What's the best way to judge management quality?

Jan 11, 2014

In this issue:
» Has shale gas changed global power equations?
» Do real estate prices fall ever?
» Robert Shiller finds US markets expensive but is not exiting at the moment
» How did global markets fare during the week?
» ...and more!

Continuing from where we left off yesterday, we are really thrilled with the response that has poured in for our new launched Equitymaster Club. And we've already discussed one of the most popular posts out there. Now here's another. 'How important is management quality while investing in stocks?'

Well, the answer is quite obvious isn't it? The importance of assessing management quality cannot be emphasised enough. After all, it is their decision making in the various areas of the business that will eventually decide whether the business is a long term compounding machine for shareholders. But it has to be noted that betting on a good quality management is not the wisest way to go about investing. It is also important to judge the quality of the business they are running. And the odds are really in our favour when a management with a good reputation tackles a good quality business. Try having one without the other and you are not quite on a fertile field we reckon.

Having said that, how does one go about judging the quality of a business? You will have to realise that there is no one way to do this. Even styles of legendary investors like Benjamin Graham, Buffett or even Peter Lynch differed in this respect. While Graham and Buffett do not like meeting managements that much, Lynch was all about company visits and frequent discussions with the management of the companies he owned. At the core of it though, they all tried to find answers to the same questions. Is the management team honest and transparent? Are they good at allocating capital? Do they really care about shareholder wealth creation or are they just behind revenues and want to grow at any costs? And only after satisfying themselves that they are reasonably confident about the quality of the management would they then pull the trigger.

A common investor should do the same we believe. They should look at managements that have a long term track record of growth and profitability and go about doing their job with a great degree of honesty and integrity. And mind you, there should be no room for complacency here. As a famous fund manager pointed out, if a management puts its hand in shareholders' pockets once, he's much more likely to do so again.

How do you judge the management quality of the companies you invest in? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Today's chart of the day points to an interesting trend. As per an investment think tank called Advisor Perspectives, nearly 2/3rd of the emerging market equity assets seem to be in stocks that are trading at premiums of about 10% or more to the MSCI Emerging Market index. In other words, while growth stocks are finding takers, value stocks are being ignored. As the chart suggests, this is in contrast to the year 2006 where there was more or less equal distribution between growth and value stocks. This is quite consistent with the trend witnessed in Indian markets over the past few years, isn't it? Does this mean it is time to exit growth and enter value? May be but what is more important is studying the fundamentals of the underlying business and only then taking a call.

Emerging Mkt Investors ignoring value stocks?

What is your view on real estate prices in India? Do you think that prices will never fall but will continue to rise? If yes, you are not in the minority. Most people in India are probably of the view that real estate prices in India falling are quite impossible. After all, they have only risen in the past 10 years. And so chances are that they will continue to rise in the next decade as well. It is slightly dangerous to adhere to this view. Simply because it rests on the overall logic that asset prices never fall. And we have enough proof in history to highlight that is never the case. Asset prices that have risen astronomically in the past are bound to correct some time in future.

What we are witnessing in the Indian real estate today is pretty much akin to the scenario played out in the US in the years before the crisis. Millions of Americans bought homes on mortgages on the wrong notion that property prices will continue to rise. What they instead had to deal with was a crisis of massive proportions in 2008 that saw significant correction in real estate prices. One of the reasons why real estate prices have been elevated in India is that the banking system lent indiscriminately to the sector. So real estate players used these fresh funds to repay old loans and never felt the need to lower prices to bolster demand. Now that the banking sector has been cautious on lending, real estate players are bound to face the heat. Another argument doing the rounds for high real estate prices is shortage of land. But India does not really face a shortage of land. And even a country like Japan which does face this scarcity has not seen property prices rise in the last 15 years or so. Of course, predicting the timing of a correction in real estate prices is always difficult. But fall they will at some point in the future.

2013 was about stocks. Benchmark indices across global stock markets ventured into unchartered territories. That too irrespective of any positive cues from global and domestic economy and notwithstanding inferior earning performance of corporates. Will stocks repeat such a performance in 2014? Well, the best indicator of such a trend is long term valuations. And the valuations for stock markets in the US give some pretty dangerous signals. As per Nobel Laureate Robert Shiller, current valuations of US stocks are at 60% premium to the long term average. The metric used here is the cyclically adjusted price to earnings ratio (CAPE).

In an interview to Business Insider, Mr Shiller has explained that the long term CAPE of the US stock market is around 16x. And that the current CAPE of 25x is closer to that seen during dotcom bubble in 2000 (45x) and prior to the Wall Street crash of 1929 (35x). While Shiller is not yet advising investor to exit stock markets, the risks he believes, are imminent. Now this holds true for not just stocks in the US but other developed and developing markets as well, including India. As and when the cheap liquidity that has made global stock markets frothy, gets pulled back, a massive correction in stock valuations can be the only consequence.

The energy sector in US has witnessed a vast transformation in the last few years. The discovery of shale gas and tight oil which are based on similar technology has been nothing less than a revolution. While the economy has seen really tough times, this is one discovery that has been a positive game changer and is likely to give the US a huge lead in maintaining its superpower status. Needless to say, it will significantly influence economic and political power equation. Infact, the impact is already evident. As Mr. Daniel Yergin; the renowned author who works for IHS suggests, the shift in the power balance is that the event has been crucial in forcing Iran to negotiate.

Some experts are even of the opinion that by the end of the decade, US will surpass Saudi Arabia as energy leader. If that happens, the global oil industry that has been mainly unipolar with Middle East and OPEC nations as the main players will be see significant repositioning. Not only will it be a major setback to the supremacy of Middle East and OPEC, but will make other economies like China and Europe relatively uncompetitive.

Meanwhile, indices across global markets witnessed mixed performance in the week gone by. Having said that, losses were more pronounced in the stock markets of Japan, the US and UK. For the week gone by, the US markets fell 3.3%, on concerns over the Fed taper program that is expected to aggressively pick-up in the current calendar year. Barring UK, all the remaining major European Indices ended the week in the green. The Indian equity markets started the week on a negative note. Indian equities traded slightly weaker during the week primarily due to downbeat signals from the overseas equity markets. The upbeat earnings performance of Infosys Ltd assured the market momentum towards the end of the week. Overall, the Indian markets closed the week on a positive note and was up by 0.4%.

Performance during week ended 10 Jan 2014
Source: Yahoo finance, Kitco, Equitymaster

 Weekend investing mantra
"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." - Warren Buffett

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1 Responses to "What's the best way to judge management quality?"

vinay kala

Mar 5, 2019

if a rumour about wrongdoing floats, the management must give a response immediately and counter the allegations serial wise.

this would be a good test to judge the management.

after all good mangements will know that the infor will be in public domain soon and giving out their version would be a test of their honesty and ability to deny with evidence the rumours that float.

vinay kala

05 03 2019

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