How to evaluate a company's management team

I spend a lot of time to evaluate a company’s management team in my investment research process. I’m also often asked by people I meet what I look out for in management.

There’s no formula, but I tend to look for company leaders who have a different way of looking at the world.

I think it’ll be useful to share a few great examples from the companies that are in my family’s investment portfolio.

Example 1

Mark Zuckerberg is the CEO and co-founder of Facebook. In the company’s IPO prospectus, Zuckerberg wrote these words in a shareholders’ letter:

"Facebook was not originally created to be a company. It was built to accomplish a social mission - to make the world more open and connected.

We think it's important that everyone who invests in Facebook understands what this mission means to us, how we make decisions and why we do the things we do."

This is what Zuckerberg said in the company’s 2020 first-quarter earnings conference call:

"I have always believed that in times of economic downturn, the right thing to do is to keep investing in building the future, and I believe this for a few reasons.

"First, when the world changes quickly, people have new needs and that means that there are more new segments to build. Second, since many big companies will pull back on their investments, there are a lot of things that wouldn't otherwise get built, but that we can help deliver. And the third, I believe that there is a sense of responsibility and duty to invest in the economic recovery and to provide stability for your community and stakeholders if you have the ability to do so.

"And we're in a fortunate position to be able to do this. Along with our strong financial position and the important social value our services provide, we're planning to hire at least 10,000 more people in product and engineering roles this year, so we can continue building and making progress…

"…Overall, I think during a period like this there are a lot of new things that need to get built. And I think it's important that rather than slamming on the brakes now, as I think a lot of companies may, that it's important to keep on building and keep on investing in building for the new need that people have and especially to make up for some of the stuffs that that other companies would pull back on, and I think that's in some ways that's an opportunity, in other ways, I think it's a responsibility to keep on investing in the economic recovery."

Example 2

Amazon.com’s founder and CEO, Jeff Bezos, said the following in a 2011 interview with Wired magazine:

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"Our first shareholder letter, in 1997, was entitled, "It's all about the long term." If everything you do needs to work on a three-year time horizon, then you're competing against a lot of people.

"But if you're willing to invest on a seven-year time horizon, you're now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavours that you could never otherwise pursue. At Amazon, we like things to work in five to seven years. We're willing to plant seeds, let them grow - and we're very stubborn. We say we're stubborn on vision and flexible on details."

Bezos also mentioned this in Amazon’s 2020 first-quarter earnings update:

"We are inspired by all the essential workers we see doing their jobs - nurses and doctors, grocery store cashiers, police officers, and our own extraordinary frontline employees. The service we provide has never been more critical, and the people doing the frontline work - our employees and all the contractors throughout our supply chain - are counting on us to keep them safe as they do that work. We're not going to let them down. Providing for customers and protecting employees as this crisis continues for more months is going to take skill, humility, invention, and money.

"If you're a shareowner in Amazon, you may want to take a seat, because we're not thinking small. Under normal circumstances, in this coming Q2, we'd expect to make some [US]$4 billion (S$5.6 billion) or more in operating profit. But these aren't normal circumstances. Instead, we expect to spend the entirety of that [US]$4 billion, and perhaps a bit more, on Covid-related expenses getting products to customers and keeping employees safe. This includes investments in personal protective equipment, enhanced cleaning of our facilities, less efficient process paths that better allow for effective social distancing, higher wages for hourly teams, and hundreds of millions to develop our own Covid-19 testing capabilities.

"There is a lot of uncertainty in the world right now, and the best investment we can make is in the safety and well-being of our hundreds of thousands of employees. I'm confident that our long-term oriented shareowners will understand and embrace our approach, and that in fact they would expect no less." [Yes, I do expect no less from Amazon, as one of the company's shareholders.]

Example 3

Warren Buffett, the CEO of Berkshire Hathaway wrote the following in his 2004 shareholders’ letter:

"What we've had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasised, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO [National Indemnity Company] had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers - but they left us."

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In Berkshire Hathaway’s 1994 shareholders’ letter, Buffett wrote one of my all-time favourite passages in investing literature:

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8 per cent and 17.4 per cent.

"But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

Example 4

Netflix co-founder and CEO Reed Hastings said the following in a 2007 interview with Fortune magazine, when streaming was about to take off:

"We named the company Netflix for a reason; we didn't name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device."

Netflix also has a letter named Long-Term View. The letter has these passages:

"We compete for a share of members' time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.

"If you think of your own behaviour any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.

"We strive to win more of our members' "moments of truth"."

