas casino had a great degree of success luring Japanese gamblers to its baccarat room, competitors tried to copy what they thought was the reason for the success: They spent millions of dollars building larger and more elaborate baccarat rooms and offered more services to lure these Japanese gamblers. For a short while, the Japanese gamblers visited the rival casinos, but they always came back to the original casino. The competitors became even more frustrated and continued to invest millions more, without any success. The reason that particular casino was successful is that the manager took the time to learn the language and culture of these Japanese gamblers. He was in the best position to understand how they thought and what they wanted. The rival casino businesses could not duplicate this because they had only copied what they could see. This should have served as a warning signal that the rival casinos did not have a sound plan of their own focusing on what they did best. Therefore, look out for those businesses that are announcing similar products or services just because their competitors have been successful.

  52. Is the CEO self-promoting?

  You need to be careful about investing in businesses run by CEOs who are self-promoting or those with larger-than-life personalities. These are CEOs who are often popularized in the media and consistently show up on business magazine covers because they are announcing headline-grabbing growth projections or transformational news. These CEOs make themselves the brand rather than the business.

  You can identify these CEOs easily because they brag about their accomplishments and are often well-rehearsed, articulate, and enthusiastic. In other words, they focus on a great pitch. They also are usually:

  Flamboyant.

  Have lots of charisma.

  Engage in aggressive salesmanship.

  Tend to command the center of attention.

  Take over discussions.

  Have an attitude that they are smarter than everybody else.

  Most of the time, these traits mask underlying issues.

  Most corporate boards choose these strong-willed, egotistical CEOs because they believe that this type of CEO will be able to meet difficult challenges. However, although these CEOs are good at selling themselves, they often bring many problems to a business because they spend an inordinate amount of time managing to Wall Street’s expectations, at the expense of the company’s day-to-day business.

  Another way to identify these types of CEOs is to monitor how much time they spend attending investor conferences that are sponsored by Wall Street sell-side research firms to promote their businesses. Look on the website of the business in the investor relations section, and identify how many Wall Street events the CEO, chief financial officer (CFO), or other managers are attending. If they are present more than two to four times per month, then you are likely dealing with a promotional CEO who is trying to increase the company’s stock price.

  As always, there are exceptions for CEOs promoting the business. If the business is dependent on Wall Street to finance its expansion, then it is necessary to generate investor interest. Many businesses issue debt or equity to expand their business or for acquisitions. For example, if they are attending high-yield conferences to generate investor interest in a debt offering, then this is a necessary function for the management team. Instead, watch out for those CEOs that are touting the stock and who do not need Wall Street to finance their businesses.

  Other ways CEOs can promote their stock is by spending a lot of time talking with TV outlets and other press. If you see CEOs who are constantly in the financial press, then it is highly likely they are just there to bring attention to their companies’ stock. Be cautious of CEOs who focus solely on the stock price. Most investors believe this is a good sign, but it is not.

  For example, in telecommunications company WorldCom’s 1998 annual report, CEO Bernard Ebbers bragged about a 132 percent increase in income and a 137 percent increase in stock price, and he promised to continue both trends. In 1997, Ebbers told a reporter, “Our goal is not to capture market share or be global. Our goal is to be the No. 1 stock on Wall Street.”23 This statement alone should have caused you to sell your stock. Ebbers was using his company’s high stock price to make multiple acquisitions, such as telecommunications company MCI; in fact, he made more than 75 acquisitions. How prominent did WorldCom become? WorldCom eventually (and famously) went bankrupt, and Ebbers was convicted of fraud and conspiracy related to accounting fraud.

  Some of the Best-Performing CEOs Are Unknown and Do Not Promote

  Some of the best CEOs are collegial, team oriented, and soft spoken, and they are able to gain the confidence of their employees. In fact, many CEOs who have compiled the greatest long-term records of creating wealth are relatively unknown and don’t self-promote, such as Yun Jong-Yong, who was CEO of South Korea’s Samsung Electronics from 1996 to 2008. Yun transformed Samsung from a maker of commoditized memory chips and other commoditized products to a company that designed innovative digital products, such as cutting-edge cell phones. The opposite of the self-promoter, Yun refused many int
erviews. Instead, he let the results speak for themselves as Samsung Electronics gained $127 billion in market value under his tenure.24

  The management teams of some of the best-compounding stocks from 2000 to 2010 spend very little time meeting with Wall Street—for example, Four Seasons Hotels, Strayer Education, Whole Foods Market, Morningstar, and Expeditors International. Instead of simply meeting with analysts each quarter, the management teams at Expeditors International and Morningstar ask shareholders to email or write their questions, and then they answer these questions in a publicly released form 8-K so all the shareholders can read their responses. Issadore Sharp, founder of Four Seasons Hotels, did not typically meet with analysts and was not available on the quarterly conference call. I once tracked him down at a hotel and asked him why he did not meet with analysts, and he said that he would rather spend time with his employees. He said, “I can spend an hour with you and you might own my stock for a year and then sell it, or I can use that time with the housekeeping staff who could potentially stay at this business for more than 20 years.”

