Quality Of Management — 2

In an earlier post ***Quality Of Management ***I had among other things, concluded management is better seen not heard. Unfortunately, most of us don't get to ‘see Management’, but we do ‘hear’ enough to form a ballpark judgement of what is ‘important and knowable’.

Many of us tend to conflate the Quality of the Business with the Quality of the Management, and it is important to differentiate between the two. Quality of Management is secondary to the Quality of the business, which is another way of saying that the horse matters more than the jockey. Assuming one has managed to identify a ‘quality business’, then the next most important metric is the person who we as shareholders have ‘hired’ to run the business. In other words, as long as we are investing in a quality business, everything above that baseline is management quality. Quality of the Management ultimately will determine the ‘value of the business’.

And, since we hear a lot from the management via the conference calls and also have access to the Annual Report, one of the best ways of tracking management quality is — don't pay attention to what they say — instead pay attention to what they do. In other words, we have to build a BS Filter — a Bull Shit filter — to pierce through the noise and find the signal.

Leadership, incentives, and capital allocation skills are, to me, the three areas for assessment of Quality of Management. Of these, Capital allocation is the one you can actually track. William Thorndike has written the definitive book on how to ‘track’ capital in his book ***The Outsiders ***and in it he says:

“The Outsiders were great capital allocators, not operators of great businesses. They succeeded across diverse industries. None had hot, easily repeatable retail concepts or intellectual property advantages versus their peers. Yet they hugely outperformed them. Industry didn’t matter; capital allocation skills did.”

In the book, he shares what you may call some kind of a checklist —

“CEOs have five essential choices for deploying capital — investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or buying back stock — and three alternatives for raising it — tapping internal cash flow, issuing debt, or raising equity.” “Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions the CEO makes in choosing which tools to use.”

Buffett has recommended this book more than once, and he also shares the reason for his recommendation, in an indirect manner. One has to read ‘between the lines’ to understand the message being conveyed:

“After ten years on the job, a CEO whose company annually retains earnings equal to 10 percent of net worth will have been responsible for the deployment of more than 60 percent of all the capital at work in the business.”

There you have it, the litmus test of the Quality of Management of a business is its Capital Allocation — what does it do with the free cash that business generates. The business is the horse. Capital allocation is the jockey’s actual skill — and it’s knowable from the numbers.

In the next part, I will share my thoughts on some of the above and also the parts that aren't ‘knowable’.

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