In the last blog post, Talking To Management, Ian argued for the importance of talking with management of microcap companies. Over my 15 years of investing in microcaps, talking with dozens of CEOs and CFOs, I have discovered that there is an art to interviewing management. When asking questions of management, there are certain principles – do’s and don’t’s – that, if they are followed, lead to much better information gathering. I would like to share these interview techniques in this post.
I am an advocate of taking the best ideas from one discipline, and applying that knowledge to other disciplines. With that in mind, the interview techniques I use when talking to public company executives are largely influenced by knowledge I have gained from outside of the investment world. Firstly, my health care training has strongly influenced my approach to interviewing management. Some of the most vital information during a patient consultation comes out during the patient history, or interview. The questions that are asked of the patient, and the way they are asked gives you the information to narrow down your possible diagnosis, and it will guide you on what tests you should perform to come to a definitive diagnosis. If you ask good questions, you are much more likely to arrive at the right diagnosis. An investor should have the same focus on asking pertinent questions of management, in a way that yields good answers that helps build a true picture of a company’s potential as an investment.
I have also been heavily influenced by studying the techniques and principles of interviewing developed by a former investigative reporter named John Sawatzky. Sawatzky has dedicated his life to studying the art of interviewing. He has spent years meticulously analyzing what makes for a good question. He has consulted with some of the largest media organizations in the world to teach his interview techniques, and for the last ten years, he has worked for ESPN where he trains the in-studio and on-field reporting staff on how to conduct better interviews.
With that, here are ten do’s and don’t’s that i have used over the years when interviewing management.
Things to do:
1) Build rapport with management. During your research, before you talk to management, try to find something in common with them. It may be something as simple as a link to the city they are headquartered in – maybe you lived there previously. Have a look at their LinkedIn summary. Maybe you know someone who worked with them in the past. Maybe you share the same alma mater. Mention it to them at the beginning of your initial conversation. A connection, however small can help you to build rapport early on and get them to open up to you. It could be something as simple as joking around with them, as Ian suggested, which might help them to lighten up and drop their guard. Once you build rapport with a CEO, they are much more likely to give you better quality information.
2) Ask open-ended questions. Open-ended questions are questions that can’t be answered with a yes or no answer. An open-ended question often involves the words what, how or why, and to a lesser extent who, when and where. These types of questions that encourage a subject to describe or explain have a better chance of giving you a complete response.
A close-ended question yields a yes or no answer. Close-ended questions are fine if you are trying to verify core information, but they do not give detailed answers. An example of a close-ended question would be “do you still think you can improve your gross margin to 50%?”. On the other hand, an open-ended question would be “what specific steps do you plan to take to improve your gross margin to 50%?” It is a subtle difference, but the open ended question will probably yield much deeper information compared to the close-ended question.
3) Questions should be lean. Keep each question short, and focused on a single subject. Some management teams have had media training, and have learned how to tactfully avoid answering your questions, and divert the discussion to their own agenda instead. Questions that are unfocused and cover a broad subject matter allows them too much range to do this. The more focused your questions are, the more meaningful the answers you will get back.
4) Questions should be neutral. Neutral questions are free of values or opinions of the investor. Avoid using charged words and try to keep your opinion out of your questions as that can distract management. When values or opinions are added by the interviewer, either positive or negative, it may bias the executive into answering your question how you want it answered. In the very worst cases, the subject closes up because they feel they have been criticized, and it may be difficult to get them to open up again. For example, a microcap company i have a holding in recently granted a large amount of stock options to management. I could have asked the CEO “a lot of shareholders are pissed off about this option grant, how do you defend it?”. Instead, I asked “what criteria did your board use in rewarding management in the recent stock option plan?” Instead of using charged words in my question, and him getting defensive, i got a very thoughtful answer that made sense once it was looked at from his standpoint.
5) Listen to answers and build new questions from there. Don’t be in too much of a rush to get to your next question on your list. By listening and asking them to elaborate, you will help management to articulate the subject matter. Also, by doing this, you are showing that you are listening, and it builds trust and credibility, which will allow management to open up deeper. When I first started interviewing public company management, i would stick very close to my question list, because i didn’t want to sound like an idiot ad-libbing off script. However, as my interview technique has improved over the years, I have noticed that a lot of the best information comes from going off script and asking for elaboration of an answer. As you gain experience interviewing management, don’t abandon the possibility of deeper information by jumping too quickly to your next question. Instead, pick up on a comment and follow-up.
