Will you invest in a business where the CEO is a fool? - The 5 Minute WrapUp by Equitymaster
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Will you invest in a business where the CEO is a fool?

Mar 26, 2015

In this issue:
» Why does Warren Buffett love brands...
» Relationship between G-Sec yields and inflation of select countries
» A round up on markets
» ...and more!

The title of today's wrap up reads, 'Will you invest in a business where the CEO is a fool?' Of course not. This is a question with the most obvious answer you would say to yourselves. Why would someone want to invest in a business where the CEO is most likely a fool?

Well, allow us to pull the rug from under your feet a bit. What if we tell you that Warren Buffett, arguably the world's best investor ever is all too willing to put his money where the fool's mouth is? Sample this quote from him. "You should invest in a business that even a fool can run, because someday a fool will."

Confused? It only gets worse if you listen to what Buffett's ardent friend and fellow billionaire Bill Gates has to say about the first and foremost quality a CEO should have.

In an interview few years back, Gates was pretty vocal in announcing that the world's best companies are built by fanatics. In other words, he seems to be hinting at best companies being built by someone whose IQ is off the charts and who keeps on working day and night.

Well, we don't know whether the definition of fool has changed. If it hasn't then its quite clear that Buffett and Gates are not seeing eye-to-eye on this one. Or maybe we are missing something.

We felt the way out of this dilemma was to take the opinions of Richa Agarwal and Ankit Shah, our brilliant editors of Hidden Treasure, one of our best selling services.

As someone whose primary job is to interact with and track the decision making of the management at some of the most promising small cap companies out there, they have what we believe front row seats to this entire fool or a fanatic saga.

So here's their reading of the situation. First up, they argue that pitting the above mentioned remarks by both Buffett and Gates against one another is like comparing chalk with cheese. There's no doubt in their minds that no great business is started and built by a fool. Therefore, one absolutely needs a fanatic to get a business off the ground and help it grow in its initial years.

However, once the business is up and running and has figured out its core competence and the various tradeoffs, then it's mostly about maintaining the culture and not doing something overtly stupid.

Please understand that you would be making a big mistake if you took what Buffett said about businesses being run by fools at face value. Knowing him, it was actually just a tongue-in-cheek remark. What he actually meant was reliance upon a superstar CEO all the time may be a wrong approach to take. Instead, emphasis should be put on the firm's ability to deliver shareholder value even under an average looking management. Therefore for him, a well established company that's past its nascent stage of growth should simply be a powerful magnet for customers and various other stakeholders to get attracted to it. It should not be dependent on superior management skills to create long term shareholder wealth.

So, in the end it all boils down to whether investing is more about the horse than the jockey. And Buffett seems to be pretty clear in his head about what he prefers. It is the horse indeed. And why not. If a certain way of thinking has put billions into your bank account, you are likely to go all the way to defend the same.

The approach in fact makes sense to us as well. The idea is to try and understand whether the underlying business has a competitive advantage that's both strong and durable. And if the answer is in the affirmative, then even an average looking management can end up creating huge amount of wealth in the long term.

We know a lot of people would bet their money on a rock star CEO who has the knack of turning even a poor or a mediocre business into gold. However, a bad business is like a kitchen to us. No sooner do you kill one cockroach, another one emerges. Therefore, as on numerous occasions in the past, we are with Buffett on this one too.

Is management quality more important than the quality of business or vice versa? Let us know your comments or share your views in the Equitymaster Club.

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We just saw Buffett's view on business quality. The reason he prefers to bet more on the horse (read business) rather than the jockey (read management) is because most of his purchases have been iconic brands that are past the nascent stage of growth. Think Coke or for that matter Heinz. Take American Express or General Motors for example or even Kraft Foods. All have been iconic brands. And when you have the power of a brand to attract customers it is an enduring moat.

So, what makes a brand such a powerful attraction to potential customers?

Let us give you an example of Snickers to answer this question. You may know its a candy bar. Would you be able to knock of this brand if someone lent you US$ 1 mn? If that isn't enough is US$10 m fine? Well, to be honest who so ever attempts this is more likely to burn his cash and go bankrupt. And the reason is simple. Snickers is a strong brand with consumption story attached to it. Now, it is not that there aren't other candy bars in the market. Or owners of other candy bars lack deep pockets to uproot Snickers through heavy advertising. The reason no one can do that or is not trying is because Snicker develops an instant recall to anyone who wants to have a candy bar. Such is a power of this brand. When you take over a customer mindset through brands it is very difficult to change that. And this is where brands score.

This is the very reason why Buffett is in love with brands. In the Indian context too there are many brands that rule the customer mindset. If an investor is able to buy them at right valuations huge returns are in for the taking.

  Chart of the day
As we saw that when it comes to equity investing assessing the quality of business is paramount. However, when it comes to investing in fixed income assessing the economic, fiscal and monetary policies of the subject country is critical. Inflation and interest rate are the key factors that need to be assessed when any fixed income manager plans to invest in any country.

Today's chart shows an interesting relationship between G-Sec yields and inflation of a few countries. As can be seen, Greece has the highest while Japan has the lowest yield. So, should one buy Greek debt as it is expected to earn highest return? Well, as it goes return should always be seen in the context of risk. The reason why Greece's yield is high is because the country is in huge debt pile. The higher return reflects the risk of investing in Greek debt which has a possibility of default as well.

Another factor which investors should take into consideration is the real rate of return while investing in debt. Let's take the case of Japan to understand better. As seen, Japan's G-Sec yields a return of 0.3%. However, the inflation rate is 2.4% indicating that the real return is negative. So, for example if you invest in Japanese G-Secs now you may get 0.3% in return. But by the time you earn this return price of essential goods and services would have risen by 2.4%. This would have eroded your purchasing power.

Thus, when it comes to investing in fixed income investors have to be aware of the inflation risk inherent in the return. Also, one should not chase a high return debt product just because it offers more. Instead one should assess and see if the risk is high or not as was the case with Greek debt.

Should G-Sec yields move in line with inflation?

The Indian stock markets are trading weak today. At the time of writing the BSE-Sensex was trading down by around 400 points, while the NSE-Nifty was down by 110 points. Losses were largely seen in IT and banking stocks. Most Asian markets were also trading in the red at the time of writing. European stock markets too opened in the red today.

 Today's investing mantra
"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

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1 Responses to "Will you invest in a business where the CEO is a fool?"

Dharmendra Kapur

Mar 30, 2015

Backing the business over the CEO needs to be done with care today as with the disruptions coming in, we really do not know how long the business will last, some fanatic will come and disrupt it. Highlighted very well by Mr. Ram Charan in his recent article about Are You an Attacker, a Defender, or a Sitting Duck on Linkedin. Cannot paste the link here as it not being permitted by your website.

Equitymaster requests your view! Post a comment on "Will you invest in a business where the CEO is a fool?". Click here!
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