One difficult task an investor must undertake is to evaluate the quality of a company’s management. While financial statements provide the numbers used to value a business, management policies are more subjective, and it takes time to determine whether their strategies were effective.
Warren Buffett has stressed that it’s enormously important to have a competent management team running a company: “You look for three qualities: integrity, intelligence and energy. If you don’t have the first one, the other two will kill you. If management doesn’t have integrity, then you really want them dumb and lazy.”
Outright accounting fraud has destroyed a few very large companies. Aggressive off-balance-sheet accounting engineered by Ken Lay, Jeff Skilling and Andrew Fastow sank Enron in 2001. The following year, bogus accounting used to falsify earnings was discovered at Worldcom, causing bankruptcy and sending CEO Bernie Ebbers to jail.
A more common trap for investors is corporate managers whose strategies fail to grow the business value. Management’s record of capital allocation over time is a key measure of performance, and includes acquisitions, divestitures and reinvestment in the company’s operations. Other cash-allocation decisions managers can choose are dividends and stock buybacks.
The recent departure of Jeff Immelt at GE after an uninspiring 17 years provides an example. In partial defense of Immelt, he took the helm in December 2000, right after the dot-com peak and at a time most blue-chip stocks, GE included, were near historic highs and clearly overvalued. Immelt also inherited a tangled mess of businesses assembled by his predecessor, Jack Welch. Immelt divested most of GE’s finance businesses acquired under Welch, but reinvested in power and oil and gas businesses at high prices. His record will show he was unable to transform the conglomerate, whose accounting and earnings reports still baffle investors. GE investors are still underwater from the $40 stock when he took control.
Steve Balmer’s record at Microsoft was marred by several poor acquisitions. Microsoft generates huge amounts of cash, and the dilemma for management was where else to reinvest and get attractive returns. The company’s franchise software business didn’t need significant reinvestment to maintain its market position, so Balmer over 13 years bought companies like aQuantitative for $6 billion and Nokia’s phone business for $7.6 billion, both of which were…