6) Use acknowledging words that show you are listening. When management are answering your questions, use words like mmhmmm, i understand, and go on. This builds trust and rapport, and encourages them to open up further.
7) Use the uncomfortable silent pause to your benefit. When I first started interviewing management, they would be finishing up their answer to one of my questions, and I would be starting to look for the next one on my list. I sometimes would pause for a brief period until I could find my next question. A funny thing happened. Some of them continued to talk when there was a few seconds of silence. Humans hate lulls in conversations, and it makes a lot of people uncomfortable. So they feel the need to fill the void with something better. Sometimes those extra little nuggets of information contain some gems You have to use this technique sparingly, but i have found it can be a very effective technique for getting management to open up.
Things to avoid:
1) Don’t ask questions with multiple parts to them. Ask one question at a time. When long, multi-part, convoluted questions are asked, they may end up leaving management confused about what information you are looking for. Or it may give the executive the option to answer either one question or the other. If they are good at diverting questions, they may answer neither of your questions and will go off on their own carefully rehearsed message track and by the time they are done with their answer you will have forgotten your original questions. I see this all the time during conference calls when analysts ask long questions with multiple parts to them. I don’t know if it’s because they fear that they will only get to ask one question on the call, but by the time the executive is done answering he has often picked which part of the question he wants to answer and left it at that.
2) Don’t ask leading questions. When you convey your expectations to management by way of a leading question, it limits the possible answers, and their answer may not reflect the truth. I have seen this happen on conference calls, when investors are trying to tease guidance out of a CEO who is reluctant to provide it. The question will often go something like “I am using a 50% gross margin in my model for next quarter. Is that a reasonable expectation?”. Management will often reluctantly confirm that it is reasonable, because they have been influenced by the leading question. If they were willing to answer the direct question “what will gross margins look like next quarter?”, I am sure it would be a different number than the investor suggested most of the time. The investor is worse off than before he asked the leading question because he then plugs this faulty information into his earnings model.
Another example of a leading question asked on conference calls is when an analyst or investor’s question starts off with “you probably can’t answer this, but”, and then they go on to ask their question. You’ve just given management an out to not answer your question, if they are at all hesitant. Nine times out of ten, management will say something like “we can’t answer that because we haven’t given out that information to the market for competitive reasons”, or something along those lines. Whereas if they had just asked the question without adding “you probably can’t answer this, but”, management might answer the question 50% of the time.
3) Don’t interrupt them. You are trying to get information out of management, so let them talk after you ask them a question. We like the sound of our own voices, and we want to demonstrate that we are knowledgable about the subject being discussed, so we interrupt. Let management finish talking. You’ll get more complete answers to your questions.
The next time you listen to a conference call, or even a reporter interviewing someone on t.v., listen to the types of questions they ask. You will notice a pattern that good quality questions result in good quality answers.
I am certainly not a perfect interviewer of management. But over time, and with practice, i think my interviewing skills have improved dramatically. By following these interviewing techniques, and asking better quality questions, the answers you get back from management should help you make better decisions on whether to make a stock 20% of your portfolio or to sell every last share that you own.
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Chip, thanks for writing this. Great job.
Ian, thanks for the opportunity to submit the article. I enjoyed putting my thoughts on the topic into words.
Chip, you mention that you have been influenced by John Sawatzky. When I went on Amazon and searched his name, I came up empty-handed. Any thoughts on where to find his writing, or the best way to get acquainted with his ideas would be helpful. Thanks for the great article.
Jason, this response is from Chip. Having some technical issues so I’m posting it for him.
Unfortunately, as far as i am aware, John has not published a book on his techniques. He has published a few investigative journalism books on Canadian politics, and one on police abuses. He does seminars about his techniques, and the Poynter Institute hosts him every once in awhile. For our purposes as investors, i think you can probably get the bulk of his teachings through interviews and articles on the internet. Here are some of the best resources i have found:
A video interview of Sawatzky done by some aspiring journalists:
Make sure to listen to the multiple audio clips on the link below. Especially the one about the beaver attack. You’ll laugh after listening to it, but Sawatzky says it’s one of the best interviews he has ever heard, and the interviewer says maybe 60 words during the entire 8 minute interview.
