Getting Started in Value Investing Chapter 5

Getting Started In Value Investing Chapter 5: Who’s in Charge? Management Counts Getting Comfortable with Management • • • • • • •

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“Good managements produce a good average market price, and bad managements produce bad market prices.” – Benjamin Graham Investors should look at management of a company as their business partners and make sure they are comfortable with their relationship Company management should be focused on increasing shareholder value Management and shareholder interests should be aligned Regulation Fair Disclosure, which was passed by the SEC in October 2000, mandates that all material information be released to all investors at the same time Proxy statements demonstrate how company management is compensated which in turn shows investors whether management’s interests are aligned with their shareholders The author points to Heartland Express, Inc. CEO Russell Gerdin as an example of management incentives that are congruent with shareholders • Mr. Gerdin receives $300,000 per year in salary with no stock options or incentive plans • He owns 35% of the company stock • “At Mr. Gerdin’s request, his salary has remained the same since 1986, and he has never been paid a bonus. Mr. Gerdin receives an incentive through appreciation in the market value of the Company’s stock. Because of Mr. Gerdin’s request, the Compensation Committee did not consider or recommend an increase in annual compensation or any incentive compensation for Mr. Gerdin. Thus, corporate performance directly affects Mr. Gerdin, but not through his compensation by the Company.” – Heartland Express 2006 Proxy Statement Kinder Morgan Management describes their management compensation policies below • “Unlike many companies, we have no executive perquisites and, with respect to our United States-based executives, we have no supplemental executive retirement, non-qualified supplemental defined benefit /contribution, deferred compensation or split dollar life insurance programs. We have no executive company cars or executive car allowances nor do we offer or pay for financial planning services. Additionally, we do not own any corporate aircraft and we do not pay for executives to fly first class. We are currently below competitive levels for comparable companies in this area of our compensation package; however, we have no current plans to change our policy of not offering such executive benefits or perquisite programs.” – SEC Form 10-K, December 31, 2006 Unfortunately many companies do not take such a responsible stand on management compensation “The salary of the chief executive of the large corporations is not a market award for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.” – J.K. Galbraith Below are several examples of poor management compensation decisions • Former Morgan Stanley CEO Phil Purcell, who was ousted by dissatisfied investors after the company underperformed peers during his tenure, was given $106,000,000 as a severance package • His underling at the time of his firing Steve Crawford was paid $32,000,000 in severance even though he was only on the job for 100 days • Bill Butler President of Aaron’s Rents, which is in the business of leasing office furniture, used $890,000 of shareholder money to send his kids to a race car driving school • Former WellPoint CEO Leonard Schaeffer proposed a retirement package in the range of $37,500,000 to $260,000,000 • The wide potential variance shows a lack of clarity that should concern shareholders One of the worst examples of shareholder friendly management was Home Depot CEO Bob Nardelli, who in 2006 ran a 30 minute annual shareholder meeting where the board of directors

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was not present and he refused to answer specific questions pertaining to his compensation package This a sharp contrast to Berkshire Hathaway where chairman Warren Buffet and vice chairman Charlie Munger answer questions each year for more than 6 hours despite being 72 and 85 years old respectively A shareholder is an absentee owner of the company who relies on a competent management to run the company because they can’t be there • Management’s goal should be to increase value for their absentee owners The top three questions Buffett asks when sizing up company management are as follows: • Is management rational? • Allocation of capital, or what management decides to do with shareholder profit, is the biggest factor in determining shareholder value • If management is not rational in how they choose to allocate shareholder money they can destroy value very quickly • The option of leaving the money in the bank and collecting interest is always available, but the following four option are usually better for shareholders • Invest Internally o Invest money back into the business if they can generate a higher rate of return than is available on a savings account • Return Money to Shareholders o They can return money to investors by declaring a dividend o Some businesses generate so much cash flow that they increase the dividend annually o Some great companies never declare a dividend because they can reinvest the money at a higher rate internally • Buying Back Shares o If a company believes that their shares are undervalued they can buy their own shares in the open market which reduces the equity outstanding o A company that continually issues more shares dilutes equity owners and should be treated with skepticism • Making Acquisitions o They can use cash to buy other companies o Acquisitions have a poor record of creating value for shareholders o “I have never seen a deal that didn’t look good on paper.” – Warren Buffett • Investors should monitor very closely how management allocates cash • Just because a company has cash does not mean they should spend it foolishly • Investors should be especially weary of companies that are constantly making acquisitions as it signals that there is not much of a prospect for internal growth • Many times acquisitions are ego driven • “When a chief executive officer is encouraged by his advisers to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life. It’s not a push he needs.” – Warren Buffett • Are they candid with shareholders? • The CEO’s letter in the annual report should be an update to shareholders on what happened over the past year and what they are hoping to accomplish in the future • This gives you an opportunity to gauge management’s focus and determine if you are comfortable being business partners with them • A manager who can give praise to others is a great sign because it demonstrates a lack of ego • Do they resist the “institutional imperative”?

Following the “institutional imperative” means doing what everyone else is doing just for the sake of it • This happens much more often than a rational person would expect • Often times companies make acquisitions simply to match the moves of their competitors and end up destroying shareholder value • A great manager, much like a great value investor, has the ability to think for himself Reading annual reports is essential to investment success The author recommends reading 5 years worth of annual reports for potential investment opportunities in order to gauge whether management has accomplished the goals they specified • He also reads their competitor’s annual reports in order to compare and contrast how companies in the same industry dealt with market conditions In addition to annual reports investors should also read the SEC filed 10-K which goes into greater detail about the business and its risk factors Management’s Discussion and Analysis at the end of the annual report helps the investor understand the story behind the numbers The footnotes to the consolidated financial statements are critical to understanding the companies accounting policies • Revenue recognition is especially important Marty Whitman, of Third Avenue Value Fund, believes that someone with an IQ of 70 should be able to understand a company’s public filings • If the filings are unclear he assumes management is trying to hide something and refuses to invest in the company Management is crucial, but so is industry competition “. . . with few exceptions, when management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” – Warren Buffett Key Points • Publicly available reports provide a type of “passive transparency.” A lot of information is in the proxy statement, for example, about management compensation. Before you hand over your money, you should do some reading. • Some corporate managers comply with the reporting requirements, knowing full well that most people don’t read them. But remember some compensation programs are schemes under which a few greedy executives siphon off your money to line their pockets. They comply, but you have to read to find out what they are doing. • When you examine a company, look for a manager’s attributes, including the ability to make wise decisions, provide real leadership, and keep the business profitable. But above all else, you want to be sure management has honesty and integrity. •

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