Example 5

In a 2015 letter, Shopify’s co-founder and CEO Tobi Lütke wrote:

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"Over the years we've also helped foster a large ecosystem that has grown up around Shopify. App developers, design agencies, and theme designers have built businesses of their own by creating value for merchants on the Shopify platform. Instead of stifling this enthusiastic pool of talent and carving out the profits for ourselves, we've made a point of supporting our partners and aligning their interests with our own. In order to build long-term value, we decided to forgo short-term revenue opportunities and nurture the people who were putting their trust in Shopify. As a result, today there are thousands of partners that have built businesses around Shopify by creating custom apps, custom themes, or any number of other services for Shopify merchants.

"This is a prime example of how we approach value and something that potential investors must understand: we do not chase revenue as the primary driver of our business. Shopify has been about empowering merchants since it was founded, and we have always prioritised long-term value over short- term revenue opportunities. We don't see this changing."

Example 6

Chipotle Mexican Grill’s IPO prospectus contained the following passages:

"When Chipotle (pronounced chi-POAT-lay) opened its first restaurant in 1993, the idea was simple: demonstrate that food served fast didn't have to be a "fast-food" experience. We use high-quality raw ingredients, classic cooking methods and a distinctive interior design, and have friendly people to take care of each customer-features that are more frequently found in the world of fine dining.

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"When we opened, there wasn't an industry category to describe what we were doing. Some 12 years and more than 500 company-operated and franchised restaurants later, we compete in a category of dining now called "fast-casual," the fastest-growing segment of the restaurant industry, where customers expect food quality that's more in line with full-service restaurants, coupled with the speed and convenience of fast food."

The prospectus also said:

"Our focus has always been on using the kinds of higher-quality ingredients and cooking techniques used in high-end restaurants to make great food accessible at reasonable prices. But our vision has evolved. While using a variety of fresh ingredients remains the foundation of our menu, we believe that "fresh is not enough, anymore." Now we want to know where all of our ingredients come from, so that we can be sure they are as flavourful as possible while understanding the environmental and societal impact of our business. We call this idea "food with integrity," and it guides how we run our business.

"Using higher-quality ingredients: We use a variety of ingredients that we purchase from carefully selected suppliers. We concentrate on where we obtain each ingredient, and this has become a cornerstone of our continuous effort to improve our food. Some of the ingredients we use include naturally raised pork, beef and chicken, as well as organically grown and sustainably grown produce, and we continue to investigate using even more naturally raised, organically grown and sustainably grown ingredients, in light of pricing considerations.

"A few things, thousands of ways: We only serve a few things: Burritos, burrito bols (a burrito without the tortilla), tacos and salads. We plan to keep a simple menu, but we'll always consider sensible additions. For example, we introduced the burrito bol in 2003-just when the popularity of low carbohydrate diets exploded-and estimate that we sold about seven million of them in that year. In 2005, we also rolled out a salad.

"We believe that our focus on "food with integrity" will resonate with customers as the public becomes increasingly aware of, and concerned about, what they eat."

Chipotle was at one point owned by fast-food giant McDonald’s, and there was a huge clash between them in terms of how they approached their food culture.

Two quotes from a brilliant Bloomberg profile of Chipotle’s entire history from 1993 to 2014 clearly illustrates the differences between the two companies:

1. "What we found at the end of the day was that culturally we're very different. There are two big things that we do differently. One is the way we approach food, and the other is the way we approach our people culture. It's the combination of those things that I think make us successful."

2. "Our food cost is what runs in a very upscale restaurant, which was really hard for McDonald's. They'd say, "Gosh guys, why are you running 30 per cent to 32 per cent food costs? That's ridiculous; that's like a steakhouse."

Sticking with great leaders makes sense

It’s impossible to get it right all the time when we evaluate a company’s management team. There can also be times when our assessment of a company’s leaders turn out to be right, but bad luck ends up causing the investment to sour.

These things happen. But by and large, if we can find wonderful management teams and stick with them, we may be pleasantly surprised at the returns we can find.

Here’s a look at the return my family’s portfolio has earned from each of the six stocks mentioned above since our first purchase of their shares:

PHOTO: Yahoo Finance

I’ve said in a few recent webinars I’ve done that I consider a company’s management team to be the ultimate source of a company’s competitive advantage.

That’s because a company’s current economic moats come from management’s past actions, while a company’s future economic moats come from management’s current actions.

And the beautiful thing about having a unique lens to view the world is that it is a trait that is not easily – or perhaps never can be – copied.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.