If you’ve been investing for a while, you’ve probably heard an investor say that ‘high quality management’ is one of the most important attributes of a potential investment. Nowhere is this truer than for microcap investors. And what better way to assess the quality of management, than by meeting them and asking questions? While the CEO of Commbank or Woolworths is unlikely to take the time to meet with a retail investor, the dynamic is very different among microcaps. At the smallest end of the market, CEOs and MDs are often willing to meet, especially if they'll be raising capital again in the not-too-distant future.
In the final part of our microcaps series, we asked our five microcap managers for their favourite questions to ask management when they meet for the first time. Responses come from Nick Guidera, Eley Griffiths Group; Shane Fitzgerald, Monash Investors; Oscar Oberg, Wilson Asset Management; Scott Williams, Fiftyone Capital; and Harley Grosser, Capital H Management.
Understand their past to understand the future
Harley Grosser, Capital H Management
Generally, you’ll need more than one meeting to get a really good idea of the quality of management. But in the first meeting you want to come away understanding their background, skill set and incentives.
Have they had success previously? Investors often talk about looking for management who have had previous success on the ASX, but it is not always this easy.
If they’ve done it before you know they can (theoretically) do it again, which is great, but if they already have a massive net worth as a result of a previous business success then building a microcap from the ground up might not be their number one priority. And in those rare cases where they are still just as hungry then the market has probably priced their stock at a premium for past success.
Usually it is best to find a balance. I like to find the ones that have had success in their careers and are well regarded by their peers (ask around) but are now looking for the really big winner - the one that sets them and their family up.
Incentives are everything. You want to know what their financial incentives are - short and long term KPIs and what they are tied to, but the most important is simply that they own a lot of shares and so their destiny is tied to yours as a shareholder.
Beyond that you want to get a feel for where they think the goal posts are. How do they track their own performance? What would they define as success in 1, 3, 5 years? You want an alignment with how management assess their performance and how you (and the market) will assess it.
Understanding the person behind the leader
One of my favourite questions to ask management is “Would your investment priorities, size and timing, change if you were not listed, you had capital at your disposal and you were not managing your business within the restriction of a semi-annual earnings cycle?”. While an unrealistic scenario, the responses usually give you a good indication on what management’s approach is to allocating capital and whether they are managing the business for short or long term.
Other questions we often ask are how much capital has been invested into the product, technology or business to date, particularly for businesses new in their listed life. This is a good sense check on the barriers to entry from a capital standpoint and whether the market is ascribing an appropriate valuation to the revenue or earnings of the business in its current form. In addition, we often ask management to describe the inherent IP within the business model partly because if it’s a relatively easy premise to understand and explain, investors will be able to assign an appropriate valuation, once the business is better understood.
Finally, one of the more obscure questions our team often asks management in a first meet is what keeps you busy outside of the business. Getting a sense for the person behind the leader can be incredibly insightful in understanding their motivations and commitment.
Passion drives success
When meeting with company management for the first time, we like to ask them ‘What are your long-term aspirations for the business?’ and ‘What personally drives you?’. These questions help us to assess the personality traits of the management team and provide us with a starting point to work out the longer-term trajectory of the business.
Another question we ask is ‘Can you describe the competitive environment?’. By asking this question, we can gauge whether they are self-aware enough to understand their competitive environment and their position within it, as well as what their individual strengths and weaknesses are relative to the rest of the industry.
Capability and alignment: The keys to success
Scott Williams, Fiftyone Capital
We have a whole range of questions we ask. But my favourite question is “what keeps you up at night with your business?” It’s important to know the risks in the small companies that we take exposure to as if there is a problem, you need to understand that liquidity can be a big issue when trying to exit micro-caps. It’s about making sure the management team is capable.
Another question we like to know is “how much money have you spent buying shares on market or in placements?” many directors try to get around this question due to the performance shares they get, so it normally follows with a brief explanation of “how much physical cash have you taken out of your bank account to buy stock”. It’s important to make sure management has money on the line and our goals are aligned.
Ultimately, backing the right people and buying at a good price relative to the risk/return is also very important. If there is a red flag or management lie, we normally don’t stick around. There is always another opportunity.
Be wary of the ‘used car salesman’
Management is always important, but in microcaps, even more so. What is the background of management and the Board? What type of personality do they have? This can be extremely important in the first meeting as a “good salesman” can provide a misleading point of view.
Key performance indicators (KPIs) are a big focus for us. If the targets are extremely high level or based on share price performance this is generally not the best sign. However, KPIs based on specific business metrics are much better. Boards will set targets that are achievable albeit stretched, and management will only sign on to targets they believe are achievable. They are the best guidance you will get from a microcap, or for that matter any stock regardless of market cap.
What is the total addressable market (TAM)? Here we prefer to see a more gradual assessment, for the simple reason that it generally implies the management is being more realistic about the prospects of their business. Those that present a huge TAM are often associated with much higher risks.
What is their competitive moat? We often hear from management that they are the only company in the world doing what they do. Well the world is big place, and just as the microcap we are meeting is “flying under the radar”, it makes sense that somewhere else in the world there are other similar businesses doing the same. Companies also fall back on statements like “it has taken 10yrs and $30m of investment to get where they are today”. The point here is that a potential competitor now knows what the end product needs to be, its features etc, and so it will take half or less time and money to develop. Understanding the moat is critical in understanding the outlook for the business. Is it a land grab in a winner takes all market, or is there a market where multiple players can coexist? Each are very different and will have different payoffs and risks.
What are the capabilities of the business today? It is very common for companies to talk about what their product will ultimately be able to do or the vision they have for the business, and this can often be very different from their capabilities today. This allows a better assessment of what management is telling us, but also the likely timing and capital needed to develop the business.
While at first these questions may seem somewhat disparate, there are a few key themes that pop up repeatedly:
- Understanding the CEO/MD’s track record,
- Assessing the investment opportunity, and
- Understanding their incentives.
If you can achieve these three goals, you’ll be much closer to finding a great microcap investment. And if you don’t have the time or capability to do it yourself, there are plenty of professional microcap managers willing to do it for you.
“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”
– Charlie Munger
More from this series
- Part one: "6 unique microcaps under the radar (for now)"
- Part two: "Opportunities and risks in microcap land"
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Great article and some thought provoking questions. I always thought this question goes to the nub of the matter: Would you invest a material amount of your kids inheritance funds in this company? Reason: mature adults with a reasonable 'work runway' in front of them are prepared to take a punt...but not so with their kids money. Of course the follow up questions are predictable: If they say "YES", then 'have you invested to date?' If NO, then 'why not?' as well as 'what, not even a small investment?"
Asking about setbacks and failures, and how they responded and overcame them uncovers a lot about their psyche and ability to cope with the inevitable future challenges.