The great football manager Brian Clough once said: “Good managers make good sides. There’s no such thing as a side making a manager." Does the same apply to managers of companies?
Management is one of the most talked about issues when discussing the fortunes of a business. Some chief executives acquire cult status for their perceived ability to create great companies, but managing businesses, while it does have some similarities, is not the same as managing football clubs.
Clough was a genius. With the help of Peter Taylor, he twice took a group of football players in teams that were in the lower reaches of the English second division – Derby and Nottingham Forest – and won the first division championship with them. At Nottingham Forest, players who were playing second division football in 1975 had European Cup winners’ medals four years later. This is like a company manager taking a struggling business in the FTSE Small Cap index to the FTSE 100. It hasn’t happened very often – if at all.
There is no doubt that a talented manager can take the assets they control and probably make them better, but they are not alchemists. I doubt that Amazon’s Jeff Bezos could wield enough magic to overcome the challenging economics of industries such as steelmaking or airlines and transform them into stable, highly profitable and growing businesses.
Management does matter, however I have long held the view that some investors have the tendency to overemphasise its importance. At the end of the day it is the quality of the company’s assets and its competitive position that have the most impact on its long-term performance.
That’s not to say that a good strategy cannot work wonders and that a bad strategy can do the complete opposite. Just like a pilot in an aeroplane or a captain of a ship, you need someone competent in charge to steer it safely to its destination.
But how does a private investor go about weighing up a company’s management? Unlike professional investors and analysts, most private investors do not have easy access to management teams. Investor shows and annual general meetings (AGMs) do give some opportunities to chat with them, but how much benefit can you really get from them?
Talking to company management
In my previous career, I was privileged enough to have attended hundreds of company meetings and presentations. I have spent countless hours talking with management.
These meetings can be very useful, but you need to understand what you can and cannot get out of them.
In my experience, many investors will come away from a company meeting feeling more positive about the business than before they went in. Their chat will leave them with a perception of increased knowledge that is often mistaken for an informational edge.
In these days of fair disclosure, companies will rightly not tell you anything that they have not publicly disclosed elsewhere. You will not get an information edge over other investors from talking with company management.
What you can get – if you get enough time – is an increased understanding of how a company works, its business model, its competitive environment and its attitude to its key stakeholders, such as suppliers, employees and customers. All of this is very useful.
You can also try to gauge the character and integrity of management. Ask yourself whether you would buy a second-hand car from them or have confidence in what they say. You need to be careful here, though, as many company managers have become very slick in presenting themselves to others and making themselves likeable. This should not be mistaken for competence and the steward of a good business.
There is a risk that familiarity with management makes investors overconfident and complacent about their understanding of a business. It is for this reason that some investors choose to distance themselves and judge a company more on what it does and avoid having their judgment clouded by talking to management.
This is my preferred approach. The good news is that there is still a lot that you can do to get a feel for the management of a business without meeting them. As with many things an investor wants to find out, a lot of the answers can be found in a company's annual report if you know where to look.
Using the annual report to weigh up company management
The annual reports of a company contain plenty of places that allow you to form a view on how good a job management has been doing. I tend to concentrate on three main areas:
- Its historic financial performance.
- The strategic report.
- The directors’ report.
Let’s look at each of these in turn using real company examples.
Historic financial performance
At the end of the day, investing is all about results. When researching a company, I always concentrate on some key financial numbers and ratios to see how it has been performing. Good and improving financial performance is often a sign of good management, but not always.
You should look at a company’s financial performance over at least the past five years and also during a recession to see how resilient a business is. Regular readers of my column will know that this is a feature of my company analysis articles.
A couple of weeks ago I looked at YouGov (YOU), which showed a very healthy and improving trend in its financial performance.
YouGov: Historic financial performance
Invested Capital ex-Goodwill
ROCE ex Goodwill
Debt to FCF
Capex to Sales
Source: Company Financial Reports/Investors Chronicle
Rising revenues is a key thing to look for, but how they are being achieved is more important. A company that is selling more goods and services to existing and new customers is usually a sign of a good business that is being managed well. Companies that grow revenues by mainly buying other companies are usually considered as having lower-quality growth.
Growing revenues with improving profit margins, return on capital and free cash flow generation is an even better sign and YouGov ticks all the boxes here.
The strategic report
This is where the company makes its pitch to investors. It has the opportunity to talk at length and in detail about its business model, its markets, its future growth prospects and financial performance.
There is also a temptation to treat it like a glorified company brochure and fill it full of management spin. That said, there’s a lot you can glean from the tone of the strategic report.
In my opinion, the concept of shareholder value as the main focus of company strategy is deeply flawed. Taken to its extreme, the pursuit of profits at the expense of other stakeholders may work in the short term, but is a recipe for long-term problems.
