May 8, 2008|
Jockey or the Horse?...
No, this isn't a primer on how to make your next million from betting successfully on the Mahalakshmi Race Course. As proponents of sensible, long-term investing, this is the last thing we would ask investors to do. Instead, this is an attempt to shed light on a long-standing and a very worthwhile debate. When analyzing companies for attractive long-term investments, which of the two is more necessary, the presence of an excellent CEO/management or the strength of the business itself? In other words, should we bet on the jockey or the Horse?
Pick up any business magazine and 6 times out of 10, one is likely to come across a full sized image of an impeccably dressed individual with something equally impressive written at the bottom of the cover page, 'The Man with the Midas Touch' or 'To Hell and Back' or 'Find out the inside story of one of the most successful turnarounds in Indian Corporate History'. Wow! The expression lights up our face and we feel sad that we lost our chance on cashing in on the latest multibagger!
A study and its findings
It must be an event similar to this that must have prompted Steven N Kaplan, a University of Chicago professor and his associates to conduct a study on whether investors should place more weight on investing in a strong business ("the horse") than on a strong management team ("the Jockey").
Laid out below are the findings of the study in their own words.
"In this paper, we have studied the evolution of firm characteristics from early business plan to initial public offering to public company for 50 VC (Venture Capital) financed companies."
They further go on to add, "Our results inform the VC debate about the relative importance of the business / horse and the management team / jockey. The results call into question the claim that "a great management team can find a good opportunity even if they have to make a huge leap from the market they currently occupy." The results for the main sample and the 2004 IPO sample indicate that firms that go public rarely change or make a huge leap from their initial business idea or line of business. An initial strong business, therefore, may not be sufficient, but appears to be almost necessary for a company to succeed. On the other hand, it is common for firms to replace their founders and initial managers with new ones and still be able to go public, suggesting that VCs are regularly able to find management replacements or improvements for good businesses. We interpret our results as indicating that on the margin, VCs should spend more time on due diligence of the business rather than management."
Indeed, not many people outside the University of Chicago precincts might know Steve Kaplan, the originator of the study and hence might raise doubts over the veracity of the report. But not a lot of people can doubt the investing genius of Warren Buffett. One of the world's most successful investor is believed to have once said that 'if a management of an excellent reputation tackles a bad business, it is the reputation of the business that remains intact'. Peter Lynch, another of the great investors that the modern world has seen also seems to concur with this theory as he has once said that 'one should invest in a business that any fool can run because eventually one will'.
Read our discussions on Warren Buffett's letter to shareholders
What managements can't do, brands can!
Richard Branson, the possessor of one of the shrewdest marketing brains, once came out with a product called 'Virgin Cola' and took upon the might of 'Coca Cola' and 'Pepsi'. The result! The much publicised failure of the product. And it was not the extraordinary management at 'Coca Cola' and 'Pepsi' that thwarted Branson's attempt but the sheer power of these two brands.
It is not as if there are no followers of the other theory. Jim Collins, widely known for his bestseller books 'Built to Last' and 'Good to Great' has built a whole cult around the fact that extraordinary management can indeed separate the men from the boys. Back home, one of India's most successful money managers in recent times has often been heard quoting that for successful investing, one has to identify the jockey and once that's done, the jockey will ride the horse.
So, jockey or the horse?
Read how to form an investing framework
While we do not intend to take sides here, but logic says that investors should look to emulate those people who have put their money where their mouth was and have generated attractive returns year after year. And this is where we believe people like Warren Buffett and Peter Lynch score over book writers and trade magazines that tom-tom turnaround stories. Because unlike them, investors like Buffett have made billions by sticking to companies that have strong competitive advantages, without focusing too much on management. No doubt, the Indian money manager has made a success out of selecting smart jockeys, but he is yet to test out his theory over a much larger period of time, something Warren Buffett has done so successfully.
Thus, by whatever one has seen so far, it has become clear that one's chances of success in stock market increases manifold if one focuses on selecting the right businesses and not extraordinary management. For, even an average management can successfully run a business, which has strong competitive advantages. Lastly, we would like to point out that it is very important that one buys such businesses at attractive valuations. For, even the best businesses might not provide good returns if bought at stretched valuations.
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