Sound management: Buffett’s continuing theme

Warren Buffett’s continuing theme

If there is one theme that continually runs through the public statements of Warren Buffett it is the principle that investor should only consider for investment companies with managers of competence and integrity.

What Warren Buffett looks for in company management

Warren Buffett has identified aspects of management that he looks for in companies in which he invests. They include:

• Buy back of shares where the buy back is in the company’s interests, for example where the company has surplus funds and the shares can be bought back at less than intrinsic value
• Capability in allocation of capital
• Managers who stick to doing what the company does best; ‘the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.’
• Ability and readiness to tackle tough problems as they arise
• The use of retained profits to increase company profitability at beyond market rates
• A conservative approach to debt and liquidity
• Demonstrated ability to consistently grow company earnings and rates of return.

Good management:  management of capital

We see this in Buffett’s ideas on share buy backs, allocation of capital and the use of retained profits.

From time to time, companies have capital surplus to their requirements. This excess capital can come about because of retained profits, sale of corporate assets, a windfall or for other reasons. Buffett believes that if the company managers can use these surplus monies wisely - to grow the company - they should do so. If not they should return the money to shareholders.

One way to use the surplus is to buy back some of the company shares. If this is done properly, shareholders will benefit because the earnings per share will increase. This will only work where the buy back price is less than the intrinsic value of the shares. In such a case, it will be the foolish shareholder who accepts the company’s offer to buy back his or her shares; the wise shareholder will retain the shares and participate in the increased earnings per share. Look at our example of how this works.

Managers who use surplus capital to buy back shares at a price higher than its intrinsic values are not good managers.

So too with using retained profits to improve earnings per share. When this happens, the value of shares will increase over time, hopefully satisfying Buffett’s requirement that each dollar of retained earnings should, over time (Buffett thinks five years) increase the value of the shares by one dollar.

Managers who fail this test are not good managers.

Good managers: minding the company’s core business

Buffett has often said that you should not invest in a company if you do not understand what it does and that it is easier to understand a company that has been doing the same thing successfully for years than a company that is continually changing its product line or branching out into areas that it does not know.

Using our favorite example of Coca Cola, it is not difficult for us to understand what Coke does because it sticks to what it knows and has been doing the same thing pretty well for a long time.

Good company managers should stick to what they know.

Good managers: keep the debt down

It is a basic principle of prudent investment that you should not put your money in companies that cannot realistically expect to pay off their debt from earnings within a reasonable time.

Buffett prefers companies with no or low long term debt and this all comes down to good management. He does not say that a company should never go into debt but he does say that debt should only be incurred where it can be used to add value to the company and where it can be repaid from earnings within a reasonable time.

Managers who rack up excessive corporate debt are poor managers.

Good managers: integrity

Buffett has famously said that you look for three things in a manager: intelligence, integrity and energy and of these three characteristics, integrity is the most important.

When you hire someone to run your business, you are entrusting him or her with the piggy bank,If these people are smart and hardworking, they are going to make you a lot of money, but it they aren’t honest, they will find lots of clever way to make all your money theirs.

Recent examples of Buffett parting company with his managers was the departure of Benjamin Moore after news reports about a jaunt on a luxury yacht (although Buffett denies that this was the reason for Moore’s departure) and the resignation of David Sokol after allegations of dubious share trading.

What Buffett does not like in company management

Warren Buffett has, throughout his career of public announcements, identified some things that he does not like in company managers:

• Managers who pursue company acquisitions for reasons other than the good of the company – ego trips, the ‘institutional imperative’ of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, ‘[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads’.

• Managers who pursue growth for growth’s sake, irrespective of the value of that growth to the company

• Managers who expend too much of the company’s worth by issuing valuable shares to buy overvalued assets or who use debt to do so.

• Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements

Good managers and bad businesses

Buffett does acknowledge that even the best managers will founder if the business is not intrinsically sound. His most telling comment on management is: ‘When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.’

How can the average investor judge management?

The difficulty of course for the average investor is how to determine if a company is soundly managed. Warren Buffett is a rich man and a big investor and, while it is not known if he ever does this, he would be able to question internal company management a lot easier than John Citizen.

The answer for the average investor is to extensively research a company before investing and to ask the kind of questions that it seems Warren Buffett asks before investing in a company.