Corporate failures and fallouts such as Enron, WorldCom and Lehman Brothers in the past have demonstrated the importance of emphasising the qualitative aspects of a company, in particular the management teams. As we stand today, we are late cycle, which means that on a theoretical basis the probability of a likelihood of a recession / economic slowdown falling within a 3-year investment time period is high, especially given the length of this economic expansion. This is our short-term concern. Longer term, disruption is a reality confronting businesses across industries and regions and, the pace of disruption will only continue to rise.
Against this backdrop, we need to look for a management team with the ability to prepare for a slowing economy and to have the right focus on investing for the future.
The sector matters when evaluating management
Most investors realise that the performance of a company is directly related to competence of the management, and it is important to invest with excellent management pedigree and track record. The problem is that evaluating management is difficult. Whilst we are evaluating managers, there are certain things that are common – their philosophies around capital allocation, incentive structures, etc. However, there are certain things which are unique to the industry they operate in.
As a former mining sector analyst, there are two things we give utmost importance when evaluating a resource management team. First, is their track record around safety and second is how they think about resource replacement. A focus on safety and evaluating the track record of safety of the management team, gives a clean lens around the operational strength of the business. Given the high-risk nature of the business, ensuring employee safety to us is the most important job of the management team and needs to be a key discussion point of every management interaction with stakeholders. A safely run business drives strongly motivated and engaged employees. British Petroleum had to learn this lesson the hard way and more recently we have seen the disaster at Vale again, confirming why it is so important for resources’ businesses to focus on safety.
The second thing that management teams of a resource business need to be evaluated against is resource replacement. Both oil & gas and mining businesses utilise a depleting resource to generate cash flows of today and hence it is imperative to invest to make sure that the resource continues to grow, and seeds are sown for the future - an important measure of business success.
In the technology sector, the only thing that matters is how the management team is thinking about innovation and disruption. It is the fastest moving sector in the markets with some of the shortest time cycles of company life yet paradoxically some of the highest valuations. Satya Nadella, the CEO of Microsoft in one of his addresses had a great quote where he said,
“The technology business is like a formula one race – it is not how fast you drive down the track but how well you take the turns that differentiates the winners”.
Disruption is that turn and what systems and processes the management teams have put into place to navigate those turns, gives investors a sense of comfort around the longevity of those cash flows.
Running a financials business is only about managing risk. Hence the key criteria of a successful financial business is how good it is addressing the regulatory risk and staying on the right side of the customer trust equation. Whether it be the Royal commission in Australia or the mortgage crisis in the US, those companies which have always had a strong focus on ethics and run their businesses with a high degree of regulatory and compliance oversight will ultimately always have higher customer trust. So again, while the excel spreadsheets might tell us one story, it is as important to get into the weeds and work to understand the regulatory perception and the customer trust that they enjoy.
Jamie Dimon, the CEO of JPMorgan Chase, a long-held position, navigated the bank exceptionally well during the Lehman financial crisis of 2008-09. JPMorgan's focus on risk and managing regulatory exposure was undoubtedly important in that. However, the bank and its management team did not rest easy. Coming out of the crisis, Jamie and his team realised that technological change was accelerating especially with the ongoing fin-tech revolution. JPMorgan ratcheted up its investment spent on technology from US$ 4 billion pre-crisis to US$ 9.5 billion1 post crisis. In an environment, when everyone became fearful of investing, JPMorgan showed courage to invest for the future.
And you fast forward to today, the bank has some of the best technological systems, it has created new business and revenue lines with its investments across business verticals especially on the credit card and US home banking side. So, here is the management team, which has proven that there is no point letting a crisis go waste and has shown its ability to accelerate its business during those bends in the road using technology to manage both the regulatory risks as also enhance customer trust.
On paper, no two sectors could be as different as resources and health care. But when evaluating the management teams, the criteria are strikingly similar. Number one is safety, obviously a health care company needs to make sure that the drugs or medical devices have a high degree of efficacy as well as balanced out by limiting harm to the patient, and also staying relevant over time.
Secondly, the key asset of a pharma company is a patent protected drug or medical device. When the drug is protected by a patent it will have very robust earnings and very strong cash flow growth; however, as soon as the drug goes off patent, the earnings fall of a cliff as generic competition enters the market. Consequently, the health care industry is very much like the resources industry on this constant treadmill of resource replacement, whether they do this through in-house innovation and drug discovery or business development through Mergers & Acquisitions. And a management team is again very important to make sure that seeds of the future are planted today!
We recently invested in UK-based pharmaceutical company AstraZeneca, with a quality management team and a very strong product suite. For the last 5 years, Astra has been going through a poor earnings progression as it navigated patent expiries around its key drugs. The current management team is transitioning the company from a primary-care focused business model to a more exciting oncology-focused business model. As we look forward, management believes that there is a significant revenue upside from drugs which have already been approved. The management team continues to focus on strong research and commercial execution, and with an attractive dividend & earnings growth profile. Astra provides stability to the portfolio with potential future dividend growth.
It is easy to make decisions and judgements of what is important, however there are times when the industry is going through such an extended period of disruption and uncertainty that it is very difficult for even the management teams let alone investors to see through the fog.
The automobile industry in our view is a case in point where, autonomous driving, electric vehicles and car sharing are likely to change the industry in ways unimaginable over the next 10 years.
Investing in the automobile industry today is very much like investing in the personal computing industry in the 1980s or the ecommerce start-ups of the 2000 technology bubble, lot of capital thrown at the problem with a lot of start-ups but unclear how it all shakes out. As participants, we continue to observe and learn along with the management teams but are very cautious about deploying capital into the industry at this stage of rapid disruption.
When moats are falling away at a fast pace, the importance of great management teams only increases. Investing is all about searching for those leaders and once you find them, sticking with them as they evolve their strategy to fight against the growth and economic headwinds with constant innovation. If your choice is right, again compounding will be your friend. The constituents of what makes a great management team are constantly changing and evolving and are probably too exhaustive to list. In our investment process while evaluating an individual management team, these are the important differentiators we focus on - company culture, capital allocation and incentives, confidence and paranoia, positive contribution to the world.
In investing for the long term always “evaluate the jockey before you bet on the horse.”
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