In our third installment in our value investing series, we’re looking at the importance of management. Even great companies can sometimes suffer from poor management.
As an investor, it’s essential to look at a company’s top executives to discern if they are worth the investment.
The First Two Principles of Value Investing
In earlier podcasts, we talked about Charlie Munger’s first two principles of value investing. For clarity’s sake, we will list them:
- Invest in a business you are capable of understanding.
- Invest in a business with a competitive advantage.
Value investors don’t get consumed by emotion. They invest rationally. Therefore, even if they see a stock climbing in a business they know nothing about, they don’t touch it.
Now, if you can research and understand them, that’s another thing entirely.
Value investors also look for companies with a competitive edge. It’s sometimes referred to as a moat.
Why does a business need a moat? Business is cutthroat. When an idea is tested and proven, other businesses take notice and play the role of the copycat. Without a competitive advantage, other businesses will storm the moat.
So businesses must have a competitive advantage that keeps them ahead of those who seek to copy them.
Remember, top value investors like Charlie Munger and Warren Buffet don’t buy stock in a company unless they are willing to hold it for ten years or more.
With the first two principles out of the way, let’s focus on the third principle: management.
The Third Principle: The Company’s Management Has Integrity and Talent
You may notice that this principle is in alignment with the first two principles. We want to know about the business, yes. We also want to know they have a competitive advantage.
However, we also want to know where the company is headed, and that falls squarely on management. Here are some ways you can determine if the top executives of a company are worth the investment.
Can the Company Withstand Human Error?
Even the greatest of business sometimes wind up under the wrong management. You want to invest in a company that can withstand human error.
Said another way, you want a business that can survive bad management periods. Can a company do well despite poor management at times? That’s the question we’re seeking to answer.
Research the Founder and CEO
Who is the founder? What’s their story? What is their previous experience in business?
If the founder isn’t running the business, who is the CEO? What is their experience? How have they managed businesses in the past? You may want to research their management style.
What do their employees think of the CEO? The more you know about the company’s top executives, the more rational you can be when investing.
Look at the Company’s Board of Directors
Most importantly, you want to know who is on the board of directors. Who is the chairman of the board? Is it the CEO, or is it someone different?
Are the Founder or CEO Invested in the Company?
If you had to choose between a founder who owns significant shares of their own company or one that didn’t, which would you invest in?
Seems a fair question, right? If the founder is not invested in their own company, that could be a sure sign of a company that may not be worth the investment.
If the CEO is running the company, do they own large shares in the company, or are they more of a hired gun? These are important questions to consider.
Companies will release annual letters that you can research. They are shareholder letters. Shareholder letters provide information about the company’s goals and initiatives.
You can look back at old shareholder letters to see if they met their initiatives and goals. If they met their goals and initiatives, how successful were they?
Looking at a company’s success rate with meeting company-wide objectives and goals is valuable information. You can usually find shareholder letters on the company’s website.
Understanding Corporate Structure
There are essentially two tiers in management—the board of directors and the management team.
Board of Directors
The board of directors comprises people from within the organization. Sometimes these can be people in the management team, such as a CEO or CFO.
Then there are people on the board that are from outside the organization. These unbiased individuals come from different backgrounds and business experiences. They protect the shareholder’s interests.
When investing in a company, you want a board with members from diverse backgrounds, cultures, and genders. That’s because they reflect society better.
We often hear about the Chief Executive Officer. The CEO is at the top of the management hierarchy. They report to the board of directors. They are responsible for implementing the goals and initiatives of the board.
The COO or the Chief Operating Officer handles the day-to-day business, like marketing and sales. They will report to the CEO.
Then we have the CFO who analyze the company’s financial data. They report to the CEO, the board, and the SEC. They will report on financial performance, budgets and monitors expenses.
Value Investing Is About Rational Thinking, Not Emotion
While you can’t control who sits on the board of directors or the management team, understanding the top executives within a company is important to research for value investing.
Used in tandem with the first two principles, they offer a clear picture of a business as a whole. That clarity offers us a chance to use our rational mind when evaluating the business.
To go back and learn more about the first two principles, please check our blog. In our next installment of the value investing series, we’ll be discussing the final principle: price.
It is one of the most important principles. You won’t want to miss it!
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