These are notes from a seminar that a journalist attended. You will notice from other comments on the thread that Sawatzky’s techniques are controversial within the journalism industry:
Hope that’s helpful.
Here’s the best book on interviewing that I’ve read, including re-iterating some of Sawatsky’s thoughts ie short questions lead to longer answers, long questions to short answers
Excellent thoughts Chip! I agree with every bullet point you have listed in regards to interviewing management. After you have already done a lot of due diligence I’ve always felt that have a 1×1 face to face conversation is extremely telling. Interviewing management has always been something that I’ve enjoyed and have found it extremely beneficial when making investment decisions. Thanks again for sharing your experiences with all of us.
“I am an advocate of taking the best ideas from one discipline, and applying that knowledge to other disciplines.” Well said Chip.
Your discipline reflects in every word you have penned. Thanks Chip, Ian
This is a great post. I would, respectfully, build on a prior comment that nothing, IMO, can replace face-to-face meetings, particularly in the micro-cap context. Even informed, highly differentiated Q&A can be materially diminished without recourse to body language, physical comportment, etc. When I was an institutional investor, I met personally with scores of CEOs who talked me right out of investing in their companies, after having first impressed me by phone. Betting on micro-cap “jockeys” sight unseen substantively elevates risk.
You like to see the CEO’s squirm in person 🙂
I agree, nothing replaces face to face meetings. You can use these tactics in either scenario.
Sean and Adam, excellent points. Face to face interviews of management is something I’ve started to do recently. As Ian said, I think these interview tactics can be used on the phone or face to face.
Great text. I’ll be eager to read more of what you have to share.
Actually, what I like the most is that I feel I can already use many of your advices to improve my interviewing skills.
Vijay and Seb, thanks for the kind words
I have a good friend who runs a local company with about $75 million in sales. He started with the company right out of Harvard Business School as their head of marketing. They had about $6 million in sales then. Now he’s the CEO. An intelligent, cautious but growth-minded guy.
I’ve known him for about 20 years. He’s been on the board of one of my companies for about 10. We go canoeing in Canada every couple of years or so — a good friend.
So we talk a lot about our different business endeavors. I don’t keep a tally, but I’d say that when he does look ahead at the 12 month prospects for his business, he’s right about half the time. They have four divisions, and one year division A is up, division B is down, and overall they do okay but maybe one year in five all four divisions are firing on all four cylinders, so to speak. Sometimes he’s pessimistic about the year ahead and they do exceedingly well. Like many, he’s in a business sector experiencing rapid change.
So he’s right about half the time, prognosticating. And if he was running a public company with all of the legal considerations, and stock value considerations, showing up in his office and trying to get information out of him that was useful to an investor would not be easy I suspect. In part, knowing him, it would be because he wouldn’t want you to bet on what he said, and then lose money.
So first, when interviewing management, I think it is important to know your objective. You want to invest in a stock that goes up, and you want management to tell you that their prospects are favorable. Well, even assuming they are honest (often a major leap of faith not justified by events past or subsequent) they too are peering into a dimly-lit future full of amorphous shifting shapes. And they may be too far into the middle of the woods to have any idea which forest they are in. Too invested. That’s why they have a board of directors, or at least should have. (You can, of course, learn a lot from the background and accomplishments of board members. Companies run by fakes and phonies and bullshit artists don’t tend to have strong independent people on their boards with backgrounds indicating good judgment and accomplishment. The promoter sleazeballs have cronies and family members and people who won’t rock the boat).
Anyway, maybe we interview management to get a sense of them as human beings. Is this a person I have faith in? Would I want to go on a long canoe trip with this person? Would I trust them with some of my retirement savings? Maybe you want a sense of security in an inherently insecure venture — investing in microcap stocks. It is so difficult, I would submit, to assess during the course of an hour or two interview things like judgment, ability to manage an acquisition, ability to make sensible trade-offs between investing in the future and short term profitability, ability to abandon a bad decision that one has invested a substantial portion of one’s time, capital and ego in. But these are the crucial issues on which the ultimate profitability of an investment will depend, at least as far as management can impact.
