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One of our three key criteria for what constitutes a durable business is an assessment of management, particularly their record of capital allocation and the incentives under which they operate. We feel these factors are underappreciated and under-analysed by many investors as a consequence of their relatively shorter investment horizon compared to ours.
Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter … And I’ll say, ‘Thank you, but that quarter was baked three years ago. I’m working on a quarter that’ll happen in 2021 right now.'
Today’s capital allocation decisions make little difference to business fundamentals tomorrow or even next year. But over longer periods? A business earning a twelve per cent return on equity that retains all of it will have doubled the equity base in just six years, even if the firm is a hundred years old. Put differently, in just six years the CEO will be responsible for overseeing the allocation of half of all the equity capital ever invested in a century-old business.
Unfortunately, while capital allocation is one of the most important responsibilities of senior executives, most do not know how to do it effectively. Through no fault of their own they typically advance through the organisation as a result of their sales or operations prowess. When it comes to the merits of paying a special dividend versus executing a share repurchase, they frequently rely on (often) woolly or conflicting from institutional shareholder feedback or consultant opinions.
The objective of a management team should be the increase of value on a per share basis by improving competitive advantage and pursuing growth opportunities at attractive returns, while maximising the cash generation of the business. We therefore pay particular attention to evaluating the economic incentives of company management, assessing the strength of alignment with long-term minority shareholders. The key criteria we look for is some linkage between growth, returns, and cash.
Assessing management ability is a subjective task, however. Historical track records, including growth rates and margin trends, and how these compare to industry peers, are crucial. We also assess the success or otherwise of acquisitions as much as the disclosure permits. The communication around dividends and share repurchases provide insights into how management regard their role. It is useful to compare previous statements of intent and how closely they match subsequent reality, and whether any deviations were due to factors inside or outside management’s control.
Emphasising the quality of management in our process is an element that helps to position for positive surprises that are unanticipated by consensus opinion.