The importance of management

In the long term, the success of equity investment relies heavily on the success of the investment target company's business. The company management plays an important role in the success of the business, and you should pay attention to their expertise and the quality of management work when assessing investment targets. However, assessing the suitability and quality of management is very subjective and situation specific.

In this article we discuss the role of management in investing. Management has been studied very extensively and there are heaps of literature on the subject. Instead of a research review, we aim to provide practical tools identified through our analysis experience that enable investors to assess the quality of the management and the conditions for creating shareholder value of the company under assessment.

Some key indicators of management quality are:

The described tools are by no means absolute indicators of management quality but we believe that they provide a good sense of the management's ability to create long-term shareholder value. These factors can almost without exception be independently assessed by all investors, and our analysts also seek to comment on them as part of research on listed companies. Due to the inaccurate nature of the tools, the assessments we make about the company management are reflected in the overall picture of our analysis and we typically do not comment directly on them in our research content.

Management is an important but not all-powerful factor in the company's success

The company's success is driven by a number of factors such as its target market, competitive position, strategy, business model, people, and culture. These factors that affect the success of the company are constantly changing. The key tasks of the company's management include identifying and anticipating changes around and within the company, the company's strategy (incl. capital allocation) and clarifying the objectives for the entire organization, and ensuring the organization’s preconditions to implement the chosen strategy.

In this context, we include the company’s Board of Directors, CEO and management team in management. Typically, the Board of Directors selects the CEO and the CEO selects the management team. The CEO is often the most visible part of the company's management and provides a window to the way of thinking of the Board that selected the CEO. We therefore believe that the CEO is the best single lens available to the investor to examine the quality of the company's management. On the other hand, CEOs are somewhat between a rock and a hard place. The company's Board of Directors decides on the strategy, in addition to which both external market factors and the internal burden brought by the company’s history are not in the hands of the CEO. A bad Board and strategy, or too deep internal challenges, can create an insurmountably difficult environment even for the best talent to generate a good result in a reasonable time horizon.

However, good management can turn a weakly performing company to a path of success and create shareholder value. Correspondingly, poor management can pose challenges for a successful company and destroy shareholder value. However, the management is by no means an all-powerful factor in the company's success and increasing shareholder value. A skilled management can help a company operating in a difficult industry to do better than its peers, even if the company ultimately destroys shareholder value. Skilled management can be seen as an enabler for talented experts in the organization to fully utilize their potential and produce positive effects for the company's business relative to the peers. In the easiest sectors, the opposite can be true, as this quote from Warren Buffet also states: "I always invest in companies an idiot could run, because one day one will.”

In small companies, the importance of management can be particularly important, as management in these companies can be close to the company's operational activities and the impact of individuals on the business is high. In small companies, key personnel risks are one of the reasons for the higher required return than for large companies. Large companies can be seen more as institutions where the importance of the management is smaller and activity less dependent on individual managers.

1) CEO’s background and track record give preliminary indications of management quality

The historic track record is not a guarantee of the future, but management’s past experience (especially the CEO) can be seen as an advantage for company development. However, the relevance of the experience should always be assessed on a company and situation basis. For example, a promising CEO for a turnaround company could have implemented a turnaround in another company. A company undergoing rapid market change could in turn benefit from a CEO who, for example, has built a company for a new market as an entrepreneur. In some situations, it is best for a new CEO to come from inside the company, for example a strategically important business manager position within the management team. A CEO from outside the industry can in turn bring a needed new perspective to the company for example on building processes for a company entering a more mature growth stage.

Inderes’ analysts assess the suitability of the CEO's background to the company's situation, typically in connection with the appointment news, when the Board of Directors comments on the background and rationale of the selection. In general, better signs of management quality are generated over time, and the importance of the “CV assessment” based on the appointment news usually becomes obsolete very quickly.