Ian wrote something a while back that I’ve often thought about — many of the microcap stocks he considers are yesterday’s failures. To paraphrase Randy Smith, Smith Management, who has made at least hundreds of millions of dollars investing in distressed securities, you can make money investing in a total disaster that improves to the point that it is merely a piece of shit. That’s a lot different than investing in Proctor & Gamble, or Coca Cola, which is what Buffet does. His assessment of management is much less crucial. The bet in microcaps is more on management than on an established brand. Ian and many of us are looking for companies that have new management or some other new factor that makes a company’s future appear brighter than its 2-3 year past. Whatever it is, in these companies, and in virtually all small companies, much of the bet is on senior management rather than on brand. Interviewing management therefore seems a logical step in making the investment decision.
It is just important I think to have realistic objectives and expectations, both of management and of our own ability to assess human beings. Bull markets tend to create an overconfidence including in one’s own ability to assess management. Everything is difficult in our chosen vocation, but few things are more difficult to figure out than human beings, and I for one doubt I can do it based on an hour or two interview, at least accurately and reliably. I didn’t used to think that. Then I encountered the bear.
Rod, great points, and thanks for the thoughtful response. The future is certainly unknown, and unknowable. But there are some businesses, as you say, like Coca Cola, or a microcap company like Biosyent, that lend themselves to better forecasting of the future. If you can find a business like that AND with a manager like Robert Goizuetta or Rene Goehrum, AND that have outstanding economics, AND are available at a reasonable price, you have found investment nirvana. In these cases, i think talking to management just confirms what you see in the financials, and it just confirms that the management team that is behind the great company is the real deal. However these companies are few and far between, so if you want to hold more than a handful of companies, you need to look to other lucrative areas of the market like, as you say, microcap turnarounds, to diversify your portfolio. In this case, past financials are not going to tell you a whole lot about the future, so relying on management to tell you their strategy and plan for the turnaround, and to get progress updates on the business is very helpful, even if the information they give you is only roughly right.
I totally agree that we have to remain cognizant of overconfidence in our ability to assess management. But assessing management, assessing subjective factors like how they will deal with strategy, or capital allocation, or different business decisions and situations that may be encountered, and relying on their subjective forward looking goals like long term margin and revenue targets is only a part of the process of talking to management. I will often ask for more objective (maybe still slightly subjective) rear-looking information like clarification on things that i need more colour on from my reading of the MD&A, financial statements and the proxy circulars. Why did AR increase while revenues were flat? What kind of multiples are acquisitions happening at in the industry? When do you plan to hire a full time CFO? Why did R&D expense decrease last quarter?
In addition, I have found that the Canadian regulatory filings disclose much less information than American filings in areas like the industry competitive landscape, and i will often ask questions about that, and the company’s place within it, and what drives their competitive advantage, especially if it is an industry that i haven’t studied before and where there is little info on the internet. I will often ask about key performance indicators that management focuses on so that i can assess the progress of the business, and so that i can assess if the KPIs will encourage long term thinking or short term maximization of incentives.
In this case, past financials are not going to tell you a whole lot about the future, so relying on management to tell you their strategy and plan for the turnaround, and to get progress updates on the business is very helpful, even if the information they give you is only roughly right.
Financial statement trends can often tell you something is up. Even if earnings are not improving, a turnaround will often show up first in expanding gross profit margins, declining receivables in relation to sales, declining payables in relation to gross profit, inventories coming under better control, etc.
I remember a market commentary from an old annual report, maybe from 25 years ago, by Ralph Wanger of Harris Assoc. Out on the African savannah he said, where the wild zebras graze, a zebra has the choice of the middle of the herd where the grass is trampled, eaten, and otherwise not appetizing, or the outskirts, where the green grass grows, and where the zebras with big bellies, shiny coats and big lion scars hang out.
Good point Rod, and I agree that you will see financial statement trends to indicate the progress. If you want to catch the entire upside of a turnaround, I think you have to invest prior to the progress showing up in the financials, but this is where the battle scars do come from. I think the safest time to invest is certainly when the financials start to show signs of the turnaround, but the stock has usually already moved up substantially by that time. Maybe you’ve missed the first 100 or even 200% move, but often there is usually still a lot more upside available at that point, with way less risk because you’ve seen the turn show up in the financial statements. I have done both types of turnaround investing, and i used to do more of the former, but now I tend to do more of the latter.
