How Do You Know that Management is Competent?

Mike Schellinger Blog, Educational Leave a Comment

Management competence is a significant factor that investors should research about a company prior to investing. To be more specific, I mostly mean the CEO.

Being a CEO of a publicly held company requires a special kind of person as the CEO needs to have the proverbial Swiss Army Knife of skills. A few of the laundry list of skills that are required are: ability to navigate the capital markets, vision, charisma, deep understanding of the company’s specialty, ability to delegate, sales skills, financial skills, adaptability, patience, and the list goes on.

So how do you assess if management is competent? It starts by reading management biographies and studying their background. It also includes talking with management or at least listening to management talk on a quarterly conference call, company presentation, or other venue where management talks about the business. Volumes could be written on this topic. In the end I think that the ability to assess management competence is something you gain with years of investing experience.

I do think there is a short cut or rule-of-thumb that can be used to determine if management is competent in many cases. To best explain this rule-of-thumb I’m going to go back in time and tell a story.

Many years ago when I first ran into Ian Cassel, the founder of MicroCapClub, I always wondered why he focused so much on management competence. I always thought management competence was important but he seemed to place disproportionate importance on management competence.

It took me a few years of knowing Ian to understand why he felt differently and why we were both right.

It is no secret that I usually only invest in profitable companies or occasionally in some that are close to profitability. Profitability is ingredient #1 in my investing philosophy which I detail in My Secret Recipe.

Most companies require significant management talent to reach profitability. First, the company needs to have the right business model that can become profitable assuming proper execution. Some business models can never reach profitability even with heroic efforts by management. There are a number of reasons for a flawed business model but I think it often boils down to two issues:

  1. There isn’t enough demand for the product either because it doesn’t meet the needs of enough potential customers or because there are equal or better solutions to the problem that are available from competitors.
  2. The pricing required to generate a profit is too high for customers to pay.

If you have a profitable company, chances are you have a management team that was smart enough to select a suitable business model. Sometimes, however, it means they were just lucky.

Now let’s say that the management team selected a good business model that could reach profitability. Unfortunately, that doesn’t guarantee profitability as they have to execute on that business model and be capable of bringing it to profitability. This means they need to do things like obtain the required capital, create the product, market the product effectively, hire the right people, provide the right incentives, manage expenses, treat customers properly, adjust the business model as necessary, etc. I know there are many more things that should be on that list but you get the idea.

When you have a management team that is managing an unprofitable company, you are generally relying on their skills to bring the company to profitability. While they might have a great idea for business with nearly limitless opportunities, they may not have the competence to bring that business model to fruition.

There are many reports that indicate that around 50% of companies fail in their first five years. This Gallup article, while corroborating the 50% number, also indicates that management (the entrepreneur) plays a significant role in determining whether the company succeeds or fails. If you are investing in a company that only has a 50% chance of making it five years, you really want to stack the deck in your favor and have excellent management. Also, that 50% number is for all startups and not just the ones that attempt to be public companies. Based upon personal experience of watching microcap companies for many years I would not be surprised if that statistic is worse for publicly held companies as they are generally trying to create an enterprise that is larger than your typical small company.

As it turns out, when I first met Ian, he invested in more unprofitable companies than I did. That explains why he wanted to make sure that management had the right skills. I, on the other hand, invested almost entirely in profitable companies. In most cases when you invest in a profitable company, you already know that management has some good skills as competence is required to reach profitability. So, understanding management competence at a profitable company, if management has been there for any length of time, is not as important.

Now I am not saying that profitability means that you can check off the management competence box for profitable companies and move on. That is far from true. However, if the management team has been at the helm for any amount of time and they have had profitability and have even improved profitability, then likely they are good managers or at least good enough. I think one can look at it as a rule of thumb.

In unprofitable companies, you don’t have the luxury of knowing management skill merely by examining the financial results unless you know about some other company which they managed to profitability.

I think the other aspect you have to look it is the type of company that is being created. A company attempting to be an enterprise with revenue of $10M with profitability certainly is going to require a talented individual at the helm. However, if the company is attempting to be the next Amazon, Walmart, Southwest Airlines, or Microsoft, it is going to require an Intelligent Fanatic type manager to make it successful.

In short, I agree with Ian that management competence is important. However, I would add if it is an unprofitable company you had better have an extra level of scrutiny to examine the skill level of management because they may not be able to make the company successful and turn a profit. Profitability, especially with growth, gives you a built-in indicator of management competence.

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