Smart Investor: you're no Buffett, so ignore company management

The performance of a company tells you all you need to know about the quality of its management, says Smart Investor.

Warren Buffett is well known for the store he sets in good management. In fact, he views it as one of the most important factors when deciding whether to invest in a company. He believes that a fundamentally sound company with an economic moat, economic goodwill and capable management is a worthwhile investment as long as the shares are traded at a reasonable rate.

Sizing up management

But how can you, the investor, assess the capability of a firm's management and their value to the business? Is there a simple method to judge management ability that provides a reasonably accurate guide of how successfully they will run the business in future?

Fund managers and financial services professionals often say that meeting management face-to-face is the best way to judge their ability. This, they claim, allows them to ‘see the whites of their eyes’ and to ask probing questions, allowing them to gain a feel for how the management thinks, acts and reacts to various scenarios.

Appearance and reality

Sounds good, but there are two obvious problems. First, as a private investor you are unlikely to have the opportunity to meet the senior management of a FTSE 350 firm and, more importantly, the idea's flawed anyway.

This is because any meeting will not be an accurate snapshot of management as it exists in the business, but will rather be a presentation. This means that the management is not being assessed on how they manage, but on their presentation skills, their people skills and, to an extent, whether they 'talk the talk'.

Thus an outstanding manager who is not particularly slick can often come across poorly, just as a poor manager who is a great talker can come across well. I know which one I would rather invest in.

Style over content

Another way to assess the ability of management is to read their statements in annual reports, interims and trading updates etc. These often go into quite substantial detail regarding the past performance of the company and the reasons why decisions were made. One of the problems with this assessment method is that once again presentation can have more sway than content. 

A statement from the CEO/CFO tells you very little about whether they are particularly skilled or not. In their summary they may take undeserved credit for successes and try to explain their way out of poor performance. As with a meeting, it is all too easy to be sold a story by a slick presenter.

In my opinion, the best way to judge management ability is simply to look at the performance of the company in terms of profitability and financial soundness. A good manager will run a highly profitable, financially sound company. A poor manager will not. The ability of management will, over the medium to long run, be reflected in a company’s accounts.

Don't 'double count' management skill

In addition, there is often a tendency to ‘double count’ the ability of management. If the value of a manager is fully reflected in a company’s balance sheet, why then pay extra for a manager who you think is particularly skilled? If you think to yourself ‘I will pay an extra 10% above a company’s intrinsic value because the CEO has performed well in the past’, you are essentially paying twice: once for a higher intrinsic value resulting from the company performing well, and again for the premium above and beyond intrinsic value.

It's certainly worthwhile to question whether assessing management quality is worthwhile at all. If a company has a strong balance sheet containing assets from which it can generate a decent return on equity then, in time, the company will almost inevitably find the right person to lead it. Although somewhat fatalistic, experience shows that this is often the case.