How Can You Differentiate between Good and Bad Managements?

A reader of The Safal Niveshak Post asked this question after reading yesterday’s post on companies taking minority investors for granted – “How can we (retail investors) differentiate between good and bad managements?”

This is a very important question, because assessing management quality isn’t an easy thing to do as compared to studying a company’s past financial performance and concluding whether it has been good or bad.

In other words, you can’t put a numerical value to a company’s management. You can create any specific metric to measure its quality.

What I consider ‘good’ management might be ‘bad’ management in your eyes. So the response to the question – whether the management is good or bad – is very subjective.

Here is the fourteenth lesson of the Value Investing for Smart People Course that answers this very question.

Let me know if you have any further doubts after reading this lesson, and I’ll be happy to clarify.

In the original version of The Intelligent Investor, Ben Graham began his discussion of a chapter on “The Investor as Business Owner” by pointing out that, in theory…

…the stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will.

But he changed this part in the subsequent editions of the book.

In practice, says Graham…

…the shareholders are a complete washout. As a class they show neither intelligence nor alertness. They vote in sheeplike fashion for whatever the management recommends and no matter how poor the management’s record of accomplishment may be.

The only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him.

Well, this is a fact that is true for not just American shareholders, but all shareholders.

Ask yourself these two questions if you have been an investor in stocks in the past –

1. How many times have I disliked what the management of a company was doing?
2. How many times have I communicated my dislike to the company’s management?

For most investors, the answer to the first question will be ‘never’. And that will automatically make the answer to the second question ‘never’ as well.

What’re your answers?

You’ve ‘bought’ the stock. But do you ‘own’ it?
You buy a house, and you own it. It’s your private property.

The same goes with anything else you buy – car, television, timeshare holidays etc. You buy them, and you own them.

But when it comes to stocks, do you really ‘own’ the stocks you hold in your portfolio?

Ownership means that we don’t allow anyone else to do anything with what we own without our permission.

Ownership means keeping a keen eye on things happening around what we own.

Ownership means if someone is acting smart to play around with what you own, you have all the right to chide him away.

And if that is what ownership of a stock means, you must know that…

1. The company’s managers, all the way up to the CEO, work for you.
2. The company’s board of directors must answer to you.
3. The company’s cash belongs to you.
4. The company’s businesses are your property.
5. If you don’t like how the company is being managed, you have the right to demand that the managers be fired, the directors be changed, or the property be sold.

But for that, you need to know that you ‘own’ the company via its stock. And if not, you should wake up and know your rights as a shareholder.

As Graham suggests, “There is just as much reason to exercise care and judgment in being as in becoming a stockholder.” This suggestion is something very basic but incredibly important.

How to ‘own’ your stock?
Just be aware of your rights as a shareholder, raise your voice if you find something fishy…and you’ll know that you own the stock.

Graham suggests that there just two basic questions to which shareholders should turn their attention:

1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?

The first question can be answered by the company’s past financial performance.

1. Has the company grown its sales at a steady pace in the past?
2. Has it generated good profitability and cash flows in the past?
3. Has it shared profits with shareholders in the form of dividends?
4. Has it been able to earn return on capital over and above its cost of capital?
5. Has it gotten too aggressive in past to make faulty acquisitions by taking high debt and thereby risking the quality of the balance sheet?

‘Yes’ to the first four questions and ‘No’ to the last question would mean that the management has been reasonably efficient in running the company.

And if the answer is ‘No’ to most or all of the first four questions and/or ‘Yes’ to the last question, you will know that the management has been inefficient.

So what can an investor do if the management has been inefficient?

The answer is two pronged:

1. If you own a major stake in the company, you can call for a change in the management.
2. If you just own a few shares in the company (and thus a minority shareholder), the best option you have is to sell your stock immediately.

But remember this – you can take either of these decisions only if you know how the company and its management have done in the past. And you can know that only if you have read its annual reports.

So, read! Read the annual reports of the company you ‘own’.

• Read the Chairman’s report to know his vision.
• Read the management discussion on the annual performance and the risks it foresees in the future.
• Read to find out if the management is taking the blame of a year of poor performance. Or whether it is laying the blame of everything else – like a global crisis, or a domestic crisis.
• Read the financial statements to find out big changes over the previous year.
• Read the schedules and notes after the financial statements to really understand what the company is up to.
• Read the qualifications and background of the independent directors – you don’t want mute spectators as people approving all management decisions.

In short, be open-minded and read diligently about the company you own.

I know this is hard work, but then do you expect just luck to help you become a smarter and successful investor?

Also, if you do what I mentioned above (read the annual reports), you’ll be better than 99% of all shareholders out there.

This will help you become intelligent, cautious, and thereby truly successful as an investor.

P.S.: This is the fourteenth lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor. If you haven’t already, sign up for the course here.