How to assess a management the Warren Buffett way
Assessing management remains one of the most difficult activities of stock investing. Here is how you can do it
Jan 10, 2019
In the stock market, more often than not, the differentiating factor behind an outperformer and a laggard is the underlying company's management. India Inc. has seen a string of crooked promoters in recent past. Mehul Choksi (Gitanjali Gems), Ramalinga Raju (Satyam) and Malvinder and Shivinder Singh (Ranbaxy, Fortis) are just some that have made it to the headlines. A countless number do not but nevertheless lead to huge losses for their investors.
Even for the well-known names, the army of analysts tracking their performance by the quarter often has no inkling of what's really behind the numbers. To be fair though, in real time, it is very difficult to ascertain if a management is indeed cooking the books. It is often when the news breaks out that ordinary investors get to know of these crooked managers and their misdeeds.
Crookedness is not the only worry about a management. How effective it is at its job is another primary concern. Even if a management is not a crook, it can remain woefully ineffective, thus hurting shareholder interest.
Even though you cannot predict how a management will behave and whether the decisions it will take in the future will work in your interest as a shareholder or not, there are ways to identify and measure the effectiveness of managements and steer clear of those that do not make the cut.
First, we take a look at how the world's greatest investor tackles management and how you can too.
How to assess whether a management is good or not?
According to Buffett, there are two factors in assessing management. The first is how the management allocated capital and how the allocation fared.
'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. Look at what they have accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry.'
The second factor is how the management treats the minority shareholders. Does it do deals that benefit itself or family members to the detriment of the company and its other shareholders? Does it extend substantial loans to promoter companies that could have been distributed to shareholders or invested with the company? How has its past behaviour been while dealing with minority shareholders? Does it enact policies that see major gains going to promoters and their families or does it distribute such gains amongst all shareholders?
The test of the management
There are a very few measures to assess the effectiveness of a management. Higher profits alone do not make the cut. Buffett has a simple test for the effectiveness of a management. 'The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.'
How you can stay away from crooked managements
As discussed above, you cannot tell beforehand if a management will cheat or not or whether it will be effective at its job or not. What you can do is steer away from those that are likely to fail on both counts. The points mentioned below will only do that - steer you away from crooked managements or those that are likely to cook their books or those that will be ineffective. If you can manage to stay away from such managements, you can avoid a lot of heartache at a later date. Here are a couple of ways to stay away from such managements.
First, keep your ears out for reputation of the management. Talk to people, suppliers, stockists, distributors and retailers. Get a feel of how the management treats them. If it doesn't treat them well, the probability of it treating its minority shareholders well goes down.
Second, take a look at the numbers. How has the management allocated capital and what the results of those allocations have been? How has the company fared in comparison with its competitors? Companies that take on too much debt to finance growth are staring at problems ahead. Or those that make foreign acquisitions on external debt are often asking for trouble down the line. For instance, the venerable Tata group is still struggling with high-priced acquisitions done years ago.
Third, look for companies that sell their past acquisitions. This behaviour is rare among Indian firms but this is what Havells did a couple of years back when a big acquisition it made earlier did not play out as expected. Yes, selling a past acquisition does amount to some sort of admission of mistake, but it shows a maturity of the management in acknowledging its mistakes, not common among Indian firms.
Fourth, keep an eye out for companies that have a large proportion of related-party transactions. Companies that give out large sums to promoter-group companies are stealing from their minority shareholders.
Fifth, use the Modified C-Score. This is a modified version of James Montier's quantitative methodology that tells the probability of creative accounting. Avoid any company that fails on this test. An excellent resource on the modified C-Score is available on the Value Research website (
Sixth, read. A recent trend among Indian entrepreneurs is to author books about their rise to stardom. While most books are sugar-coated or even ghost-written (someone is paid to write them), there are some that will tell you about the industries they operate in, what works and what doesn't. Ignore tales of superhuman feats such books are often peppered with. Read books by outside authors that try to take in a more unbiased view. A couple that stand out include The Inheritors by Sonu Bhasin, The Consolidators by Prince Mathews Thomas and Business Battles: Family Feuds That Changed Indian Industry by Shyamal Majumdar.
Reading up on managements
Don't beat yourself if you don't have direct access to any management. Some of the most successful investors in the world have not had any access to managements or have even avoided talking to them altogether, preferring instead to read up on their activities. Legendary investor Walter Schloss was one such investor. Even Buffett at times reads up on managements.
'Almost everything we learn is from public documents. I read Jim Clayton's book, for example. There is adequate information out there to evaluate businesses. We do not find it particularly helpful to talk to managements. Often managements want to come to Omaha to talk, and they come up with all sorts of reasons, but what they really hope is that we become interested in their stock. That never works. The numbers tell us a lot more than the managements. We don't give a hoot about anyone's projections. We don't even want to hear about it.'