2) Clear and transparent communication helps convince the market and the company's employees

Quality management is often a clear communicator. Management must continuously communicate within the company, for example to keep the company’s direction clear and the organization motivated. On the other hand, the management also communicates to the capital markets, which affects the acceptable valuation of the company and thus the conditions for access to capital. Transparent communication indicates the management has a clear picture of the situation and a clear strategy, which supports the conditions for the strategy to be successful. Clear communication naturally also requires management to be able to communicate complex issues in an understandable manner.

The investor can assess management communications, e.g., in connection with financial reporting, when the management will at least provide written information about the company's status and typically also a webcast. Different Q&A events are also excellent opportunities to examine management communication. The investor should have a clear picture of the company's situation and direction, based on management's investor communications. Is communication concrete? Can the management defend and explain their choices clearly? If investor communications are difficult to understand and the company's situation and direction do not seem clear, it is easy to imagine that management communication within the organization generates confusion about the same issues and ultimately problems in strategy implementation.

In addition to clarity, the content of the communication is also important. Quality management is usually also open about business challenges, and communication does not focus solely on highlighting the company's excellence. A certain humility in communication, as well as the transparent identification of the strengths and weaknesses of the managed company point to a realistic situation picture and ability to adapt to changing situations. If communication lacks mention of challenges and development points it raises concerns about the management’s ability to detect and respond to problems that each company inevitably faces. In our research, the clarity and transparency of management communication is one of the factors we include when, e.g., commenting on the clarity of the company’s investment story, the logic of the company’s strategy and estimate risks.

3) Consistency between management comments and the subsequent business figures is a sign of management ability

A key factor in the credibility of the company's management and investment story is the management's realistic picture of the company's situation, potential and ability, and timing to achieve this potential. In the short term, the situation picture may include company guidelines or other individual business indicators mentioned by management, the development of which can be monitored in the shorter term. Similarly, in the longer term, strategic objectives are part of management communication about the company's realistic potential.

An investor should monitor the relationship between the management’s words and actions, i.e. “Say/Do-ratio”:

• Are the results in line with what management has previously said?
• Are targets set high at first, but when the results are lagging, they are buried in management communication?
• Does the management constantly speak very optimistically about the business in between the lines but number development is consistently weak and the management sees no need of improvement in the company itself?
• Or is the company's development in line with the management's view of the company's outlook, and the management's words and actions are not contradictory?

Unrealistic goals, and business results that are consistently conflicting with management messages without clear reasons or management accountability for results, give rise to suspicion about the management's conditions to successfully lead the company. Similarly, business figures that develop over time in line with management communications and accountability when facing challenges suggest the opposite. Even the best management is not perfect, so it is important to follow management actions over time. In our analysis, the relationship between management’s words and results is a factor in our comments on, e.g., estimate risks, the credibility of management objectives, and our readiness to rely on the longer-term outlook in the company's valuation.

4) Management’s track record of capital allocation that generates shareholder value

Capital allocation is also a key task of management. Capital allocation, i.e. managing the company’s financial position and determining where cash is used, is a key process affecting the creation of shareholder value. The capital allocation decided by the management plays an important role in the return company owners will get on their investment especially in the long term. It is valuable for the investor to try to form an understanding of the management's ability to allocate capital in a way that creates shareholder value.

In summary, the company's decision on using cash for investments, acquisitions and profit distribution (dividends and share repurchases) is capital allocation. The quality of the management’s capital allocation can, e.g., be assessed with the following questions:

• Does the management actively talk about capital allocation and the company's strategy in this respect?
• Does the company make investments whose return exceeds the cost of equity?
• Does the company make acquisitions with attractive valuation multiples?
• Does the company use own shares as payment in acquisitions, especially when its valuation is sufficiently high?
• Does the company repurchase shares in situations where the valuation of its share is low?
• Does the company avoid unnecessarily leaving cash laying around in the company’s balance sheet?

In our research, we comment on the company’s capital allocation, e.g., concerning related decisions and when assessing the company's ability to create shareholder value. We will discuss capital allocation later in our Equity Research Insights.