Trusting Management and the Limitations of Research

Mike Schellinger Blog, Educational 11 Comments

One of the things I have learned through my years of investing is that there are limits to the usefulness of research and there is a point of diminishing returns. No matter how much due diligence you perform on a company there will always be blind spots and risks. Even the CEO can’t know and predict everything. Some risks and facts are knowable and others just aren’t. As an investor, I think it is important to be cognizant of these limits and to know where the boundaries might be. I don’t want to spend too much time researching a company when my efforts might be better spent researching another company or another investing activity. Let me illustrate my point with some examples:

  1. Companies are involved in lawsuits. It is impossible as an investor to know the details of every business relationship a company has had and whether any of them might lead to a lawsuit. You can even have a competitor or totally unrelated company that sues a company for patent infringement. While reading the legal section of the 10-K can give you some clues here, it is not uncommon to be blindsided by a lawsuit that significantly impacts a company.
  2. Competition can often have an impact on the financial future of a company. You can research competition to know the company’s competitive position but it might be difficult to guess moves competitors might make. A company in a seemingly good competitive position today might not be in as good of a position tomorrow. For example, a competitor could drop prices by 20% tomorrow but it is hard to predict that. Sizing up competition is a valuable part of the due diligence process but it can only go so far.
  3. Often, government regulation can impact a company. I avoid companies that have significant government regulation but virtually every company has some risk here. Sometimes something comes out of the blue.
  4. Companies can occasionally lose customers through faults that are not their own. You can assess how strong a company’s bond is with their customer and look at customer concentration, but beyond that it is hard to know when they might lose customers.
  5. Quality issues with a company’s products occasionally happen. Even a good management team can be tripped up by quality issues.

As you can see from the above, there are risks that you just can’t avoid and often large amounts of due diligence will do little to mitigate the risks. Let me be clear by saying that I’m not advocating small amounts of research or buy and forget. I’m simply saying that beyond a certain amount of due diligence you are often wasting your time. I’m reminded of a famous Warren Buffett quote:

“You should focus on what’s important and knowable.” – Warren Buffett

While there are limits to what you can learn by research, having the right management team in place at the company and knowing that they are trustworthy will go a long way to mitigating many risks. A good management team will know how to take steps to mitigate risks and will also be adept at steering the ship when the waters get choppy. Companies are not just assets and liabilities and are run by people. How good those people are will greatly impact how the company performs.

One of the key steps in due diligence of a company is determining if management is trustworthy. When you buy a stock you are hiring someone to manage your money. It is no different than hiring an electrician or anyone else that provides a service for you. You want someone that is trustworthy.

There are a few aspects of being trustworthy.  I think there are two basic categories to examine. First, you want to know if management has the right ethics and is looking out for your best interest. Second, you want to know if management has the skills for the job so you know if you can trust that they will make the right moves. I’m going to focus more on the former than on the latter as I think the later is a much more involved and complex subject. On the later it might be better to read a book like the Intelligent Fanatics Project or some other book on management.

There are lots of different ways to determine if management has the right ethics and is looking out for your best interest. The main key is to look at past actions. Below I list a number of things I evaluate and some tips to determine if management is trustworthy.

