January 6, 2009 - "The importance of good management when picking stocks"
Summary:Bad management can kill any company. Even if a stock is trading at a good discount below its intrinsic value, bad management will find ways to destroy value over time. Don't underestimate the importance of evaluating management when making decisions of whether or not to buy stocks.
Don’t underestimate the importance of good management when picking stocks. It’s not enough to buy a cheap stock that you think trades at a comfortable margin of safety from its intrinsic value. A stock may be cheap for a reason. Bad management can consistently destroy value that will destroy the margin of safety you are investing with.
What makes a good company a good stock to invest in is what management does with retained earnings. Retained earnings is just a fancy word for the earnings the company keeps instead of distributing as dividends. For example, Warren Buffett’s Berkshire Hathaway has been so successful over the years because he uses all of Berkshire’s earnings to invest in undervalued securities. He has been able to invest earnings at an impressive 23%.
Return on Equity, ROE, measures the rate of return on return on the ownership interest of the common stock owners. It measures a firm’s efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth.
A company that has a high ROE that has done well over the years is American Express. American Express over the last decade has consistently had ROEs over 20% and as high as 37%. Given that the average American company has an ROE of 12%, American Express has had significantly above average ROEs. This consistently high ROE shows American Express has good management and is efficient at investing the company’s money.
Bad management has time and time again destroyed value in companies. Look at companies like Ford, General Motors, Citigroup, and Advanced Micro Devices. Companies that have historically had bad management have killed shareholders. All of these companies now trade in the low single digits after having once traded at glorious prices. It doesn’t matter if the company is cheap, bad management may get lucky in a given year, but over the long-term, will hurt the company they are in control of. For years, analysts said Citigroup was cheap and traded below its break up value. However, just a few months ago, Citigroup was on the verge of bankruptcy until the government bailed them out. On the other hand, companies with good management in the financial sector such as Wells Fargo, US Bancorp, and Goldman Sachs have help up relatively well. While their share prices have declined, they have held up and outperformed other companies in their sector.
Don’t underestimate the importance of management when investing. One of my favorite mutual fund managers, David Winters, looks for the trifecta in every investment: good economics of the business, good management, and cheap stock price. Remember, good management can only do so much. If good management is managing a terrible business, there is only so much they can do. You should also make sure the fundamental of the company are good, and you are investing in the company at some discount to its true value.
Monte Malhotra, Jan 6, 2009.
