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June 30, 2006

Investment Selection: How to Evaluate a Company’s Management

A few weeks ago I ran some excerpts from the book The Big Money and also had Fred Kobrick, the book’s author, do some guest posts here at Free Money Finance. Over the course of a couple posts, we had a discussion on the importance of company management when deciding to purchase an investment. It started with Fred’s #3 guest post where I asked:

You talk a lot about the importance of management when considering a stock purchase. I’ve recently made two stock purchases where management was a big factor pushing me to buy. The first was Disney (DIS) and the latest was Home Depot (HD).

I’m currently thinking of buying JPMorgan Chase (JPM), again in part because of their leader. Jamie Dimon just seems to me to be the kind of get-things-done sort of CEO who is destined to perform well.

Can you comment on the following:

1. In general, how much weight you put on management (versus other factors) when you decide whether or not to buy a stock?

2. Specifically, your thoughts on DIS, HD, and JPM both as stock buys/no buys as well as the skill (or lack thereof if you think so) of their top managers.

Fred responded:

On the importance of management, let me start with this quote from my book, keeping in mind that with the four factors (BASM) that identify the greatest wealth stocks, management is responsible for them, starting with a great business model:

“This is one of the most important chapters in this book, and for some people it will be the most important. For some, picking stocks on the basis of management will be all they need to do.”

This begins the chapter on management but I would urge people to keep reading and see what the characteristics of great managements are. Remember, BASM guides the investor to find the great companies very early, and BASM is the golden goose that lays those golden eggs of earnings.

Thus, if you only define a great management by its earnings track record, you will come into the stock much later than some others, and it may be a very good investment, but not a “Big Money” or wealth stock to make you rich for life.

So, with the 3 companies you name—Disney, Home Depot and JP Morgan, I have met all these managements and think very, very highly of all three.

There are two things that are important to know, here.

First, they are all big and so while they are going to be good investments over time (not quick trades), they are not going to make people rich for life in my opinion. They already did that, and the first two are detailed in my book as stories with lessons as to how they did that and how people recognized them early.

JP Morgan is over $80 billion in revenue on it s way to $100 billion, and even more than that—the second thing—it does not control its destiny as much as the other two stocks.

I say in my book The Big Money that the amount of control over destiny a company can have vs. the amount that its destiny is controlled by the economy or outside factors, is a degree of how great it can be. JP Morgan is very good and will do well for investors, but it is subject to changes in the economy and interest rates more than the average company and one needs to understand that.

Also, JPM is up over 32% the past 12 months, and is somewhat expensive relative to its own historical price earnings ratio, while analysts on Wall Street see growth for the next 12 months to be somewhat slower than the last 12. So, just know that.

I hope that helps you.

The conversation continued to a later post (an excerpt from the book) on how to pick great company management (and thus, a great investment ). At the end of the excerpt I said, This is one metric that I give pretty heavy weight to when buying a stock. On two recent purchases of Disney (DIS) and Home Depot (HD) stock, top executives were one of the main reasons I went ahead and bought the stocks. To this post, a reader responded:

How does one exactly go about evaluating the executives of the company? The things that you listed are somewhat subjective. How does one tell a crook from a visionary, especially when you are not very familiar with the industry? I’m interested in whatever that you could elaborate further. As on how I do it, I just go by financial numbers.

I explained my thoughts:

There’s not a single method, but I can describe how I came to believe in the three leaders I noted on Fred’s other post.

With DIS, I detailed my thoughts pretty much in this post . In short, Steve Jobs has made me a ton of money on two separate occasions and he seems to have the magic touch. I think he’ll do it again with DIS.

With HD, I’ve followed Nardelli since he lost the race at GE. Often a smart guy spurned is a powerful force — he’s out to prove something — so I’ve watched him. Recently, the fundamentals of HD were attractive. I then read a positive story in Business Week (and listened to their behind the scenes podcast) and it reinforced much of my thinking about HD. So, I took the plunge.

With JPM, you’ve got the smart guy spurned issue working again. In addition, I did a bank deal at my last employer just at the time when one of the banks we were considering merged with Dimon’s bank. The execs I was dealing with had met with Dimon and said he was the real deal. His performance since then seems to back up their feelings, and while I haven’t purchased JPM yet, it’s on my short list.

Fred responded with his thoughts as well:

I know it seems frustrating or potentially hard to evaluate the executives of a company. Like most good investment issues, experience is the best teacher, and if you want that experience with somebody else’s money first, as well as lots of it with guidelines to boot, you need to study the experiences of investors before you and what they did to solve these problems. That is why I wrote the book as what we call “the case method”, or condensed experiences with lessons.

All the top investors have learned that way. So, when investors want to boil it down to a few simple rules, they should realize that this is why people fail to get rich—a few simple rules will not make you millions. The quick fix books come and go over the decades, and people still try, but find me the people that have read all the quick fix books in each generation and ask them if they finished the book let alone where their yacht is.

I have a chapter that is fun like the rest of my book, and uses great examples like McDonald’s to teach about management—but, I have already quoted from that chapter in this site, and if you have not read that stuff yet, you have to ask yourself if you are in the quick fix camp and will stay their all your life, or if you truly, truly, want to get rich and read and use a few hours a week to do so. I do realize that much of what people try and read is worthless, but go to a bookstore and thumb through my book, or look at al the excerpts and quotes on this site, and you should see what I mean about using your common sense and having a compass to guide you to just the four key factors of the wealth stocks.

The same goes for crooks—my example of how Sambo’s restaurants in the 1970s taught me what I needed to know to avoid Enron in the 1990s is a great, fun story, and that chapter tells you what you want to know. Thumb through it in a bookstore if you want more, or actually use a few books and try the book—you have a lot of preview material right here.

ONE simple things is that when you learn how to look at a company’s business model and you look at an annual report and either they have not made the business model clear or how they describe their operations or earnings reports, never, ever feel dumb, just know that they are doing a lousy job of reporting to you, or they cold even be crooks. But some case experience and personal experience is what ultimately guides people to know how to recognize the great stocks and the crooks—it will never be a few simple rules, in my opinion.

I’m a big believer in buying (a few) stocks based on very strong management. It seems to me to be a solid practice and in more cases than not has made me a great return (Jobs at Pixar, Jobs at Apple, Gerstner at IBM, Gates at Microsoft, Lafley at P&G, etc.).