  Key Points to Keep in Mind

  When it comes to people, the best predictor of future behavior is past behavior.

  Passion motivates more than money.

  You gain more insight into management when conditions are adverse than you do when circumstances are ideal.

  The best managers to invest with are those who quickly and openly communicate how they are thinking about problems and outline how they are going to solve them. They communicate things as they are and do not attempt to manipulate information.

  The more transparent management is about the business, the more accountable they are. In contrast, whenever managers make something complex, they may be concealing risk taking or bad judgment.

  CEOs that focus on their stock price aren’t focused on their business.

  Some of the best CEOs are collegial, team oriented, and soft spoken.

  1. Varchaver, Nicholas. “Buffett Goes to Wharton.” CNN Money. May 2, 2008. http://money.cnn.com.

  2. “The Best Advice I Ever Got.” Linda Mason, Chairman and Founder Bright Horizons Family Solutions, interviewed by Daisy Wademan Dowling, Harvard Business Review, September 2008.

  3. Tapscott, Don. “Changing the World, One Friend at a Time.” Globe and Mail, July 3, 2010.

  4. Vascellaro, Jessica. “Facebook CEO in No Rush to ‘Friend’ Wall Street.” Wall Street Journal, March 4, 2010.

  5. Efrati, Amir, and Pui-Wing Tam. “Facebook Share Clamor Heats Up.” Wall Street Journal, March 17, 2011.

  6. Interview with Dave and Sherry Gold, May 2010.

  7. Sparks, Debra. “Conseco’s Morning After.” BusinessWeek, June 5, 2000.

  8. Porter, Jane, and Alina Dizik. “Make That ‘Dr. Chainsaw,’” BusinessWeek, September 11, 2007.

  9. Bloomberg, Michael. Bloomberg by Bloomberg. Upper Saddle River, NJ: John Wiley and Sons, 2001, pp. 62–64.

  10. Lynn, Matthew. “The Fallen King of Finland.” BusinessWeek, September 20–26, 2010.

  11. Coffey, Brendan. “Every Penny Counts; Selling Everything for 99 Cents Made Dave Gold Rich.” Forbes, September 30, 2002.

  12. Kelly, Kate. “Bear CEO’s Handling of Crisis Raises Issues.” Wall Street Journal, November 1, 2007.

  13. McNish, Jacquie. “Brookfield Begins to Rebuild: Firm Mends its Office Towers, Reputation.” Globe and Mail, September 24, 2001.

  14. Daly, John. “The Toughest SOBs in Business.” Globe and Mail, January 31, 2003.

  15. Ignatius, “Mistakes.”

  16. “Dot-com job: As InfoSpace Stock Collapses, Insiders Cash Out.” Seattle Times, Knight Ridder/Tribune Business News, March 7, 2005.

  17. Rittenhouse, L.J. Do Business with People You Can Trust: Balancing Profits and Principles. New York: and Beyond Communications, 2002.

  18. “Reuters Shares Rise on Upbeat Revenue Statement.” Reuters News, October 8, 2004.

  19. Larsen, Peter Thal. “Griffin Mining.” Financial Times, February 21, 2006.

  20. Howell, Martin. Predators and Profits: 100+ Ways for Investors to Protect Their Nest Eggs. Upper Saddle River, NJ: Prentice Hall, 2003, pp. 44–45.

  21. Lyons, Daniel. “The Interviews: Books (Jeff Bezos).” Newsweek, December 28, 2009.

  22. Ignatius, “Mistakes.”

  23. Barrett, Amy, and Peter Elstrom. “Making WorldCom Live Up to Its Name.” BusinessWeek, July 14, 1997.

  24. Hansen, Morten T., Herminia Ibarra, and Urs Peyer. “The Best-Performing CEOs in the World.” Harvard Business Review, January–February 2010.