  1. Is management compensation reasonable and does management own a significant amount of stock? Reasonable compensation and heavy ownership of stock isn’t an indicator of ethics but it does help to know that management is aligned with shareholders and is likely going to look out for them rather than just worry about themselves. If management takes a small salary and has a significant ownership interest you can bet that they value increasing shareholder value more than their salary. See this article for more thoughts on the subject.
  2. Has management treated stock like gold or have they issued shares like candy? Poor utilization of stock currency often leads to bad investment results. It is important to pay particular attention to stock awards to management. If they give themselves large amounts of stock be very wary.
  3. I like to look at past press releases of the company. If the company made forward looking statements such as guidance, did they come true? I want management that follows through on their statements. Often things happen that impact whether forward looking statements come true so a few things that don’t happen or don’t happen in the time frame projected will not turn me off. However, if I see a pattern of promises that never come true then it is really hard to trust management.
  4. Talking and meeting with management is a great way to learn how trustworthy management is. Often how they answer questions will give you great clues into their trustworthiness. One particular thing that sets off five station alarms is when management is evasive in answering questions that they should be willing to answer. It can mean that they are hiding something that isn’t particularly good. Adam Epstein does a great great job of covering management discussions in his blog 10 Lessons Learned from Interviewing Hundreds of MicroCap CEOs.
  5. When I read SEC filings I make note of things that don’t make sense. Even little things like math errors in the filing really turn me off. Some of my worst investments have come from situations where there were errors or problems with the filings. In fact, one turned out to be a fraud. Their reports had many errors and the biggest ones were in the area of share count. If management can’t be trustworthy in small matters like getting the filings right, can you trust them in larger matters?
  6. If you find yourself needing to do excessive amounts of research to determine if management is trustworthy or the company is a good investment, then chances are it is the wrong investment and should be placed in the “Too Hard Pile.”

The list above certainly isn’t exhaustive but it gives you some ideas on sizing up management to determine if they have the right ethics and are looking out for your best interests. While I indicated I’m not going to focus on whether management has the right skills for the job, I am going to leave you with one thought on the subject. I invest mostly in profitable companies or at least those that are close to profitability. Investing in profitable companies derisks the business model but it is also a great shortcut in evaluating management skill.

I have often said that..

If management has been able to bring the company to profitability, then usually they have some pretty good skills in management. For example, it usually means they know how to create a product or products, they know how to market and sell, and they know how to manage expenses. If the company is not profitable, you need to assess management even more closely because you usually don’t have as much of a track record on which to build trust. That doesn’t mean you can’t make money on an unprofitable company. It is just much harder to pick the ones that are going to make you money.

In summary, performing research on a company is an important aspect of the investing process but there are limits to research so you need to be able to trust management to know that they will be able to steer the ship through the inevitable challenges that any business will encounter. A crucial step in researching a company is assessing management. You should do maintenance research on a company after you own the stock to continue to evaluate the company but remember that there are limits to how much due diligence is effective. Also, all the due diligence in the world will not prevent you from making investing mistakes. Nobody with a significant amount of investing experience will get every company right. That is why you need to diversify your investments so you spread risk around.

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Comments 11

  1. I’m not good at assessing management. I’m too drawn in by charisma, by articulate, intelligent people with a lot of drive and great track records. As I write of this I think of Ira Koger and Red Scott, both of whom had great track records before I invested with them, intelligent men but not forthcoming. They both cost me both money and faith in my ability to assess character.

    One thing I look for is the background of directors. Are they people of accomplishment and achievement in business, or university professors, consultants (I do give credit for some consultants such as those with McKinsey or Booz Allen) but not consultants I’ve never heard of whose firm name is the same or similar to their own, family members, and anyone who appears to be a toadie or a hack. But highly-accomplished investors and directors don’t tend to be on the boards of dishonest or half-ass managements.

    Even Buffett, who as has been pointed out elsewhere in MicroCapClub forums is an astute judge of character and great manager of people, has a failure rate — Salomon Brothers, for instance. A den of thieves. And as far as focusing on what is knowable — companies that have a brand that is virtually impenetrable and not subject to technical innovation — has some notable failures. Large, dominant city newspapers, for example. And he may be the best in the world at identifying companies with a sustainable competitive advantage.

    If only investing was easy, or even easier. If only it was a trouble-free path through life in a state of perpetual bliss.

  2. Post


    Assessing management is definitely an imperfect art and there are all sorts of nuances. I believe one can eliminate most of the ones that aren’t trustworthy but there will always be some that are very difficult to detect. Again, diversification helps.

    Reputable directors is a very useful tell but I’ve even seen cases where good directors were fooled.


  3. My views on limitations of Research:

    In-depth research and financial models can never be fool proof, due to presence of a plethora of variables, mostly unpredictable. These include wrong-doings of management, accounting issues, technological changes, competitive pressure, regulatory changes, currency movements, etc.

    Wrong assumptions for market size, revenue growth, EBITDA margins, by analysts/investors can also result in wrong calls.

