In investing, look at the jockey as well as the horse
This spring marked the 50th anniversary of a great sporting event – Secretariat’s Triple Crown win. Photos taken near the finish line at the Kentucky Derby show the jockey, Ron Turcotte, looking back and seeing no horses anywhere near him. Secretariat was a phenomenal horse and Turcotte, who controlled how fast he came out of the gate and decided whether to set the pace or conserve energy for a late push, was a great jockey.
In investing, the analogy to a horse and a jockey is a business and its CEO. An outstanding long-term result requires both an exceptional business and excellent management.
If you question whether the intelligence and integrity of a company’s leader is an important determinant of investment returns, think of companies like Enron and WorldCom.
When true investors buy a stock – a piece of a business, in other words – their goal is to achieve a superior return over the long run. It follows that they should look for a CEO who is likely to create long-term value for the shareholders.
How do you identify such a CEO? In addition to past performance, there are a number of characteristics to look for – and to avoid.
One place to start is public disclosures. If management commentary is highly promotional, you should probably think twice before investing. When management proclaims their company’s stock is undervalued, you should ask why they are making that statement. Similarly, if the accounting treatment appears aggressive or inconsistent, that is a red flag.
Conversely, when management speaks to you as an owner, in a straightforward manner, it’s a good sign. Ideally, the CEO will disclose the long-term goals that management has set, and explain how you might reasonably calculate changes in the company’s economic value. Two CEOs who do this regularly, and with a high degree of sophistication and humility, are Warren Buffett of Berkshire Hathaway and Mark Leonard of Constellation Software.
You should also look at other factors such as how long managers have worked there, how much of their net worth is invested in the company, and how their compensation is calculated. Charlie Munger has said, “Never, ever, think about something else when you should be thinking about the power of incentives.”
Are management incentives tied to the long-term performance of the business (a good thing) or to the current stock price (a bad thing)?
While stock-based compensation can be used to retain management and foster a sense of ownership, stock options dilute your ownership. Furthermore, most options are not well designed. If a company issues options, management’s ability to exercise them should be conditional on longer-term operational targets having been met. Also, management should be obliged to hold at least some of the shares for a few years after the options are exercised.
A CEO’s most important role is capital allocation. How are profits employed? Through a repayment of debt? Reinvestment in the business? Acquisitions? Dividends? Stock buybacks? In his book, The Outsiders, William Thorndike describes the extraordinary effect intelligent capital allocation can have on shareholder value.
How have past acquisitions and divestitures affected profit per share? Also, what is the track record of management when it comes to stock buybacks?
Buybacks are not created equal. Every company has an economic or intrinsic value, which can be roughly estimated. The market price of the stock is often well above, or below, that value. If a company buys back its shares for less than their economic value, it is positive for the shareholders. If it pays more than economic value, it is negative. It’s surprising how few CEOs appear to understand this. A good question to ask any CEO is “How do you think about stock buybacks?” Often, the answer speaks volumes.
Over the past several decades, investors have obtained access to more and more quantitative information on listed companies. As market participants increasingly rely only on numbers, you will do well to examine other aspects of the business – and to begin by assessing management.
Don’t bet until you know both the horse and the jockey.