Sunday, February 10, 2008

Bruce Sheppard: When the going gets tough...

If my readers haven't already read Bruce Sheppard's Stirring the Pot Blog his latest post is right on the money, so I have added to my blog below. It is essential reading and you need a gander at it before you invest in the sharemarket, or any business for that matter.

The focus by an investor on the quality of management, before anything else, is one of the main criteria for picking a good company to invest in.

If you have good management , it will follow that the business that they management will probably be a good investment.

It is at these times of market stress and economic downturns that good management can get through the tough times.

Bruce Sheppard in Stirring the Pot | 4:03 pm 8 February 2008

When investing in a share you are investing in a business. A business is an opportunity run by management with your capital.

But how do you judge the quality of management? It is easy to judge the numbers but hard to judge the resilience, integrity and determination of people, particularly if you never eye ball them.

You have one opportunity a year to do this and it is the annual general meeting. Once the prepared speeches are done, the response of management to shareholder questioning gives a wonderful opportunity for insight into these people who have the responsibility for the prudent and rewarding use of your capital.

Over the next 18 months, shareholders are likely to see reversals in profit performance and it may even flow though into reduced dividends. Mr Market, as imperfect as ever, is anticipating this and as a result share prices have fallen.

But the real entertainment, and the chance for insight, will come as our managers seek to explain the situation to shareholders.

The explanations will fall into these broad categories:

1. “The profit is down, and we know the mistakes we made. We have changed the way we do things to evolve our practices to adjust to the changed environment.”

2. Some will go a step further and analyse the mistake for the benefit of shareholders and will also advise the lessons learned.

3. A few, but not many, might actually admit that conditions are difficult but may still report improved earnings. Of this group, some might admit that it was luck more than good management. Others might share a little of the decisions they made to make their own luck, of course taking care not to give away operational secrets.

4. Some will seek to blame others for the earnings reversal. “It is all the fault of the economy and in due course earnings will improve.”

Those that adopt the fourth approach are useless tossers who should not be left in charge of running a bath. Their management style is reactive, they take what is given to them and if you are lucky make the best of it. They don’t try to alter their environment and or even anticipate it.

Businesses run by such people will never perform long term without luck, and luck favours those who make it. Hopefully the board will recognise this and move the management team on, replacing it with a more dynamic approach. But generally boards recruit people that are similar in temperament to them so don’t hold your breath waiting for the board to react.

Generally “blame others” management only gets moved on when the business is at or near the precipice. Such managers should not be provided by shareholders with the custody of the wealth of others, so sell. A difficult business with an inspirational manger will outperform a business with favourable economics and a tosser running it.

Those that prosper in recession, and are self aware enough to admit when it is luck, give shareholders the confidence to know that they will in future make their own luck. These are safe guys to back.

Those that are honest enough to admit their mistakes and tell you what they have learned are okay too. They are learning, and honest. Honesty is a really good start. If, however, as the years unfold they descend into a pattern of making new and distressing mistakes each year, they are honest fools and should also be avoided.

So in picking a recession proof investment, look for simple businesses run by honest, hard working people who over time will make their own luck and beat the market.

We have 160 listed companies, and not many fall into this category. And in reality you won’t know which do unless you analysis the history, review critically the prospects and understand the underlying strength of management. Sounds like a lot of work. Well it is to a point. But if you keep your focus and apply the work to five or 10 good businesses, and don’t waste your time on trying to adopt portfolio theory with hundreds of separate investments, it is not too hard, and what’s more it is fun.

In the words of Warren Buffett: “Modern finance theory teaches students to do average” with my addendum “less costs.” Just as you don’t want your mangers to do average, why would you aspire to it?

Related Share Investor reading

The Intelligent Investor: Book review

Mr Market gets his groove on
Business Gobbledygook puts up barriers
Business Mis-Management

C Share Investor & 20o8

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