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4 simple steps to Value Investing: Step 3

May 7, 2013

In the previous article, we covered the second of the four steps to successful value investing created by the legendary investor Warren Buffett. Let us now move on to the next step in this article.

A word about management

Perhaps among various factors that need to be looked at before investing in a company, the management is the most important. But that is also where the difficulty lies. After all, how do you assess management? Unlike company financials, ratios and valuation methods which can we quantified and expressed in numbers, management quality is more subjective. No number can be assigned to it. And yet it is one of the most crucial elements in value investing.

Buffett's views on management quality

Legendary investor Warren Buffett also attaches a lot of importance to management quality. He is of the view that there are two main factors in assessing management:

  • The results of the company
  • The treatment of the company's shareholders
  • How well it allocates capital
Let us consider these separately.

Results: Past performance is highly indicative of how well the management has been able to steer the growth of the company. This is through both good times and bad. Indeed, a good management needs to be proactive and should have the ability to respond to changes, competition, opportunities and threats. Having said that, what needs to be noted is that the management track record has to be evaluated in context of the sector dynamics in which companies operate. For instance, it would not be fair to compare Infosys' management with that of Bharat Petroleum Corporation Limited (BPCL), as the oil and gas sector is highly regulated, whereas the software sector is not.

Treatment of shareholders: Shareholders obviously stand to benefit if the management has been able to provide healthy returns on capital and dividends on a consistent basis. Return on invested capital and dividend yield are some of the important parameters to be looked at while determining whether a shareholder is getting the most of what he has put into the company.

Allocation of capital: How effectively the management is able to allocate capital is a very good indicator of its quality. For instance, one needs to evaluate whether this capital is being invested in projects or activities in line with the company's overall growth strategy. Moreover, are these investments generating good returns? If the capital is not being invested, then whether the same is being distributed to the shareholders. For instance, FMCG companies do not require heavy capex and hence rock solid companies such as Nestle and Hindustan Unilever have not only been generating strong returns on capital but have also been doling out healthy dividends.

There have been instances in the past where the management of cash rich companies has made ill suited acquisitions which have been a drag on the overall company performance. Instances such as these are examples of misallocation of capital by the management.

Management strength at the end of the day is a qualitative factor. But investors need to have a grasp on the people at the helm of affairs before they decide to invest in the stock of a particular company. This would mean reading annual reports, analyzing company performance and keeping check on the management's communication with the shareholders. This may not be as concrete as numbers but it certainly helps in forming a reasonable judgement on what the management's objectives are and what it intends to do to drive company performance going forward.

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Radhika Pandit

Radhika Pandit (Research Analyst), is one of our senior analysts with more than a decade-long stint in the field of equity research. She has helped build our pharmaceutical sector research from scratch and has a firm grasp of the Indian automobile industry. Being an ardent follower of Warren Buffett's value investing philosophy, she believes in investing in solid businesses for the long haul.

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