Five criteria to assess a company’s management

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06/28/2019 | 12:53 am
Basically, when a shareholder invests in a company, he or she trusts that company’s management with their capital.
As such, shareholders give the management a mandate to make that capital flourish, either by increasing the value of the equity via skillful management of that equity or by paying them the generated profits in dividends. Or, under certain circumstances, via share buybacks. 

This is why it’s essential for minority shareholders who are thinking of investing to carefully assess the quality of the management in charge - meaning their competence, their dynamism and their integrity - the same way a majority shareholder would exercise their control rights to select the best team to run their company.

The following five criteria are meant to help with this. However, it’s important to keep in mind that this isn’t an exact science: not seldom a company’s management ticks all the right boxes on paper and still leads its shareholders down a disastrous path; just like some management teams that look dodgy on paper can sometimes create huge value.  
 
Basically, the difficulty is the same as when you hire an employee, an associate or a management team: as much as we want to make sure to do everything right, there always is a part of the equation that remains unknown and risky - without even talking about a simple error of judgment.

On paper there are, thus, the following five selection criteria for a company’s management:  

One, in its various announcements/speaking engagements (letters, annual reports, conference calls, etc.), the management openly recognises the problems the company is dealing with, talks honestly about them, advances out in the open, and avoids the pitfalls of outrageously promotional communication to the shareholders. Check out our article A hint of scandal in that regard.   

In fairness, this kind of transparency policy isn’t always easy to adopt, because the company’s leaders are responsible for the value of the capital that the shareholders trust them with. This means that a too ‘honest’ kind of communication could lead to a fall of the share price or even comprise the company’s access to funding and lead to potential prosecution or layoffs.  

Two, the management isn’t overpaid and, ideally, a large part of their remuneration is variable - meaning indexed on their performance - rather than fixed. Examples of incompetent and yet generously paid management teams - paid by shareholders who don’t pay much attention - are plenty, especially in large companies. 

It’s essential here to assess the details about the variable remuneration (like the stock option threshold, and by extension their dilutive effect) as well as the set objectives: for example, a simple growth of the turnover is a strong incentive to make acquisitions that are potentially value destructing; along the same lines, the temptation to buy back shares of the company without taking its valuation into consideration is almost irresistible when the payment of the variable remuneration mainly stems from the profit per share…. 

Three, the past performance of the management - measured in terms of the growth of the equity, the profit per share and other payments to the shareholders - seems satisfying and is above the market average. However, even with solid analytical competencies, it’s difficult here to evaluate precisely what the return of the various growth investments made is.
 
To keep it simple, we’ll try to check that the margin profile remains well defended as the turnover grows while the different investments in fixed assets (capex) and in acquisitions generate a sharp rise of the consolidated profit.

Four, the company generates a free cash flow, meaning above the accounting results, profits in cold hard cash. To measure the cash profit, we have to focus on the cash flow rather than the income statement and subtract the short and long term investments in the working capital from the cash from the operations while verifying the legitimacy of the latter.

Then we have to subtract from this first result the amounts invested in acquisitions, if there have been any. Then we can clearly see how much cash came in, how much went out, and especially what it has been used for: we can then calculate how much there is left at the end of the year, ready to be paid to the shareholders if necessary - this is the company’s free cash flow, to be compared with the accounting result which in turn is impacted by significant so-called ‘non cash’ adjustments like the depreciations or the revaluation of participations. Check out our article Accounting profit vs. free cash flow in that regard.  

Five, the capital returns to the shareholders are opportunistic and decided at appropriate times. Therefore, the excess capital is returned via dividends or share buy backs, without these distributions compromising the future of the company, for example by emptying the reserves that could turn out to be very useful when times are tough, or when the company would need to auto finance a strategic acquisition.

A final note on share buybacks: while they represent an optimal capital allocation when the shares seem undervalued by the market, they can also be dangerous if they are done when said shares trade at high valuations. 

Neelie Verlinden
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