For most, the process of assessing how capable a company’s CEO / management team is mostly qualitative – look at the their profile and background (education, previous workplace, past projects), ask a couple of smart questions and see if you like their responses. I used to follow the same approach of “due diligence” until I realized it runs the risk of letting my own personal feelings towards the person be the deciding factor, without me even knowing it. I’m sure you have seen many infamous cases of failed investments due to investors falling in love with the “promotional type” of founders / CEOs, who can talk really well but can’t execute. I myself have learned it the hard way.
As a personal preference, I tend to always try to put a number on most things. And in making investments, I have tried to think of a way to quantify “management team’s capabilities” – numbers would make this process much more systematic and replicable over and over, without the personal biases getting in the way.
The main purpose of a company is to expand shareholder’s wealth and as such, the company’s CEO / management team is the steward of shareholder’s capital. If you think of a business as an investment fund (in which the capital is being invested into working capital and capex), the CEO / management team would be the fund manager and their job is to, over time, generate returns on shareholder’s capital that exceed what the shareholders would find elsewhere. As such, Warren Buffet has succinctly summarized the main job of a CEO being capital allocation.
For public companies, the most obvious metric for shareholder’s wealth is the company’s market cap. While I would ignore stock price action in the short-term, in the longer-run, stock price would reflect the value creation in a business. If you see a company’s market cap expanding over say 10 years at a CAGR more desirable than a standard required rate of returns, that usually means the company’s CEO / managers must have done a lot of things right.
For private companies where there is an absence of the market’s weighing mechanism through market cap, determining whether value creation has been taking place requires more work. Fundamentally, when the amount of cash that the business splits out keeps growing over time, no doubt value creation has been happening. Thus, growth in revenue and profits is obviously an important metric to look at. Growth, however, always comes with a cost – in achieving growth, the CEO would have had to deploy additional capital to reinvest in the business, reducing the cash available to shareholders (Free Cash Flow). Very rarely do we see a business that can keep growing without the need for reinvestments.
A capable CEO that understands capital allocation would always ponder over questions such as: How much does this growth cost in terms of shareholder’s capital? Do I reinvest to grow or should I distribute all of the earnings to shareholders? Do I pay dividends or spend the fund to pay down the existing debt on balance sheet? Do I distribute cash or buy back shares?
The metric that ties growth with its cost (the capital needed for growth) and helps solve all the questions above for the CEO is ROIC – Return on Invested Capital. If the ROIC of a new initiative can be ascertained to be higher than the business’ cost of capital and other investment alternatives, that initiative would be value-accretive to the shareholders. When a company’s ROIC expands over time, that usually means the CEO has been using shareholders’ capital efficiently (provided we can verify that it was not purely from some fundamental change in the industry structure – “tide lifting all boats”). And if a company’s ROIC contracts over time, the CEO has been using shareholder’s capital on value destructive projects. Benchmarking a company’s ROIC over time against its competitors is also a good way to assess whether its managers have been able to outperform their peers and deliver excess value.
One of my favorite analysis is to look at how much the business profit has grown and compare that against how much the company’s capital base has expanded over an extended period of time, and see if that rate is satisfactory. Of course, in performing the analysis, some qualitative judgement would be involved as for instance, sometimes certain investments made by management could take several years to bear fruits.
One important thing to keep in mind is that for business with bad economics or one that turns worse over time, it does not necessarily mean that the CEO / management team has destroyed value. As Warren Buffet says “When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”. Sometimes, things change and a business model once viable may turn irrelevant – e.g. phone book business.
An overwhelming number of CEOs / managers I have encountered in Vietnam fall into one of the two categories:
Category 1 are those who just desire growth and completely ignore its cost, which is the additional capital required, because (i) their incentives are entirely based on revenue / profit (more profit more bonus) and / or (ii) they believe the business value is largely driven by growth (which was the widely common belief during the era of low interest rate, cheap money, the P/S valuation!!). This is the newer-generation owners (in their 30s and 40s) who take pride in raising money from VCs and consider the number of fundraise rounds to be the yardstick for their business success ??!!
Category 2 are those who are simply just not aware of the concepts or do not think numerically in general. This is the previous-generation owner (typically in their 50s and 60s), who don’t speak finance, believe that as long as they can engineer products there shall be demand; since they used to solely rely on licenses / cornered resources / monopolies to do business in Vietnam’s olden days.
The biggest pitfall in most people’s thinking (both operators and “investors”) is that they only look at the P&L and not Balance Sheet. Running a business or making investments without being aware of concepts such as ROIC, cost of growth or cost of capital is like being “a one-legged man in an ass kicking contest”.
There’s nothing I love more in a CEO / manager than the ability to pay attention to cost of capital in business decision making process or if responsibilities are delegated and decentralised, an appropriate incentive structure with cost of capital being incorporated into it is in place. Any system that rewards growth and overlooks capital efficiency is deemed to provide tragic outcome for shareholders in the long term.
So that’s the quantitative part of the equation. As for the qualitative part, a favourite question of mine, when I have access to the CEO / management team, is “If there was only one business metric for you to track at the moment, what would that metric be?” That would usually tell me whether the they really understand their business and what the current strategic priority of the company is. Then, in assessing whether the CEO / manager is honest and has high integrity, one simple way for me to frame my thinking, if the CEO is a man, is whether I would be happy to let my (future) daughter marry him and into his family.
Sometimes, doing all of the above can be too complicated. So perhaps, a more simple approach, as Charlie Munger would always advise, is to flip the problem upside down. If you can’t seem to identify “star” managers to back, just eliminate the bad actors…
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