To meet or not to meet

August 20, 2014

We are often asked, how important is meeting management of the companies we invest in?

We do not generally consider meeting management as a high priority, nor a prerequisite for investment, as some do. We much prefer to focus on the objective metrics of a company such as long-term profitability, balance sheet metrics, valuation etc. There are two main reasons for this. First, it is impossible to assess the impact of management or quantify the degree of success or failure that should be attributed to management in any objective way. Second, meeting management can put your objectivity at risk.

There are various questions which we have to ask ourselves, such as how well can we assess management of a company? Can we measure it? What makes good management? Are we any good at sifting out the good from the bad?

How much influence do senior management really have on the future prospects of a company? Intuitively, it seems likely that they are very important. After all, they are the people responsible for setting the goals and strategy for the company and ensuring its implementation. They make significant decisions about how capital is employed, the level of employee headcount, etc., which can all have a significant bearing on the future prospects of a company.

Given that management are the public face of the company, people often attribute company successes and failures to management. The media love to praise management when the company is performing well and criticize them when the company is performing poorly. However, there are clearly many other factors, be they macro, industry-specific or company-specific that could, individually or in combination, have a stronger effect on the prospects of a company than the decisions of management. Therefore, we think too much emphasis is often attributed to management decisions.

Mathematically it’s impossible to isolate the degree of impact that management has on financial metrics and show causation. Even if we did have a suitable metric to use, what would be the appropriate period over which to assess performance and when should it begin? Many of the big capital budgeting decisions that management make will not have a noticeable effect for perhaps a year, two years or more. Therefore, we wouldn’t be able to objectively assess management without a considerable time lag.

So, we can’t quantitatively deduce the degree of success or failure of a company that should be attributed to management. But perhaps we could make a qualitative assessment of management’s value?

What is good management?

Lots of books have been written that profess to define what the key tenets are that make a good manager. They tend to be based on studies that show that most of the senior managers shared X number of skills or characteristics, therefore to identify good management you have to identify the people who have these X number of qualities. These characteristics will likely make sense because they support one’s existing notions of what makes a good manager: bold, visionary, shrewd, decisive, good under pressure, organized, level-headed, etc.

At the same time, many books have been written that attribute successful businesses to individuals, perhaps the maverick who did everything differently to the commonly held idea of good management. They explain the effect their personal experience had on their business philosophy. They discuss the key people that influenced them and why. They explain important decisions they made to which they attribute their success. The books are often packed with proverbs, aphorisms and insights that are all interesting and intuitively make sense.

However, what these books really provide are simply good stories: stories that appeal to the way our brains function. They provide clear, rhetorical, definitive arguments, often stated as “facts” or truths. They may appeal to our existing beliefs, creating emotional resonances which confirm the “truths” we already know.

Much of the role of management when they meet investors is that of a salesperson. They are trying to sell a good story about the company. They attempt to provide a persuasive and appealing story that would resonate with our way of thinking to convince us that they are in control of the company’s destiny, that the value of the company will increase and therefore we should buy their shares. They aren’t going to provide us with the highly complex, conflicting, uncertain, uncomfortable reality, that there is much outside of their control. Who would want to buy that?

We therefore have to be very careful about listening to what management tell us. We need to be clear what is fact and what is opinion.

What is an expectation or forecast and what is real and present?

This is an incredibly important and somewhat uncomfortable realization: in many instances when analyzing aspects that affect the future prospects of a company, not just management, all we can genuinely conclude is, “we don’t know”. We can’t rely on predictions and forecasts, we can’t rely on an elegant, optimistic story that “makes sense”. While uncomfortable, it is vital to realize this, and it focuses the mind away from what we think we know towards what we don’t know, i.e. away from attempting to make predictions and forecasts based on unprovable qualitative factors but instead towards the risks of our decisions. This uncertainty makes us prefer a strong balance sheet today over expectations of earnings growth in the future, diversified established product offerings over hot new products, cash over earnings, and companies that have been successful in most economic and industry scenarios.

Evidence suggests that all of us as have a human psychological bias towards confident statements over balanced statements, certainties over probabilities, simplicity over complexity. Just look at the media: they make strong assertions, condense complex issues into bite-size chunks, and make clear conclusions. This makes it easier for our minds to understand, remember and make sense of the world. Our minds naturally use stories to make sense of our world in any situation where there is conflicting information as our way of dealing with what psychologists term Cognitive Dissonance. Conflicting information is everywhere when you are trying to decide whether to invest in a company – arguments both for and against. We need to be aware that our mind’s natural desire to resolve cognitive dissonance towards a certainty can be an obstacle to making good decisions, and meeting management does not help us maintain our objectivity.

As Mark Twain said, “It’s not what you don’t know that kills you, it’s what you know for sure that ain’t true.”

 

Matthew Page, CFA

Co-manager, Guinness Atkinson Inflation Managed Dividend Fund
and Guinness Atkinson Global Innovators Fund

  

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

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Mutual fund investing involves risk and loss of principal is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater for emerging markets countries. The Inflation Managed Dividend Fund also invests in medium and smaller companies, which will involve additional risks such as limited liquidity and greater volatility. The Fund may invest in derivatives which involves risks different from, and in certain cases, greater than the risks presented by traditional investments.  The Global Innovators Fund is non-diversified meaning its assets may be concentrated in fewer individual holdings than diversified funds. Therefore, the Fund is more exposed to individual stock volatility than diversified funds.

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