The smaller the company and the more illiquid its currency, the more the investment process becomes an art and less of a science. Just like with any art form, whether it’s music, acting, painting, etc it just takes a lot of time and experience to do it well. The art of investing in small companies is evaluating management teams. If you don’t believe that management is important when investing in small companies like microcaps, just wait a little longer. You will.
Chip Maloney, wrote a great article entitled, The Art of Interviewing Management. His article does a great job at giving a general overview of the art-form. Let’s now dig in a bit deeper and talk about which questions are the right questions. Put differently, what are some questions that have a deeper meaning, that drill down into some valuable areas that we can tap into as investors.
I’m going to leverage the knowledge and expertise of several others including Joe Koster, of Boyles Asset Management and his fabulous blog ValueInvestingWorld.com. I have also stolen generously from Michael Shearn’s book, The Investment Checklist. I also want to acknowledge Todd Wenning’s wonderful article, 15 Questions to Ask Management Teams, which in itself provides a robust list of great questions.
Some favorite questions from master investors:
Warren Buffett used to ask this question to all CEO’s after assuring them that their answer would be kept private: “If you could only buy stock in one company that was not your own, which one would it be and why?”
This was Phil Fisher’s most important question to management: “What are you doing that your competitors aren’t doing yet?”
Tom Russo said the late Bill Ruane used to always ask management: What are the chances that your business will lose money next year? All of the conversations they’d normally have with Wall Street were about whether they’d make $2.10 or $2.11 per share next year or whatever. At first management would be a little perplexed, then a little disturbed, but at the end, they’d say something like: “Look, for that to happen, the following 3 things would have to happen…” And those are about the only 3 things you should really care about. It tells you a lot about the business. [Source: Wealthtrack]
Michael Shearn from The Investment Checklist provides some great advice and example questions:
The conversation you want to have will be focused on management’s view of how the business is run. Ask questions that are open-ended rather than closed-ended:
An open-ended question is, “How did you make the decision to hire the senior vice- president of development?” This type of question requires a detailed, conversational answer.
A closed-ended question is, “What is the tax rate for this quarter?” This type of question can be answered with only a one- word answer, which won’t reveal anything about how a manager thinks or makes decisions.
As interviewer, your job is to listen, and then continue to ask questions to clarify what a manager is saying.
Do not ask hypothetical questions, such as, “What would you do if you were confronted with a certain problem?” The answers to these questions do not yield many insights because what managers think they will do is often different than what they will actually do. Instead, ask questions that will help you learn how the manager thinks and how he or she plans to execute.
The following are a few open- ended questions you might ask (in no particular sequence). You should focus on the questions that you think will be most revealing to you:
Why did you join the business?
How did you rise at the business?
What skills made you chief executive officer (CEO)?
What do you believe the job of the CEO is?
What do you want to be known for?
How do you measure whether you are successful?
If you were sitting down with some potential long- term investors, what two or three reasons would you give them to take a look at the business at this time?
Is there a possibility this business is going to be two to four times as big as it is today, five, or seven years down the road?
If you were a private business, how would you operate differently?
What do you like about working here?
Who are your current and past mentors, and what impact did they have on your life?
What character traits are needed for your job?
What character traits do you look for in a successor?
What three things would you do to destroy the business as quickly as possible? Give yourself a one- year time frame.
What type of people are you looking to hire?
How do you find quality candidates?
How are you developing future leaders?
What is the culture you are trying to instill at your business?
If we were meeting three years from today, what would need to have happened during that time for you to feel happy about your progress?
How do you keep the big picture in perspective and not get too bogged down in the everyday details?
What factors do you consider before you expand into a new market?
What are the biggest opportunities the business has?
How many people do you need to hire to grow?
How do you stay close to your customers?
What type of information do you need on a weekly basis?
If you were away for one year, which key metrics would best tell you how the business was doing? Why can’t other people do what you are doing?
Here are some questions for management from Tweedy Browne [modified]:
What does your global competition look like over the next several years?
What have your competitors done in the last few years to upset the competitive dynamics?
What have you done to them in the last few years to affect those dynamics?
Who is your toughest competitor? Why?
What worries you about your company in relation to your competitors’ moves and potential moves?
How easy is it to enter the business? What prevents new competitors from entering? Are entry barriers sustainable?
Describe pricing behavior in the company’s industry: Which competitor, if any, typically increases prices first? What has happened next? Who cuts prices? What happens next? Has pricing behavior been rational/“statesmanlike” in the company’s field of business? Describe pricing “signaling” behavior in the company’s field of business. Describe recent pricing moves.
How are the prices of your products compared to competitors?
Could new technology have a dramatic impact on the company’s business model, earning power and growth prospects?
Looking out 5 to 10 years, how does the company plan to invest cash that is retained in the business? Expected return on equity on incremental investment?
What new investments, new ventures, or new experiments that the company is working on (or envisions) could have a significant positive impact on the value of the company in the future?
What is the company’s philosophy/strategy with respect to using free cash flow for stock buybacks when it is not required to support growth?