To demonstrate, I invested in a microcap turnaround back in 2009. The company was a Canadian furniture, appliance and electronics retailer called The Brick, and was acquired recently by Leon’s Furniture. They were in bad shape, but the founder initiated a recapitalization and hired a seasoned retail turnaround guy as CEO to lead the turnaround. After talking to new management, I decided that the new CEO had a very rational turnaround plan, and that’s when I invested. His plan was to repair relationships with suppliers, put sales staff on the floor, where they had been cut to the core before, improve advertising (getting more ad space for less ad spend and actually having advertised products in stock) and emphasizing appliances, furniture and mattresses which carried a higher gross margin, and de-emphasizing electronics which carried a much lower gross margin. The quarter after he came in you could already see SSS, gross margin, and inventory trend improvements. I had decided to invest prior to seeing the trend in the financial statements, and to get the maximum amount of leverage by buying the warrants that were free trading as a result of the recap. The warrants had moved up about 150% by this time, but, risk adjusted, was probably a better time to invest. All told, it was a 10 bagger in less than 2 years, and had I waited for the trend in the financial statements, it still would have been a much lower risk 3 or 4 bagger.
It certainly hasn’t been all successes with turnarounds, as I have certainly had my failures and lion scars investing in turnarounds before the turn showed up in the financials, that didn’t eventually turn. As I’ve gotten more experienced, i would guess that I am a Zebra that likes to hang out 2 rows in from the outside of the herd.
BTW Wanger’s book “Zebra in Lion Country” was my first introduction to small cap growth company investing, and had a big influence on my investing philosophy. I loved reading his quarterly commentaries, and would highly recommend the book.
Are there any books you would suggest to read to better understand turnarounds from the financial statements?
Fantastic post Chip.
I read a bunch of books developing my financial statement analysis techniques — everything from books by and for bankers (suggesting ratios), junk bond analysis, the Z-Score, but it was so long ago — twenty years ago now — that I don’t really remember which one I got what from.
Right now I’m deep into reading material by and about Michael Porter. Much of his stuff is academic and repetitive, but still the best material around on understanding what contributes to superior long term profitability. I find insights like “it is not about being best, it is about being unique” and his reasoning behind that statement, very useful. A company has to either deliver the same product or service to its customers differently, or deliver a different product or service, Porter says. BUT ALMOST ALL COMPANIES ARE STUCK IN THE MIDDLE, trying to be best at doing the same things their competitors do. That’s a race to the bottom, Porter says.
Right now I’m finding a book by his protege, Joan Margretta, “Understanding Michael Porter” — to be simpler, clearer than Porter’s classic “Competitive Advantage” and thus particularly useful.
In financial statement analysis terms, competitive advantage shows up in return on capital, which has two main components, margin and sales turnover. It is really the DuPont financial analysis protocol, used by Alfred P. Sloan to turn General Motors around in the 1920s (hope I have that decade right). He broke the company’s activities down by their contribution to return on capital, in order of impact. So margin was broken down into all of its constituent aspects — supplier relationships, labor cost, etc. And capital turnover was broken into its constituent aspects — pricing, assets employed to generate a given sales volume, etc. He could thus understand what was working and what wasn’t.
In the final analysis, investing over any reasonable period of time is about compounded rate of return. Buffet’s great insight was that a tiny percentage of companies are compound earning machines. It’s not about value investing. I looked up today Buffett’s purchase price for Coca Cola in 1988 — he purchased his initial position at a PE of 15, a 20% premium to the market at the time and at 12 times cash flow (a 50% premium to the market’s ratio to cash flow) and after years of the stock price going up. He put 35% of Berkshire Hathaway’s stock portfolio into that one company. By 1999, it was a 12 bagger. That’s the power of a company with a competitive advantage, and the resulting compounded earnings growth. And his dividend yield now versus his original purchase price is about 40%, I think, or more.
