How to Pick Stock Based on Management Quality

Over the weekend, a young 21-year-old aspiring investor, who had just finished his graduation, met me at a family function.

On realising that I'm an analyst, he came up to me for advice on investing.

On a lighter note, whenever I want to be politically correct or a generic question is put across, I normally answer the question with a question.

It works many times.

So, I asked the young kid, 'What do you look for when you want to invest in a company'?

Management Quality, he replied instantly.

That was a perfect answer for someone who hasn't started his investing career.

Over the years as investors, we have been told that one of the most important parameters in investing is quality of management.

Warren Buffett once said, 'You should invest in a business that even a fool can run, because someday a fool will'.

Does it mean Buffett is saying management is not important?

No.

Buffett's point is with regards to the complexity of the business and not the integrity or aptitude of the management. The more complex a business, the more it's dependent on the management expertise.

On the other hand, a simple and effective business runs itself.

But the billion-dollar question is this... 'How do we judge management quality'?

Is it so easy to form a judgement between good and not so good managements?

When we talk about management quality, we tend to focus on things such as 'integrity' and 'vision'.

Words like 'pedigree' are often used when evaluating companies.

In my view, management quality is important but overrated.

It's difficult to figure out what really goes on behind the scenes.

Negative things which are clear, should raise a red flag. However, identifying the thin line between good and bad is an art.

Here's some food for thought on why management quality is overrated.

Why is the Maggi Fiasco Different from the Welspun Fraud?

I am sure you must be aware of the ban which was imposed on Nestle Maggi due to high levels of monosodium and lead beyond the permissible limit.

Who could have imagined this from Nestle? It's one of the most ethical companies in the world.

Does the Maggi Fiasco make Nestle a fraudulent company?

When we talk about the integrity of the management, wouldn't this qualify as an example of bad management practice?

Let me give you another instance of an Indian company - Welspun India.

Welspun India is a leading exporter of home textiles to North America and Europe. It counts retailers like Walmart, JC Penny, Bed Bath and Beyond, and Target as its key customers.

However, in 2016, Target, a major client, severed ties after an internal investigation revealed Welspun had misrepresented its 100% Egyptian cotton sheets. Walmart too cut ties with the company.

The perception about Welspun India in the investing community remains tainted. Words like bad management, poor corporate governance were attached to the company.

Now this comparison between Nestle and Welspun is on this specific topic only. It does not compare Nestle and Welspun in any other aspect.

But the big question is this...

Both Nestle India and Welspun India had reported frauds, why is it that perception about corporate governance is different for these two companies? Why are the so called 'coffee can investors' not talking about corporate governance issues in Nestle?

Isn't too much focus on 'corporate governance' overrated?

Managements Will Tell You What They Want You Hear

I have not come across any management who will openly acknowledge their company is doing badly and will continue to do so.

Have you ever heard a management say 'The worst is ahead of us'?

They all say, 'The worst is behind us'.

In that case, how do we judge the management? Or the company's prospects?

The management will tell you what it wants you to hear.

The Notion that the Management Knows the Future

Bill Gates sold majority of his shares before leaving the board in 2020.

I'm sure you would appreciate the fact that nobody knows Microsoft better than Bill Gates, the guy who founded it.

Microsoft's performance has been among the best over the last 2 years. This is especially true after the pandemic where its cloud business accelerated.

If Bill Gates wouldn't have sold his stake, he would have been richer than Elon Musk and Jeff Bezos combined.

Now that's quite a statement. Who would have thought that Microsoft's best days were ahead of it when Satya Nadella took over?

How Many People in the early 2000s Knew Aditya Puri was a Visionary?

Many investors talk about betting on the management, especially during early days of the company.

HDFC Bank is synonymous with quality in the banking sector. Back in the late 1990s, HDFC Bank was an upcoming back led by Aditya Puri.

My question is, 'How many people knew who Aditya Puri was in the 90s'?

How many of you would have bet on a young Chartered Accountant brought in from Citibank Malaysia by Veteran Deepak Parekh to run the bank.

Remember, HDFC Bank became one of the finest financial institutions in India, after 25 years.

As an investor, you need to do your due diligence before you make any investment.

Despite of the handicaps I mentioned in the above examples regarding judgement, there are quantifiable and objective filters which should be used to identify management quality.

Here's what I use...

My Top 3 Management Quality Filters

1. Stay away from all companies/promoters who have any political affiliation.
2. Always check what the management had said in the past and if was done. A variance of 10-15% between words and deeds is fine. However, a major deviation or a repetition of mistakes is not acceptable. Avoid such companies.
3. Check the management's remuneration with respect to profits of the company. Expenses like the promoter's travel need to be checked in context of the big picture.

These filters are easily identifiable and can be quantified. I hope you will use it, dear reader, to improve your judgement of management quality.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure