- Is Management rational?
- Is Management candid with the shareholders?
- Does Management resist the institutional imperative?
When considering a new investment or a business acquisition, Buffett looks very hard at the quality of management.
"When you have able managers of high character running business about which they are passionate, you can have a dozen or more reporting to you & still have time for an afternoon nap."
Buffett believes that management's most important act is the allocation of capital & that this allocation, over time, will determine shareholder value. If extra cash can be reinvested internally & produce a return higher than the cost of capital, then the company should retain all its earnings and reinvest them. That is the only logical course. Retaining earnings to reinvest in the company at less than the average cost of capital is completely irrational. It is also quite common.
A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroad that Buffett keenly focuses on management. It is here that managers will behave rationally or irrationally.
Generally, managers who continue to reinvest despite below-average returns do so in the belief that the situation is temporary. They are convinced that, with managerial prowess, they can improve their company's profitability. Shareholders become mesmerized with management's forecast of improvements.
If a company continually ignores this problem, cash will become an increasingly idle resource and the stock price will decline. A company with poor economic returns, a lot of cash, and a low stock price will attract corporate raiders, which often is the beginning of the end of current management tenure. To protect themselves, executives frequently choose the second option instead: purchasing growth by acquiring another company.
Announcing acquisition plans excites shareholders and dissuades corporate raiders. However, Buffett is skeptical of companies that need to buy growth for two reasons, (1) it often comes at an overvalued price, and (2) a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.
In Buffett's mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: raising the dividend or buying back shares.
With cash in hand from their dividends, shareholders have the opportunity to look elsewhere for higher returns. On the surface, this seems to be be a good deal, and therefore many people view increased dividends as a sign of companies that are doing well. Buffett believes that this is so only if investors can get more for their cash than the company could generate if it retained the earnings and reinvested in the company.
The ultimate test of owners' faith is allowing management to reinvest 100 percent of earnings.
The second mechanism for returning earnings to the shareholders' is stock repurchase.
When management repurchases stock, Buffett feels that the reward is twofold. (1) If the stock is selling below its intrinsic value, then purchasing shares makes good business sense. Such transactions can be highly profitable for the remaining shareholders. (2) Secondly, when executives actively buy the company's stock in the market, they are demonstrating that they have the best interests of their owners at hand rather than a careless need to expand the corporate structure. That kind of stance sends good signals to the market, attracting other investors looking for a well managed company that increases shareholders' wealth.
Frequently, shareholders are rewarded twice; first from the initial open market purchase and then subsequently from the positive effect of investor interest on price.
Sometimes companies tend to manipulate annual reports with inflated numbers, half-truths, and deliberate obfuscations. Warren Buffett gives some important tips in this regard:
"When you have able managers of high character running business about which they are passionate, you can have a dozen or more reporting to you & still have time for an afternoon nap."
Buffett believes that management's most important act is the allocation of capital & that this allocation, over time, will determine shareholder value. If extra cash can be reinvested internally & produce a return higher than the cost of capital, then the company should retain all its earnings and reinvest them. That is the only logical course. Retaining earnings to reinvest in the company at less than the average cost of capital is completely irrational. It is also quite common.
A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroad that Buffett keenly focuses on management. It is here that managers will behave rationally or irrationally.
Generally, managers who continue to reinvest despite below-average returns do so in the belief that the situation is temporary. They are convinced that, with managerial prowess, they can improve their company's profitability. Shareholders become mesmerized with management's forecast of improvements.
If a company continually ignores this problem, cash will become an increasingly idle resource and the stock price will decline. A company with poor economic returns, a lot of cash, and a low stock price will attract corporate raiders, which often is the beginning of the end of current management tenure. To protect themselves, executives frequently choose the second option instead: purchasing growth by acquiring another company.
Announcing acquisition plans excites shareholders and dissuades corporate raiders. However, Buffett is skeptical of companies that need to buy growth for two reasons, (1) it often comes at an overvalued price, and (2) a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.
In Buffett's mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: raising the dividend or buying back shares.
With cash in hand from their dividends, shareholders have the opportunity to look elsewhere for higher returns. On the surface, this seems to be be a good deal, and therefore many people view increased dividends as a sign of companies that are doing well. Buffett believes that this is so only if investors can get more for their cash than the company could generate if it retained the earnings and reinvested in the company.
The ultimate test of owners' faith is allowing management to reinvest 100 percent of earnings.
The second mechanism for returning earnings to the shareholders' is stock repurchase.
When management repurchases stock, Buffett feels that the reward is twofold. (1) If the stock is selling below its intrinsic value, then purchasing shares makes good business sense. Such transactions can be highly profitable for the remaining shareholders. (2) Secondly, when executives actively buy the company's stock in the market, they are demonstrating that they have the best interests of their owners at hand rather than a careless need to expand the corporate structure. That kind of stance sends good signals to the market, attracting other investors looking for a well managed company that increases shareholders' wealth.
Frequently, shareholders are rewarded twice; first from the initial open market purchase and then subsequently from the positive effect of investor interest on price.
Sometimes companies tend to manipulate annual reports with inflated numbers, half-truths, and deliberate obfuscations. Warren Buffett gives some important tips in this regard:
- Beware of companies displaying weak accounting. In particular he cautions to watch out for companies that do not expense stock options. It's an obvious red flag that other less obvious maneuvers are also present.
- Another red flag: "unintelligible footnotes." If you can't understand them, he says, don't assume it's your shortcoming; it's a favored tool for hiding something management doesn't want you to know.
- "Be suspicious of companies that trumpet earnings projections and growth expectations." No one can know the future, and any CEO who claims to do so is not worthy of your trust.
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