Thanks Rod. Earlier this year, i was on a Porter kick, and read Magretta’s book after it was recommended by Sanjay Bakshi. Another book i think you would like, along similar topic lines of product or service differentiation and uniqueness, but easier to read than Porter is Blue Ocean Strategy by Chan Kim. It puts forward the idea that there are blue oceans or areas of uncontested market space within industries, where you are not even competing against incumbents, because you are able to draw in customers who have not traditionally been customers of the industry. One case study used in the book is Cirque de Soleil. They created a blue ocean on the boundary of circus and theatre, a unique product that wasn’t trying to pull customers away from traditional circus shows, or theatre, but drawing in a totally new larger demographic of customers, and because they were attracting the customers from other areas outside of circus and theatre industries, these new customers were less likely to balk at higher prices because it was a differentiated product with no cost comparison available.
I’m glad you mentioned Sloan – i have been meaning to read his book about his time at GM (I had it borrowed from the library at the same time as the Magretta book, but never cracked open the cover), and will move it to the top of my list. I have done a little reading on DuPont Analysis, but just have a surface knowledge of the concept. Anyways, thanks again for your response.
I’ve heard about Blue Ocean Strategy — it has been mentioned to me in the context of a rebuttal of Porter’s writing on competitive advantage — but from what you indicate is complimentary to Porter. Anyway, thanks Chip, I’ll get it.
Yeah, i read a critique Iike that as well, might have been in Magretta’s book even, but I think they are complimentary. A friend of mine who has been involved with 2 tech startups recommended the book. I think Porter’s concepts are much more applicable for the average investor analyzing public companies, and Blue Ocean Strategy may be more applicable to start-ups (not necessarily tech), and very early stage public companies.
Superb piece, Chip.
I’ve spent the last five minutes trying to come up with something (something!) to add to your insights but I’m stumped. Well done indeed!
Thanks for the kind words Jason
Thanks Chip, very good article, as I saw you have a conversation with a CEO I know you are excellent doing this ! Based on your experience, could you give some exemples of responses you saw or could see as red flag ?
Thanks Steve. I have often received good information from asking management “what is your background?” A number of years ago, I had invested in a multi-level marketing company who had a new CEO, and when I asked him this question, he confessed that he had just learned what a downline was about a month prior. If you are not familiar with the MLM industry, a downline is all the sales reps that are recruited under another sales rep. This CEO had been on the board of directors for some time prior, and he should have had a working knowledge of the industry terminology at the very least. That was a major red flag, but I was anchored on to how cheap the stock was in relation to historical results, and i continued to hold the shares, and might have even added a few more. But that was the beginning of a quick demise as a large % of the distributors left the company, and it was a 90% loss by the time i sold.
For companies where management has done a phenomenal job and has been a large part of the success of a company, I want to know that they are sticking around if i am going to be a long term shareholder. So I will ask “What are your plans with the company for the future?” In two cases, i found out that they had a desire to follow their aspirations in a different field altogether, which is definately a yellow flag, depending on whether you have faith in the succession plan. For example, one CEO of a company that i had held shares for almost 10 years and had performed very well over that time told me, when i asked him the question a few years ago, that it was no secret around the office that he had political aspirations. I want to know that a CEO is engaged in the business, and if they are not doing what they are passionate about, i probably don’t want to invest with them.
Some management will comment about how cheap they think their stock price is, and in cases where management has not been buying shares in the market, I will ask them “why are you not buying shares in the market?”. Often they say that they are blacked out because of this or that, but they would be buying if they weren’t blacked out. I will often watch for insider purchases over the next quarter or two to see if they were just giving me a line. If they don’t buy, after they said they would, that is certainly a yellow flag.
I asked one CEO why their accounts receivables had ballooned much higher than revenues in the quarter, and he said that it was all related to an acquisition they had recently done. That answer didn’t make sense because even though they hadn’t disclosed the financials on the acquisition, it was a small acquisition in relation to their historical revenues, and the large growth in receivables just couldn’t fully be explained by the acquisition. It later came out that he had been using the title of Chartered Accountant, when in fact he had no such training. The company ran out of cash and was bankrupt within a year. In a previous comment in this thread, Rod made a good point that financial statement trends can tell you something is up. In this case, the financial statements should have spoken louder than the explanation of the CEO.
Those are a few examples that come to mind.