It is all too easy to reduce ASX investing to picking ticker codes on a screen. Corporations and companies are big and complex business structures with more moving parts than we can comprehend. It's only natural our brains feel much more comfortable representing these elaborate entities in four letters or less.
Sadly, the reductive portrayal of companies as a handful of letters (or numbers) and a squiggly line does little to remind investors of what they're, in fact, investing in. Like a mechanical watch on the wrist, the real magic happens in the carefully constructed workings that lie beneath the ticking hands.
People. You… I… Alan Joyce… and all the others. All companies are made up of people. Yet few investors will devote much time, if any, to evaluating the quality of management before investing in ASX shares.
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Why management can make or break returns
Genuinely, how many times have you heard a company's management team be the main point of discussion for an investment? Seldom, I would assume.
The conversation is often fixated on revenue, earnings, market sizes, product development, expansion, contraction, acquisition, demerger… the list goes on. Many fail to see that all of these outputs are dependent on decisions made by people.
Poor management = poor outcomes; good management = good outcomes. It may not always work out that way, but there are certainly stronger odds.
Peter Lynch, one of the most successful fund managers of all time, once said:
Management is the single most important thing in a company.
See, management is the group of people responsible for making the most powerful decisions in a company. They can single-handedly create or destroy millions or billions in shareholder value. When someone has that capacity, you ensure someone capable is at the wheel.
Aside from capability, management motivations are another important consideration. Unfortunately, some people will put their own short-term self-interest above the long-term prosperity of shareholders.
How to add management to your ASX investing process
Now we know the importance of management, but how do we embed it in our stock-picking?
There are a few simple ways to gauge the quality of a company's management, including:
- Remuneration: Compare the CEO's pay with companies in the same industry with a similar market capitalisation. This can help identify executives who see the company as their personal money fountain.
- Capital allocation: Check the return on capital employed (ROCE). Management is responsible for capital allocation. Good management invests money wisely to create long-term value for shareholders. Look for ROCE above 15% as a rule of thumb.
- Ownership: Do the CEO and other executives hold a meaningful number of shares in the company? Management with skin in the game is incentivised to create value when invested alongside you.
A more challenging way to evaluate management quality is through character judgement. If you have a sixth sense for dishonesty and BS, you can dodge a few bullets this way.
Alternatively, Warren Buffett and Charlie Munger often say to buy businesses even an idiot could operate. In other words, companies with such large moats and such simple business models that poor management couldn't even hold it back.
However, when I'm investing in ASX shares, I don't dare underestimate the destructive force of people driven by short-term thinking.
