Investor Warren Buffett once said ‘I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.’

He was referring to newspaper businesses in the 1960s where often a single dominant title held a monopoly position, which meant the economics were so strong it didn’t matter who was in charge.

In later years he put much greater store in buying wonderful businesses with a strong management team.

‘The important thing we do with managers, generally, is to find the .400 hitters and then not tell them how to swing,’ Buffett said, referring to the baseball statistic considered to be an elite standard.

The truth is that all businesses are run by people and investors rely on senior management to make sensible decisions and be accountable for their actions.

Key qualities for investors are integrity and competency. Without the former it is impossible or unwise to rely on management communication and without the latter the stewardship of the business is probably on shaky economic grounds.

Stewardship is important in this context because legally shareholders own the company while management ‘steer the ship’ in the interests of owners. Conflict between stewards and owners can be disastrous for shareholders over the long run.

Communication matters

The tone and content of management communication is key to understanding how they view shareholders. For example, Buffett has said his approach to writing annual reports is to provide information that he considers pertinent to judging performance and which he would expect to read if the roles were reversed.

If done well this approach provides all the necessary information about a company to allow the average investor to assess the viability of the business and its future direction.

A good way of building up a picture of management is to read everything they publish including regulated news announcements, presentations and annual reports.

One small but important point to make is that the clearer an annual report is written and the better understanding you have of how the business works after reading it, the better the quality of management.

The annual reports written by Henry Engelhardt who co-founded and ran insurer Admiral (ADM) for many years are a good example of an informative and engaging style of communication.

Also, it might not seem obvious but reading older reports can provide valuable clues about management behaviour. For example, look for previously announced investment plans to see if they were actioned. You might discover projects that were mentioned one year mysteriously disappear in the next review.

Former CEO Henry Engelhardt was praised for the way he
communicated with Admiral shareholders.

‘I would sum up all our results since 2000 as being akin to a seedless watermelon: tasty and refreshing but somehow you always wonder “how can that work in the future?”

‘Every year Admiral’s customer growth and profit growth always seems to take people a bit by surprise.

‘Despite the fact that we’ve prospered in good economic times and bad economic times; that we’ve prospered when prices for car insurance were on the rise and when they weren’t; that we’ve prospered even allowing for investment in new operations outside the UK; and that we’ve done it all organically, without any acquisitions.

‘Despite this history we seem to surprise people when we pop up out of the ground each spring with better results than the year before.’

Henry Engelhardt, March 2016

GAUGING CREDIBILITY

Another key to gauging management credibility is to see if prior judgements about future events were borne out by actual events.

Generally speaking, better quality managements ‘tell it like it is’ without offering excuses and have a tendency to under-promise and over-deliver.

A good example is clothing retailer Next (NXT) which has built a well-earned reputation for over delivering against expectations.

Chief executive Simon Wolfson writes clearly and explains the risks and opportunities facing the company so that investors aren’t negatively surprised by future events.

In Next’s case it isn’t just about providing an accurate, honest assessment, but executing well thought-through plans.

LOOK FOR RED FLAGS

It might seem unnecessary but checking the career history of top management can sometimes uncover patterns of behaviour which may prove helpful in building a rounded picture of ability and integrity.

Twenty years ago, Gaston Bastiaens the chief executive of Lernout & Hauspie, a European dot-com darling and technology leader in speech recognition, was arrested and prosecuted for accounting fraud along with other senior executives.

A closer look at his career would have revealed that before joining Lernout & Hauspie, Bastiaens oversaw Apple’s Newton personal digital assistant project which failed spectacularly when only 50,000 devices were sold in the first three months.

Prior to Apple, Baestiaens was president of US company Quarterdeck and began an ultimately unsuccessful series of acquisitions and the company was eventually acquired at a fraction of its former value.

MAKING A JUDGEMENT

Ultimately judging the quality of management is not an easy task, but it is possible to build up a fair picture by using publicly available information.

Individual investors aren’t necessarily at a disadvantage compared with professional fund managers who get access to management because there are quite a few funds that deliberately shun meetings.

The reason is that CEOs tend to be skilled communicators and good salespeople and some fund managers don’t want to be unduly swayed.

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