Most investment research focuses on the quality of a business' operations, competitive position, returns on equity, earnings growth, and so on--and rightly so--but far less attention is paid to the quality of the people running the business. Both factors matter.
Indeed, Warren Buffett frequently speaks about the importance of evaluating the people who run the businesses he owns.
Here are just a few examples:
- "Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value."
- "It's hard to overemphasize the importance of who is CEO of a company."
- "Charlie (as in Charles Munger) and I look for companies that have ... able and trustworthy management."
- "You need two things--a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle."
While management itself cannot constitute an economic moat, at Morningstar we believe management’s capital-allocation decisions can lead to the establishment, enhancement, or erosion of an economic moat. Put another way, we want to better understand the intersection of management and moat with each company we research.
To understand moats better, read How we use moats to pick stocks and Explaining economic moats to an 8-year old.
Our stewardship methodology emphasizes management’s record on items such as financial leverage, investment strategy and valuation, and operational execution, among others. We find these factors not only to be universally applicable for comparing stewardship across global markets, but also to better reveal how well management teams are allocating shareholder capital to enhance or establish an economic moat.
We're also keen to evaluate how well a management team has played the hand it's been dealt. Rather than using hindsight as our primary guide in evaluating a management team’s capital-allocation skills, Morningstar analysts bear in mind that some results have more to do with luck than management’s skill--particularly pertaining to short-run results--and instead put themselves in management’s shoes at the time the decision was made.
In other words, we want answers to questions like these:
- What other options did management have at the time?
- How did the timing of the decision fall in the industry’s cycle?
- What were the prevailing industry multiples at the time the acquisition/divestment was announced?
Because one can take all the right steps in evaluating a stock only to have the market fall or have another unforeseen event lead to poor short-term results, we want to learn more about the company's decision-making process for acquiring another company, starting a joint venture, investing in growth capital expenditures, or repurchasing stock. As Michael Mauboussin puts it in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, "When a measure of luck is involved, a good process will have a good outcome but only over time."
Realizing that luck is often fleeting, Morningstar analysts want to determine the thoroughness of management's investment evaluation process and whether recent successes and failures have altered that process. This, we believe, will tell us more about the quality of the firm's general capital-allocation decisions than what short-term results might suggest.
Admittedly, outside of sitting in a room with the CEO and CFO as they evaluate investment opportunities, it can be difficult to evaluate management's capital-allocation decision-making processes. That doesn't mean we shouldn't try, of course.
This article has been authored by Todd Wenning, an equity analyst who leads Morningstar's stewardship methodology. Also read his article What goes into evaluating stewardship.
