Generally, when we analyze stocks, it is based on quantitative data. But everything about a company is not quantifiable. Quality of Management is one of those things which cannot be judged based on numbers alone.
Hence, before digging into the numbers, starting stock research by just observing a company is considered great. What to observe in a company? We can look at the group of people who run the business. In colloquial terms, we call those people the “Top Management” of a company.
Why these “people” are important for the company? It is because they are the drivers. Without a good management team, the company cannot be steered towards success.
Warren Buffett bestows confidence in companies that are run by competent managers. Here is what Buffett says about the importance of quality of management:
“I think you judge management by two yardsticks. One is how well they run the business, and I think you can learn a lot about that by reading about both what they’ve accomplished and what their competitors have accomplished, and seeing how they have allocated capital over time.”
– Warren Buffett
Why Quality of Management is Critical?
Shareholders of a publicly listed company are its owners. The decision taken by the management of such companies should benefit the company. If the company will benefit, it will ultimately enhance the shareholder’s value.
The decisions taken by the management drive the company to success. The qualified and experienced will be the managers, the better will be their decisions.
To make sure that the management takes only company-friendly decisions, it is important to align their priorities. This can be done by tieing incentives of the top managers with the company’s performance.
Such a management style is a way of aligning the interest of the management with that of the shareholders. Such a management team eventually takes shareholders-friendle decisions by default.
How to Analyze Quality of Management of a Company?
Analyzing the propensity of management is not easy. One of the reasons for the difficulty is that the parameters based on which analysis is done are not quantifiable. Hence the study and analysis become more theoretical.
Even experts on this topic judge the management of a company based on their qualitative factors. But I think that there are some quantifiable parameters of a business that speaks in loads about the quality of management.
Let’s know more about both quantitative and qualitative factors we can use to analyze the management of a company:
The management of a company has a responsibility. When we are talking about “Management” we are referring to the top managers. These people do not involve themselves in the day-to-day operations of the company. Their job is mostly concerning the future of the business.
In order to do this, they care more about growth, margins, resource utilization, use of capital, shareholders’ interest, etc. Most of these factors can be quantified to judge the quality of management. Let’s see how.
A company which is growing and doing it consistently has not done it ad hoc. It is the result of painstaking efforts of the whole team, more importantly, the top managers.
Management which was able to push the sales, net profit, and EPS growth of the company in the last 10 years deserve praise.
Why credit should go to the top managers? Because rendering growth is very tasking. Given a choice, the employees would like to continue doing the same things again and again. But it requires the vision and motivation of top managers to push the team to ensure growth.
#2. Resource Utilization
The management has two types of resources at their disposal, manpower and capital. Effective utilization of these two resources can take a company long-way. In this point we will talk about manpower utilization.
How to know if the the company is utilizing its manpower as per industry standards? For that we will have to take the following steps:
- Step A: Note the sales and net profit (PAT) of the company. Also, note its total permanent employees as indicated in their annual report. Calculate the ratio, Sale/Employee and PAT/Employee.
- Step B: Calculate the same two ratios of three more companies operating in the same sector as the company in Step A. Compare the ratios.
The company with the highest number (S/E-ratio) is utilizing its manpower the best.
#3. Enhanced Profitability
Only a handful of companies can claim enhanced profitability over time. It is one of the most difficult performance parameters to achieve. Why? Because the company must build an economic moat to do it. Moreover, without gaining a competitive advantage in its sector, for a company, profitability enhancement by other means is less feasible.
If profitability enhancement is in the priority list of the top manager, everyone in the company will work towards it. Cost reduction, work simplification, product development, brand promotion, etc are few ways to better profitability.
As an investor, we would like to see a company whose profitability numbers (ROE) have increased in the last 10-Yrs.
#4. Capital Allocation
There are two parts to capital allocation. First, to be aware of one’s cost of capital, and then ensuring that the return on capital employed (RoCE) is more than that. Second, ensuring that the reinvestment of profits is in line with the shareholders’ interests.
Top managers must always be aware of their cost of capital. Ensuring RoCE above this cost is critical. A management that is not able to do it, is actually destroying the wealth of its shareholders (owners).
Cost of Capital
To know about the cost of capital, please check the provided link. The company needs capital to do business. It can source capital from two avenues, equity route, and debt route. Both these routes have a cost. It must pay back its debtors a fixed interest. It must also yield the needful returns for its equity financiers (shareholders).
How to ensure that a company is able to pay its shareholders and debtors their due rewards? By comparing the cost of capital with profitability parameters like RoCE, ROE, etc.
It is important to understand why a company retains its profits (reinvestment). The objective is to use that capital for conducting the business. A business needs funds for its working capital and also for its CAPEX plans (future growth). All this is done to ultimately serve the needs of the owners (shareholders) of the company.
What is the need of the shareholders? They expect at least above-average returns. The returns could be in the form of dividends and/or share price growth.
Now suppose a company is retaining its profits, but those profits are not getting converted into either dividend income or price appreciation. What do you think, shareholders would like such a company (management)? Absolutely not.
One way of checking if the reinvested money is rendering to the needs of the owners is to compare equity growth with dividend and price growth.
#5. Promoters Stake
The high stake of promoters in a company is one indirect indicator that its management will be “shareholder’s friendly”. If not, then promoters have the power to change them. So as an investor, we should look for companies where the promoters stake is high (like 50% or more).
How the promoters stake has changed over time must also be taken in consideration. Increasing promoters stake is a confidence booster for the shareholders. Whereas, if the stake is decreasing, questions must be asked.
Who are the promoters? In the “Shareholding Pattern” section of the annual report, the company is obliged to declare the holdings of their promoters. Here, they also declare their names.