    However, research can help reduce the investing risk to a large extent.

  4. Mike,
    I recently trolled a bunch of biotech companies, all in the early stage of developing some humanity saving drug or procedure. It was appalling to see the salaries many of the people in management awarded themselves without a single dollar of revenue. As an instance, in one company four members of management each was making more than $300 K per year, or $25,000 each month. They had a pot of money from an IPO and no debt and apparently thought they could milk it till it ran out. I don’t spend much time looking at biotechs.

    I also like to ask questions of management not so much to get information that I know they can’t provide, (since it isn’t public) but to see how they answer the question. I prefer forthright negatives rather than mealymouthed baloney.

    Some years ago a study was conducted by a guy who searched the chairman’s presentation in annual reports. It was found that the longer the chairman’s message the worse were the year’s results.

    In short, due diligence you conduct should look for meaningful facts while being alert to things that give off a bad odor. Good article.

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  6. Hey Mike! Awesome article!

    I just have a question about accounting firms and how you conduct DD on them. I notice that a lot of accounting firms in the microcap space has reported deficiencies by the PCOAB, even the good microcap companies that a lot of investor in the community likes. I was wondering how you conduct DD on accounting firms to tell if theyre good or not.


  7. Post

    Thanks Robert and you have a good question.

    I do occasionally research the accounting firm of companies to know their track record. Mostly, I look at the PCAOB report. One thing I like to know is how many public companies an accounting firm audits. The more companies they audit the better. As I said, this is something I do occasionally and probably only on 20% of the companies I own.

    More often than not, however, if I’m concerned enough to check out the accounting firm, then it likely isn’t a good investment. I have found that if I am concerned enough about the accounting, then the company likely isn’t a good investment. A good auditor isn’t going to make a bad company good. All they can do is shine the light on the bad accounting things in a company which perhaps a poor auditor will not do. Even a good auditor can be fooled by a company that is crafty enough to hide their misdeeds.

  8. Hey Mike, so just a quick question about internal controls and this seems to be more common among US microcaps than Canadian ones. A lot of US microcaps I’ve noticed disclosed that there is a deficiency in internal controls but all the other metrics are fine when it comes to valuation, growth, and margins. Would you still invest in a company like that if there are deficiencies in internal controls but everything else looks good?

    1. The importance of internal controls and internal audits can never be over-emphasized. If there indeed are stark deficiencies in internal controls, it’s a red flag for investors.

      How can one trust the financial statements of such a firm, where internal controls are weak? Poor internal control could mean possible revenue leakages or frauds or accounting irregularities.

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    You are right that many small companies have deficiencies in internal controls. The SEC requires that companies report such deficiencies.

    The answer as to whether I would invest in a company with deficiencies in internal controls depends upon the situation.

    Whenever a company reports that their is a deficiency in internal controls they also report where the deficiency is. Of course, it might not list all of the deficiencies. I recall that sometimes companies report deficiencies in internal controls because they have small accounting departments and there aren’t enough people to have checks and balances. Most of the time I think they report a deficiency because they recently found an accounting problem that shouldn’t have been there.

    I think what one has to do is to look at the overall situation. For example, let’s say it is a company with high accounts receivable and poor internal controls. I am highly unlikely to invest because account receivable is an area where accountants need to make a judgement and companies with high accounts receivable balances can be a good place for poor judgement. Another way of saying that is that sometimes the accounting statements of companies with high accounts receivable balances do not accurately portray the financial situation of the company.

    Another situation where I would not invest is a company with poor internal controls combined with sloppiness in SEC reporting. That can be another recipe for a poor ending as it shows that the potential for an accuracy problem is much higher.

    A situation where I might invest could be a company that just reported a small accounting problem and thus reported a deficiency but otherwise the company is really solid.

    Pretty much any company has some amount of warts on it. In the end, I think you have to look at the entire situation and make a decision. On balance, I’m more likely to pass on a company with accounting deficiencies than buy it even if everything else looks pretty good. Even if I do invest in a company with accounting deficiencies, those deficiencies are likely to influence me to make the position size smaller.


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