We often highlight the importance of having a sound investment framework when building portfolios. This framework considers a broad range of variables encompassing competitive positioning and future prospects, balance sheet strength, cash generation, profitability metrics and management quality. It is this final point that I’d like to drill into as a focal point of this week’s analyst opinion piece.
(Bain and Co) research shows that companies that maintain the founder’s mentality as they age are four to five times more likely to be top quartile performers.”
Over the past decade I have at times grappled with the importance of senior management when assessing a potential investment. This internal reflection was in part impacted by the philosophy of Walter Schloss, a noted value investor who started his journey in the 1950s at the famed Graham-Newman partnership. Schloss went on to produce an average compound return of about 15% per year for just under half a century, a remarkable effort by anyone’s standards.
While Schloss’ value style always appealed (to me at least), it was the unusual indifference to management and the underlying nature of the business that made him somewhat unique. Schloss didn’t believe in meeting management and instead sat at his desk and focused solely on the numbers. Clearly this approach worked for him but that doesn’t necessarily mean that it’s for everyone. Another Ben Graham acolyte, Warren Buffett, has walked a different path and that also worked out just fine.
In evolving my own approach to analysis over the years, I have attempted to incorporate what has worked for successful value investors such as Schloss, Buffett and many others as well as what has worked for me. For the most part investing is as much about gathering as much relevant information as possible, then rationally filtering and processing it. In my view, management quality, engagement, passion, knowledge and vision should form at least part of this process – especially when dealing with the smaller end of the market. Put another way, I tend to believe in a sound mix of both quantitative and qualitative research, where a view on management is another aspect of the decision making process.
In thinking about the context for this opinion piece, a meeting with Nick Scali (ASX: NCK) Managing Director Anthony Scali comes to mind (several years ago now). Anthony was and still is a man that is extremely devoted to his business. It was immediately obvious this was a manager that knew every aspect of his business and industry, to the second decimal point! Anthony goes to sleep thinking about his supply chain, gross margins and customer experience. He is a man that lives and breathes NCK, a business he owns 27% of and one that has the family name on the door. It’s more than just a job and it shows. Contrast this approach with a typical corporate CEO who gets paid handsomely to be a three to five year custodian of an entrenched institution (a company Peter Lynch would likely term a ‘stalwart’).
One prominent (and highly successful) US based microcap investor suggests that he is always on the lookout for ‘intelligent fanatics’ when reviewing investment opportunities. Such a CEO is broadly defined as someone who is hard working, passionate, customer focused, pragmatic but entrepreneurial, engaged and aligned with minority holders. These types of managers are fanatical about the business they run, treat their scrip like gold and generally look to self-fund growth. NCK hasn’t issued a single share since listing over a decade ago.
Those that are familiar with dental group 1300 Smiles (ASX: ONT) and the obscure property-focused United Overseas Australia (ASX: UOS) would swiftly realise parallels in the experience noted above. While financial achievements are clearly front of mind and how we (the investment community) tend to judge the outcome, these types of management teams go above and beyond the ‘9 to 5’. They focus on the customer and on executing the vision. In doing so, they build a profitable legacy based on a trusted brand. The experience for long term shareholders can be just as satisfying. Total Shareholder Returns (TSRs) for NCK, ONT and UOS over the past decade have been 18.0%, 16.1% and 20.8% per annum respectively.
Though earlier in its listed journey, Citadel Group (ASX: CGL) is another company whose prospects and management team we find to be impressive. If one were to review this Board and senior management team without actually knowing the company, it would be easy to believe this is an ASX100 company and not a small cap few have heard of.
Being aligned with an ‘intelligent fanatic CEO’ that has skin in the game has always intuitively appealed to me. An increasing volume of evidence is however suggesting that such a notion has genuine substance. We recently came across an interesting article written by the Harvard Business Review that adds weight to this view:
A recent study by three professors at Purdue’s Krannert School of Management is part of a growing mountain of evidence of the superior and more lasting performance of companies where the founder still plays a significant role as CEO, chairman, board member, or owner or adviser. Specifically, the study found that S&P 500 companies where the founder is still CEO are more innovative, generate 31% more patents, create patents that are more valuable, and are more likely to make bold investments to renew and adapt the business model — demonstrating a willingness to take risk to invent the future.
Bain & Co added: “Our research shows that companies that maintain the founder’s mentality as they age are four to five times more likely to be top quartile performers. For instance, an index of Fortune 500 companies in which the founder is still deeply involved performed 3.1 times better than the rest over the past 15 years.”
Founder-Led Companies vs Other Companies 1990 – 2014.
Figure 1: Founder-Led Companies vs Other Companies 1990 – 2014.
Source: HBR
Understandably, just buying any business (at any price) that happens to have an energetic CEO with a substantial shareholder isn’t a guarantee for investing success. It is a reasonable starting point and when combined with a sound mix of insightful quantitative and qualitative research, is a valuable aspect of the decision making process.