You can see this in companies that are continually restructuring their businesses and cutting costs to keep underlying profits growing. A lot of badwill can be generated with key stakeholders in the process, which rarely serves the long-term shareholder well.
For me, outstanding businesses are created by focusing on serving their customers well. They do this by providing excellent products and service at prices that offer outstanding all round value for money. Consumer giants such as Amazon (US:AMZN) and Costco (US:COST) have made this part of their DNA and I see this as a key thing to look for when a company is talking about its business.
Kitchen supplier Howden Joinery (HWDN) is a great example of this. On page 16 of its 2019 annual report it makes the following statement:
What Howdens stands for: “To help our trade customers achieve exceptional results for their customers and to profit from doing so. When our customers succeed, we succeed.”
On page 17, it then goes on to explain its culture, which is based around being worthwhile for its trade customers, staff, suppliers, and finally its other stakeholders such as shareholders.
These are statements that sit well with me and perhaps go some way to explaining why Howden has been such a successful business over the years.
The directors’ report
The directors’ report contains lots of useful information about the senior management of a business. You can use it to learn about things such as their pay, relevant experience, shareholdings and how they are incentivised to grow the business. A close study can tell you a lot about their attitude to the business and its investors.
YouGov: Key executives' annual salary and value of shareholdings
Value of Shares at 569p
% of Salary
Source: Annual report
YouGov’s annual report tells us plenty of useful stuff in this respect. The chief executive (CEO) happens to be the founder of the business. This can be a good and a bad thing.
Founders are extremely proud of what they have created and tend to be very passionate about the business and very driven to see it improve and grow. This is a good thing, but sometimes they can be too dominant, stifle innovation and resist change.
This doesn’t look to be happening at YouGov as both the chief financial officer (CFO) and chief operating officer (COO) have been at the business for a long time. This would not be the case if the CEO was hard to get along with. High staff turnover in a business with a dominant owner should be treated with caution and seen as a warning sign.
Salaries do not look excessive and both the CEO and COO own plenty of shares. As a rough rule of thumb, executive directors should have at least 200 per cent or more of their basic salary – or working towards that – based on the value of their shareholdings. Based on the share price at the end of YouGov’s 2019 financial year, the CFO’s shareholding is very small and is not a great sign.
You should also take time to look at what the non-executives bring to the company. Do they have relevant industry experience that can help the company, or are they just box-tickers picking up a nice non-executive’s fee. One of YouGov’s non-execs is the head of corporate branding at HSBC, which would definitely bring something useful to the business.
One of the key areas of scrutiny should be any long-term incentive plan (LTIP) for the executive directors and the rewards that can be earned. You need to try to work out whether the plan is challenging enough or a case of the directors writing their own cheques.
YouGov’s 2019 LTIP is for a four-year plan between July 2019 and July 2023. The CEO can earn up to 1,200 per cent of his 2019 basic salary (£3.2m) and the others 600 per cent of basic salary in nil-cost share options if adjusted basic earnings per share (EPS) (before exceptional items) increases as a compound average annual growth rate of 35 per cent.
Adj Basic EPS
Source: Annual report
These targets are certainly very challenging. No doubt many shareholders would be delighted if EPS more than tripled in four years. After all, management has form on delivering the goods and was paid handsomely for averaging annual EPS growth of more than 25 per cent between 2014 and 2019.
However, shareholders need to be wary of EPS-linked bonus schemes like this. After all, EPS excludes share-based payments and the future dilution that comes from them. EPS can also be increased by buying companies and buying back shares. If YouGov reaches these targets largely through organic growth then management will have earned every penny of the bonuses that will pay out.
More rigorous bonus schemes have more challenging additional criteria such as ROCE and free cash flow targets. YouGov’s has a discretionary 15 per cent profit margin threshold as its only quality criteria.
You should also be mindful of bonuses linked to total shareholder returns (share price gains plus dividends received). While in theory this aligns management’s interest with how shareholders make money, it is possible for share prices to increase much faster than profits and managers to get paid in excess of what they have delivered.
Some companies reward their managers too much. If you don’t like this then there’s not much you as an outside private investor can do apart from choosing not to own the shares.
Other ways to check out a company
Annual reports are a great resource, but they can only tell you so much. A key area of further investigation is to try to get a feel for the culture of the company. Talking to customers (or being one yourself) will provide you with a great insight into how good a business is, as is talking to employees (websites such as Glassdoor can provide some interesting insights) and suppliers.
Internet forums can also be very revealing as long, as you bear in mind that you always find someone moaning about a business. This is only a warning sign if lots of people are doing so.