Avoiding Bad Jockeys Is More Rewarding Than Picking Good Ones

"Their office – Castle Schloss has one room – is spare; they don't visit companies; they rarely speak to management; they don't speak to analysts; and they don't use the Internet. Not wanting to be swayed to do something they shouldn't, they limit their conversation. There is an abundance of articulate and intelligent people in the investment world, most of whom can cite persuasive reasons for buying this stock or that bond…"

I begin the article by quoting this paragraph from the book "From Graham to Buffett and Beyond" by Professor Bruce Greenwald. This quote came from value investing legend Walter Schloss who outperformed the market for 45 years.

My personal investment philosophy is to avoid buying stocks based purely on good management, but always avoid buying stocks with known bad management. To use a racing horse analogy, a good jockey may not win you the horserace, but a bad jockey will ruin the race and may even throw himself (and the shareholders) off the horse on purpose.

Management Background

There are three types of management, each with its own set of pros and cons: (1) Founder or substantial shareholder (2) Long-service employee who rose through the ranks (3) Outside hire.

The background and track record of the manager is crucial. Managers with a non-operating background could fail to connect with the ground, or in the worst case be out of touch with the core business needs of the company.

Management Character

Is the management in for the money or the business? Distinguish the "build and sell guys" from "the business is my baby."

In most cases, the CEO is best unknown and out of the media spotlight. The CEOs of high profile failures and corporate scandals are mostly media whores, who show up on television more than they show up in the corporate office.

Differential disclosure is also a key criterion in differentiating between good management and bad management. Read through all the material to fin! d consistencies or inconsistencies between what management is saying and doing.

Management Compensation

CEOs with low salaries and high stock ownership and that promote a dividend policy are the best management. On the other hand, companies who pay excessive stock options to management, but refraining from paying dividends should be avoided.

Management as Allocators of Capital

Besides being operators of businesses, management are also judged as allocators of capital. Cash on the balance sheet will be eroded by inflation; while reckless acquisitions will destroy capital. Dividends and share repurchases are preferred if there are no competing opportunities for growth that are value enhancing.

Share repurchases are also a favorite of Warren Buffett. A shareholder sees his ownership interest rise without any cashflow out on his part. Repurchases made to offset options dilution should be disregarded.

Management – Alignment of Interests

Insider sales should be watched closely. Management selling into a falling market are not the kind that shareholders should be entrusting their money with.

In Summary

I prefer to bet on the horse, rather than the jockey. For me, management matters - only the bad ones. I am more concerned about the negative impact of bad management than any positives from quality management. I hope this article provides a useful checklist for avoiding companies with bad management.