Interviewing Management – Core Issues To Discuss by Tom Macpherson, Dorfman Value Investments
“Good questions are often far more powerful than answers,” they argue. “Good questions challenge your thinking. They reframe and redefine the problem. They throw cold water on our most dearly held assumptions, and force us out of our traditional thinking. They motivate us to learn and discover more. They remind us of what is most important in our lives.”
Andrew Sobol and Jerald Panas[1]
In 2013 during a strategy session reviewing decision-making in the Second Iraq War, an officer heard a case study and whistled. “How the hell could we have missed something like that?” he asked. After a long pause, the facilitator said, “Simple. You never asked the question”. Since then the Army War College has spent time developing a course on how to ask the right questions – obtaining information that will affect your decision-making and produce better outcomes.
I bring this up because in our article last month (May 25th, 2016, “Asking the Right Questions”), we discussed the importance of asking the right questions about a possible investment opportunity. In the ensuing discussion, Zejia asked me about what questions I might ask management of an investment opportunity. Much like the army officer training, I look for questions to management that can increase the possibility of a successful investment. In today’s article, I wanted to briefly discuss the topics I discuss with management as well as specific questions I might ask in the course of our conversation.
Before I get into greater detail, I should make it clear we generally talk to roughly one-half of our investment holdings’ management. Our ability to get on the calendar of Bob Deuster (CEO of Collectors Universe CLCT) is far greater than with Intuitive Surgical’s (ISRG) Gary Guthard. When we can’t actually speak to management we will occasionally send in a questionnaire asking our questions. How (or if) management replies can make or break our decision to invest.
There are four (4) major areas I want to explore with management – capital deployment, compensation, forecasting, and corporate responsibility. I look to map management’s responses with the historical record from SEC filings such as the annual 10-K or quarterly 10-Qs.
Capital Deployment and Returns
Perhaps that greatest role played by senior management is to wisely deploy the company’s capital so that it earns a good return. Wise allocation of capital is harder to find than you might think. Why is that? First is the truly abysmal record of management itself. Of the S&P 2000 roughly one-half of the companies’ weighted average cost of capital (WACC) exceed their return on invested capital (ROIC). It is also estimated that roughly 80% of all mergers and acquisitions destroy value. Second, there is no real training to become CEO or on allocating capital. You either learn it on the way up or through on-the-job training. It is no wonder managements have such a poor record. Some of the questions I ask are:
- What are your key drivers for return on capital?
- What are your key measures in capital deployment decision-making?
- Does success/failure in allocation of capital impact compensation?
- What do you define as long-term thinking?
- Do you integrate long-term thinking with allocation of capital?
Compensation and Incentives
There really isn’t any best way to align management’s compensation with long -term value creation. We know with some certainty what doesn’t work: free stock options, measuring value by stock price, easily obtainable goals that can be manipulated. The list goes on. I look for management that openly grapples with this issue and isn’t afraid to tinker with the system to improve it. It’s better to try to align goals with some uncertainty than not align goals with a fixed certainty. Some questions I might ask are:
- How do you align management and shareholder goals?
- Do you try to incentivize management and employees equally?
- How often do you measure the impact of incentives?
- What changes have you made over the past 12-24 months?
Forecasts, Mistakes, and Reviews
Over the course of their tenure, CEO’s will make a fair amount of predictions, estimates, and assessments of their strategy. They do this through investor documents (such as their Annual Reports), quarterly earnings conference calls, and presentations made at industry conferences. I look for managements that openly acknowledge failures and address what went wrong and what they’ve learned. Most of all they must measure and adjust as time passes. A management team that fails to learn and adapt is a prescription for underperformance. Some questions I might ask are:
- What predictions have proven correct? Incorrect?
- What have you learned from getting predictions wrong?
- How often do you review your predictions and assumptions? Quarterly? Annually?
- How do mistakes impact your role as CEO? How does it impact the company?
Corporate Responsibility
I look for management that realizes it doesn’t work in a bubble. Companies can have an impact on public policy, their community, and their workers’ family life. This doesn’t mean I’m looking for a not-for-profit socialist haven. Rather I look for a blend of shareholder value with an enlightened approach to corporate responsibility. Treating your employees – and the community you work in – with respect and fairness simply makes business sense. Some questions I might ask are:
- How do you help your employees assist their community?
- Are any of your employees on public assistance?
- How does the company give back to the community?
- What is the payroll ratio between the CEO and the lowest paid employee? The median average employee?
Conclusions
Understanding how management thinks about allocation of capital, compensation, decision-making, and corporate responsibility can shed light on some of the most important jobs a CEO must master for success. From this give and take an investor should feel comfortable that management is honest in their communication, skilled in the strategic decisions, and acutely aware of the power of incentives. By not asking the right questions, investors might focus on topics that will play no role in the long-term success of their investment. To do so – in the parlance of our War College students – would be to win the fight but lose the war.
As always I look forward to your thoughts and comments.
[1] “Power Questions”, Sobol and Panas, Wiley; February, 2012