What information does management monitor and consider to be important in managing its business?
Here is another one I’ve added since writing this post:
In management meetings we never let the meeting end without asking which of their competitors they respect or which of their suppliers or clients have a competitive advantage. (Peter Kinney’s letters, Acacia Capital) – H/T Joe Koster
Whether its microcaps, private equity, or venture capital, investing in small illiquid companies is an art-form because you are investing in people. You need to find out all the valuable nuggets you can which means asking the right questions. You can’t expect to become a master interviewer or master investor overnight. It takes a lot of practice. A common thread with people that ask great questions is they spend more time listening than talking. It’s hard to truly listen and let the conversation take you where you need it to go instead of always thinking about the next question and forcing it. As Chip Maloney stated in his article, it’s important to not be robotic or rude. A CEO or management team isn’t going to give you thoughtful answers if they think you’re an asshole. You need to be respectful and friendly, so you can build rapport and trust quickly. View the questions in this article as tools for your toolbox. The more you use the tools the better you’ll get at using them.
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I hope your statement Ian, “The art of investing in small companies is evaluating management teams” is not an absolute, not a sole determining factor. I have an exceptional record as an investor but I haven’t been particularly great at assessing management teams or CEOs. I’ve tried to compensate.
I don’t think I could have identified Steve Jobs as an executive with exceptional potential in his early days. I don’t think I could have identified Tom Brady as a great quarterback when he first came into the NFL. Looking back now, I’d think that they share at least a couple of characteristics. They both put a lot of thought into the crucial qualities or characteristics that make a difference in their chosen line of work, and they both are obsessive about it. Steve Jobs was reportedly so obsessive he didn’t get around to buying furniture for his house. Tom Brady obsesses over diet, what time he goes to bed at night, in addition to exercise and practice — practicing with his receivers the plays over and over until the delivery is deeply engrained into their mental and physical processes.
From an investment perspective though, I wonder if a faker could convince me that they are a Steve Jobs, a Tom Brady, that they possess that single-minded focus. I know that I am susceptible to a good faker. I find them entertaining and get caught up in their bullshit. The Donald Trump syndrome although I had experience decades ago with Trump so I saw him coming from way off. And of course lots of people disagree with me. Lots of people think Trump is a great success.
Anyway, I wonder if there are not three questions in assessing a business. (1) Does the company have a competitive advantage? (2) If it does, is it sustainable? (3) If it doesn’t, can it, will it, within a year or two? I can answer the first in a few minutes with ten years of financial statements. The second is more challenging, as Buffett found out in dominant city newspapers. They dominated their market but had a difficult time competing against Craigslist. It is hard to compete against free. Sears had a competitive advantage before Walmart and Amazon. As for the third question, that absorbs the attention of probably three quarters of investors — peering into the thick fog of tomorrow, and predicting what will happen. Assessing management tends to be a big part of that — assessing management and products. I submit that most investors are not nearly as good at either as they think they are. They are great at it in up cycles. Many are anyway. Lots aren’t even very good at it in up cycles.
Finally, I wonder if the questions you suggest, however important and relevant, aren’t expecting too much. They are the perfect questions for a director to put to management over a period of years of getting to know the business, but for someone new to a business to pose to management, and expect a comprehensive answer in an interview or two, may be expecting too much. So much of running a business is degree of emphasis on one of the considerations you raise versus another. So much of running a business is doing something that your competitors are not doing versus doing something better than they are. It takes a whole different mindset to stand up in front of momentum and say the problem isn’t that we are moving too slow in direction A, it is that we are going in completely the wrong direction. Most executives are not capable of that — unorthodox thinking is by definition rare — and of those few that are, a number will change direction and go in another, uniquely wrong, direction.
A couple of final thoughts. To the extent that the few extremely successful businesses, over decades, tend to follow a bell-shaped curve in terms of growth and profitability, the further up the rising curve an investor invests, the less the risk. The more a business has proven itself capable of taking resources and turning them into more resources, as evidenced by its financial statements, the less the investment risk. The lower down on the curve, the more marginal the business now, the more important management assessment is. The crucial question is, where is the optimum combination of risk/reward: before the business has proven itself or after it has proven itself but is more expensive. And how much of one does an investor trade off for the other. Most investors with great thirty year track records have few or none great years. They have lots of years of performance that is a little better than average, with few really bad years.
I wouldn’t be surprised Ian if your real skill wasn’t building trust and confidence with managements. You put time and thought into these relationships, management realizes that you are serious, thoughtful, and that you won’t abuse their time or their confidence, and gradually, as that human connection evolves, they share with you what they think really matters. To the extent they know what really matters. That alone is not easy. It is really hard to run a business and have the detached perspective that combines both intimate knowledge and detachment from sunk cost. Anyway, most investors approach management with the underlying though unstated mindset of, “How can these bums, these overpaid, overly-comfortable obstacles to my investment performance, make me lots of money?” As the CEO shakes the average investor’s hand, he (or she) is thinking, “Here today, gone tomorrow.”
Great article and equally insightful reply, Rod. Thanks