#6. Dividend Affordability
There are many dividend-paying companies in the stock market. Shareholders do not mind holding on to their stocks for the long term. But they also like short-term gains in terms of trickling dividends.
The decision of dividend payment is taken by the top manager (Board of Directors) of a company. It will be interesting to check if the company has dividend-paying affordability, or it is doing so to fool its shareholders.
How to do this check? By comparing net profit (PAT) reported vs total dividend distributed. If the company is paying more dividend than its PAT, it is a questionable action. If a management does it time and again, it does not show them in a good light.
You can see, our example company was paying 66-95% of its PAT as dividend to shareholders. These are high payout numbers, but we cannot criticize management based on high dividend payout.
But in the period between Mar’12 and Mar’21, the share price of the company rose at a dismal rate of 4.3% per annum. When share was not doing so well, we can ask, why the management was paying so high dividends. They could have retained the cash and made the stock stronger.
#7. Remuneration of Management
Chairman, CEO, CFO, etc top managers of a company do get paid handsomely. There is no problem with that. The kind of responsibilities they have on their shoulders, they must get properly compensated.
But it becomes a problem when they are being compensated irrespective of the company’s bad performance. Hence, often a part of their salary is tied to the performance of the company.
In the above example, it can be seen that between Mar’12 and Mar’16 (5-Years), EPS of the company was continuously falling (reduced by 60%). But in the same duration, its CEO’s salary grew by almost 25%.
#8. Shares Buyback
Whenever the management takes a decision to buyback its shares from the market, its says two things about them:
- First, the decision of buyback goes in favor of the existing shareholders. This is one nice way of utilizing the accumulated reserves of the company. It immediately affects the stock price. For good companies, shares buyback is welcomed.
- Second, a company buys back shares only when it thinks that it is trading at undervalued price levels. The management of a company that is also tracking the intrinsic value of its business can take the buyback call wisely. Tracking intrinsic value is not so easy. So management which is doing so must be good.
Tracking the numbers of shares outstanding of a company will give an idea about shares buyback. Increasing shares outstanding numbers is not good for shareholders. Decreasing shares outstanding numbers is a positive sign.
#9. Manipulation in Books of Accounts
It is almost impossible for a retail investor to find if the books of accounts of a company are cooked or not. Please note that a company can manipulate its accounts without crossing the line of legality. So, external help will be needed.
One of the better metrics that can be used here is James Montier’s C-score. For Indian companies as well, their C-score is published. The companies are rated based on 9 parameters. If a company gets a score of 4 or above, it is a hint of manipulation happening in the accounts.
The responsibility of manipulation of company’s financial records sits straight with its top managers.
#1. Management Discussion & Analysis (MD&A)
MD&A is a portion of the annual report which is published right at the beginning. In this section, the top management presents its analysis of the company’s past performances (mostly last 1-Yr).
For me personally, this section of the report is one of my favorites. There are some company’s who do a realistic analysis of their performance. But some tend to be more boastful. Just reading this section repeatedly, it gives an insight into the minds of the company’s management.
Not only this, but it also gives a peep inside the minds of people (like the Chairman, MD, CEO, CFO, Directors, etc) who are running the company. In this section, the company declares its goals, future plans, CAPEX initiatives among other things.
#2 Related Party Transactions
This is another portion of the annual report which cannot be missed. We have heard about people siphoning the company’s money to outside. They take bank loans in the name of the company and then do not use them for the company. They divert that money elsewhere.
Generally, the money is diverted among group companies, promoters, etc. Though such transactions are not illegal at the outset, a case of conflict of interest is possible. Hence it is mandatory for companies to file all such transactions in the annual report.
Look for companies that are neck-deep in debt. Then, open their annual report and go to the section (Related Party Transactions). For good companies, that section is mostly blank.
But accounts of dodgy companies are comparatively more loaded here. Transactions like loans to promoters, directors, group companies, etc are not acceptable. Moreover, if these loans are low-interest bearing, it becomes questionable.
Sometimes a company may also take high-interest-bearing loans from its promoters or group companies. This is also a doubtful deal. There are also examples of the company selling their assets to their promoters or group companies at hugely discounted prices.
Idea is to keep an eye on such transactions. Check if those are one-off examples or they are appearing there time and again.
[P.Note: Dividends paid to promoters, commissions paid to the sitting directors of the board who are also the company’s promoters qualify as a legitimate transaction.]
#3. Tenure of the Management
People who administer a company do come and go. When good managers come in, it benefits the company and vice versa. But the top managers of the company like Chairman, Managing Director/CEO, CFO, etc must be a stable group.
As an investor, we would not like to see frequent changes in this group. When a company is not doing well, even these people change.
Download the last 10-Yr annual reports of a company. Check who are the people in the helm of affairs, and since how long they have maintained that position.
Example, when MD/CEO, CFO, etc of a company changes every 5 years, it is not a good sign.
Analyzing the quality of management of a company is not so easy. It can become subjective, and different analysts may see it differently. This is one reason why I thought to approach this subject in a more analytical way. I try to quantify the parameters based on which the management can be judged. This way, it reduces the room for subjective interpretation.
In my stock analysis worksheet, I’ve tried to incorporate some of these points. It helps the worksheet to give a score for the quality of management of the company.
Sometimes, few readers question my worksheet’s score on management. This particularly happens when they see a low score for group companies like Tata’s. We often confuse between ethics and good performance. Ethical management does not always translate into good governance. Also, only a couple of years of good or bad performance does not make management great or dull.
I’ll like to sum-up the subject with a very apt lines from Warren Buffett:
“You want to figure out … how well that they treat their owners,” he said. “Read the proxy statements, see what they think of — see how they treat themselves versus how they treat the shareholders. … The poor managers also turn out to be the ones that really don’t think that much about the shareholders, too. The two often go hand in hand.”