Evaluating Management

June 2018

Have you ever gone on a date? Have you ever interviewed someone for a job? Have you ever done both at the same time? (Let’s ignore the HR implications of this scenario.)

Professional investors often find themselves in situations that are a hybrid between a date and an interview. When meeting the management team of a public company for the first time, an investor must strive to evaluate the qualifications of the executives. Do they invest wisely in new initiatives? Do they have a deep understanding of the industry? Do they have realistic compensation expectations?

But these meetings also resemble a first date. When thinking about these executives, investors may ponder: Will they be honest with me? Will they take care of me (and my capital)? Will they go Dutch on this lunch bill with me?

If you’ve been on many dates, or conducted many interviews, you would have noticed that some people present themselves exceptionally well in these situations, whereas others underwhelm. If you’ve subsequently gotten to know these same people, you’ve learned that initial impressions aren’t always indicative of what these people are like over the long term. This is the same with CEOs.

In fact, the evaluation can be even more challenging when meeting CEOs. These people frequently spend a lot of time in meetings. As a result, they know how to look and sound impressive in such a setting. But just as you wouldn’t want to hire someone because they are frequently in job interviews, nor would you want to marry someone because they go on a lot of dates, you wouldn’t want to hire a CEO simply because he or she knows how to sound impressive in a meeting.

Far too often, professional investors find themselves exiting a meeting with a charismatic executive team thinking, “I really like them”. To be clear, that isn’t necessarily a bad thought to have. Where investors get into trouble is when they make the leap from “I like this person,” to “therefore, I like this company”.

It’s rare for an investor to leave a meeting with management and not find themselves liking the CEO. Especially with larger companies. To explain how so many charismatic people land the top jobs within public companies, let’s take a moment to think about how they got there. They likely started at some lower rung before steadily rising through the ranks. To do so, the individual was likely an excellent salesperson, especially when it came to selling him/herself. He or she would have had to convince scores of managers to promote him/her along the way. As a result, many companies breed a survival of the fittest situation, where the person deemed fittest for the job is simply the best salesperson.

So why meet with management?

In general, we would argue that because executives tend to leave overly-rosy impressions, investors shouldn’t meet with management. But that doesn’t mean we never meet with management. We are simply selective about who we meet.

We have found that executives at smaller companies tend to offer better insights about their businesses than their counterparts at large-cap firms. Whether it’s because there are fewer layers of management between the executives and their front lines, or because they are less concerned about having their words parsed line-by-line by investors, we believe that executives at smaller companies tend to answer questions with more candour.

That’s not to say that CEOs at large companies lack in candour. We just find that they are more likely to skirt questions they don’t like. Frequently, these CEOs are impressively eloquent when skirting these kinds of questions. But sometimes they aren’t. The following is an excerpt from the most recent Tesla Inc. (TSLA-NASDAQ) quarterly earnings call. Apparently, CEO Elon Musk didn’t want to address the company’s capital spending needs (which is a pressing concern in the eyes of many investors):

Source: Bloomberg

Nor did Mr. Musk want to talk about pre-orders for the company’s next model of automobile:

Source: Bloomberg

But when given the opportunity to talk about something he thought was important, he didn’t waste the opportunity to publicly correct his CFO, Deepak Ahuja, about TSLA being the bestest of the bestest:

Source: Bloomberg

It’s not very often that a CEO will be this forthcoming with his disdain for answering honest questions. But many executives are resistant to addressing tough topics that matter to shareholders. As a result, many management meetings amount to giant wastes of time.

There are benefits

Management meetings can be useful to get an insider’s view of how an unfamiliar industry works. Annual reports and press releases are useful sources of information about an industry. But for legal reasons, they are usually sterilized versions of reality. A casual conversation with management and other industry insiders, however, can provide investors with more nuanced information. If they aren’t being quoted, executives can be more forthcoming with information. We aren’t referring to inside information, but there are things – such as competitive pressures – that executives are more likely to talk about in person than they would be willing to commit to in print.

A favourite question of ours to ask is, “What do you want your company to look like in five years?” You would be shocked at how often that question is accompanied by an uncomfortable silence as a CEO struggles to think up an answer. Perhaps it’s because of the short-term focus on quarterly results that many public companies have, or perhaps because of poorly-designed compensation structures that don’t encourage executives to think for the long-term. In any event, we have found it to be a rare (and highly impressive) CEO who has previously given this question serious thought.

Speaking of compensation, public companies must disclose the pay of its top executives. We are all for capitalism and encouraging exceptional performance with exceptional pay. But the way many companies quantify “exceptional” is lacking. We are of the view that simple return on capital metrics are the best way to judge an executive’s performance. Instead, what we frequently see are executives whose performance targets are calculated based on things like revenue and earnings growth – metrics that can be inflated by expensive acquisitions undertaken to the detriment of shareholders’ best interests.

Furthermore, there is an upper limit to how far our capitalist leanings will take us. We were recently perusing the annual filings of the Walt Disney Company (DIS-NYSE) when we noticed that CEO Bob Iger was paid $36 million in 2017; and this was a pay cut from $44 million the year before! In our view, that is an obscene amount of money to pay a single person. Additionally, we find it hard to believe that an extra $20 million or $30 million paid annually to Mr. Iger would induce him to put forth a greater effort for the benefit of DIS shareholders.

Two-way street

While there are pitfalls to avoid when listening to management opine about their company’s prospects, sometimes the goal of management meetings is simply for investors to be heard. The management meetings we most frequently attend are with smaller companies held within our portfolios. In these cases, listening to updates from management is important, but we sometimes have concerns that we believe the executives need to address.

For a company like DIS, no single shareholder owns enough shares to have a meaningful influence on management’s or the board’s decisions. We suspect that is why the executives at the company can pay themselves so much: there is no meaningful pushback from shareholders. But there are companies within our portfolios where our shareholder votes represent a significant proportion of the total shares outstanding. Taken to the extreme, some investment firms brand themselves as “activist investors”; these types of firms often look to elect themselves to board seats to shake-up a company’s strategy. We aren’t activists, but we aren’t fully passive shareholders either.

We believe there is a time and a place to meet with management. But we think it is important to not let these meetings occupy most of our due diligence process: we know we are much more susceptible to be swayed by a charismatic CEO than we are by a 200-page annual report. It may not be the most exciting way to evaluate a company, but we believe it is a prudent one.