  CHAPTER 10

  Evaluating Growth Opportunities

  Businesses that are growing profitably create a lot of value. The main advantage of investing in a growing business is that you can receive the benefits of tax-deferred compounding. This is due to the fact that you can hold onto the stock for a long period of time without having to sell it. This advantage has formed the basis of success for many long-term investors, most notably Warren Buffett.

  Growth does carry many risks. There is uncertainty about any company’s future, but when you purchase growing companies, you are generally paying for future growth as well as current cash flow and profitability. This requires you to determine whether growth can continue, for how long, and at what rate.

  This chapter is intended to help you reduce the uncertainty of investing in businesses that are growing. Let’s begin by looking at how a company is growing.

  53. Does the business grow through mergers and acquisitions (M&A), or does it grow organically?

  You can answer this question by viewing the cash flow statement found in the 10-K. In the Investing section of the cash flow statement, there is a subsection titled Acquisitions. Calculate the percentage of cash flow from operations spent on acquisitions for the last 5 to 10 years. Depending on the percentage spent on acquisitions, a business can be classified along a continuum of growth styles. On one end would be those businesses that grow organically. On the other end would be serial acquirers. Selective acquirers belong somewhere in the middle. For example, compare the following companies:

  For-profit education business Strayer Education has not made any acquisitions, but has been growing steadily for many years. Businesses that grow organically are typically not paying a premium price to acquire additional customers. They also don’t have to worry about spending their time integrating a new business and its employees into their own operations.

  Medtronic, a medical-device manufacturer, made acquisitions in 2002, 2008, and 2009 and is considered a selective acquirer. Selective acquirers typically are not growing to achieve scale, but make purchases to expand their existing product lines. This way they do not have to spend valuable time attempting to gain expertise in new areas.

  Stericycle, a medical-disposal business, is a serial acquirer that regularly spends from 30 percent to 150 percent of its cash flow from operations on acquisitions each year. The potential risks to a serial acquirer are paying too much for a business or putting too much debt on the balance sheet.

  These are the three basic ways that management can grow the business, and each can be successful. But there is decidedly more risk associated with acquisitions, including taking on too much debt, overpaying for an acquisition, or difficulty integrating the target company.

  Make Sure You Place Growth in Context to Revenues

  You must always place growth in context to the existing revenues of a business. Many management teams will highlight the growth of a certain division, such as one that is growing 50 percent a year, yet that division may represent only 1 percent of the company’s total revenues. Therefore, this high growth rate will not materially increase the intrinsic value of the business.

  54. What is the management team’s motivation to grow the business?

  There is often pressure on management teams to grow their business, because top-line growth can increase the stock price. This pressure can cause senior managers to make mistakes, especially i
f the growth of the core business slows and they seek growth by launching new initiatives or by making acquisitions in unrelated business lines. Many of these new ventures and acquisitions may fail, and management will spend valuable time selling or closing them. You should become especially concerned whenever management launches new growth initiatives outside of its core business, which increases the probability that management is about to make a mistake.

  For example, when Jack Greenberg became the fourth CEO of McDonald’s in 1999, growth at McDonald’s began to slow as international markets matured and concerns about fatty foods in the United States hurt consumption. Greenberg announced that he would focus on improving the core business, but at the same time, he would pursue new platforms for growth by acquiring other restaurant businesses such as Chipotle, the Mexican food restaurant chain. The result of this growth initiative was that in 2001, McDonald’s announced a quarterly loss for the first time in its history. With the core business still deteriorating, Greenberg resigned. During Greenberg’s tenure, the stock price dropped from $45 per share when he joined the business in May 1999 to $15 per share on December 31, 2002, when he announced his retirement.1

  McDonald’s then announced that James Cantalupo, who had spent 28 years at McDonald’s, would become CEO. Cantalupo’s first announcement was that McDonald’s was trying to do too many things, and he sold or closed most of the prior acquisitions that were made under Greenberg’s tenure. The stock price has since increased from $15 per share at the end of 2002 to more than $70 per share on December 31, 2010, as McDonald’s has renewed its focus on its core business.2

  55. Has historical growth been profitable and will it continue?

  In order for growth to add value to a business, it must be profitable. Growth often fails to translate into profits.

  For example, the solar energy industry is growing quickly, but as of 2009, solar panels that are made of silicone produce energy at a much higher cost than conventional methods. Therefore, even though the industry is growing, it is not growing profitably.