You can also read the articles about – Growth Stocks and the Value Investor and The Debt To Equity Ratio.

When Warren Buffett puts great emphasis on well managed enterprises and forms an opinion of the management of any company before buying a stake in it, people are not surprised. After all, Buffett is mostly interested in acquiring majority shareholdings (with certain exceptions) and understandably needs to have confidence in the management of a business that he owns. Ordinary investors normally acquire a very small shareholding in percentage terms and may think that in this situation the quality of the management is not so relevant. All the small investor needs to consider, surely, is the price paid for the share in relation to the future income stream from that share. The only management strategy they may want to look at is the dividend policy.

At this point Warren Buffett would strongly disagree with that investor. In his opinion an assessment of the quality of management is vital in making a decision on either acquiring a controlling shareholding or making a portfolio investment in the share capital. Although in theory a controlling holding brings with it the luxury of being able to change the management, this is in practice a difficult matter that brings disruption to the whole enterprise. The assessment of management competence should be done before making the share acquisition. If the management is not considered to be of sufficient quality to take the company forward in the right direction the investment should not be carried out.

Buffett considers himself to have learnt the advantages of acquiring good businesses, rather than just acquiring undervalued shares, after a painful learning process during the first years of his career.  His preferred order of actions is to first assess the long term prospects of a business, then form an opinion of the management before finally taking the decision to invest if the share price is sensible.  Both assessing the long term prospects and assessing the performance of management requires knowledge of the type of business activity in which the company is engaged and this is another of Buffett’s investment principles. For example, assessing which information technology enterprise has a competitive advantage that will bring it success for a long time into the future requires knowledge of that industry that is difficult for the layman to acquire. The direction in which that industry is moving is only clear to the layman with hindsight and that comes several years or decades too late.

Buffett looks for a management that keeps in mind the concerns of the shareholders, who are after all the owners of the company. This is reflected in his attitude to stock repurchases made by managers in companies in which he has a stake. Where the share price is considerably below the value of the company, a stock repurchase can bring the share price more in line with the intrinsic value. Also important for Buffett though less tangible is the information this gives him about the attitude taken by the company’s management towards their own role. This provides evidence for Buffett that the management is considering the interests of shareholders and is indeed putting their interests above any selfish attempts to expand their own sphere of influence. Shares in the company become more expensive for new investors as the share price increases after the repurchase. This is worthwhile however because that new investor is buying into a company whose management puts the interests of investors first.

One area where Buffett believes that management can be carried away with its own ambitions at the expense of shareholders is the tricky area of mergers and acquisitions. One does not need to quote the well-known examples from the opening years of the twenty-first century to know that corporate takeovers and mergers can go badly wrong. The pursuit of an acquisition seems sometimes to mesmerize management which only listens to reasons why the acquisition can go ahead without taking the time to reach a reasoned decision. An ill-judged acquisition can have an adverse effect on the value of shareholdings in the merged company.

When the management of a company takes the decision to go ahead with an acquisition this should be with the intention of increasing shareholder value. In the view of Buffett too many managers have pursued acquisitions as a way of making the numbers look superficially better (by increasing sales and profits) rather than considering economic substance. Even worse, some managers have pursued acquisitions out of personal ambition, extending the boundaries of their personal empire while disregarding shareholder value.

Clearly the value investor must ensure that any company in which shares are acquired has a management that puts shareholder value above any superficial or selfish motives. A good management is a factor in the computation of the intrinsic value of a company, although it may be harder to quantify than cash projections or profit forecasts. Despite the difficulty of putting an exact figure on the value of management there is no doubt that it has a real value and the true value investor must take this into account. In addition to looking at the figures the potential investor must take a step back, read the annual report and look at statements from the management. This is an integral part of the process of investing.