What is Great Management Worth?

What Is Great Management Worth?

In some respects, corporate management seems to be a bit like the weather - everybody talks about it and everybody agrees it's important, but nobody can ever seem to quite figure it all out. More to the point, only a momentum investor or chartists would likely even try to claim that management does not matter when assessing a stock merit's. Yet even value hounds have a hard time assigning value to management, or even proposing how such a thing could be measured.

Great Management Sees the Future

In 1998, Finland's Nokia was the world's largest cell phone maker and Apple was struggling to right itself just over a year into Steve Jobs' return to the company. While Apple developed breakaway winners like the iPod and the iPhone, Nokia introduced lead balloons like the N-Gage. Worse still, Nokia seemed to make the decision to play it safe and follow the market instead of looking out ahead of the curve and anticipating what customers would want. As a result, while Nokia is still the largest phone company in the world, Apple has jumped ahead both in revenue and in how much investors will pay for that revenue (Apple is over nine times larger in terms of enterprise value).

This is relatively common occurrence in business, and a major axis around which management value revolves. It is incredibly difficult to succeed by forever playing catch-up or hoping to take an already proven idea and execute it just a little bit better. The CEOs of companies like Microsoft, Intel, Wal-Mart and Nike saw a future that other CEOs could not see and they positioned their companies accordingly - building billions in shareholder value along the way.

Allocates Capital

Product development and marketing is not the only, or even the most important, job of management. Management is also preeminently responsible for allocating a company's capital. If management wisely feeds high-return projects and chokes off (or milks) low-return businesses, the business will thrive.

Supposedly Apple spent around $150 million to develop the iPhone, a product that produces billions of dollars in revenue per year now. What if Apple had allocated that to a gaming system to rival Microsoft's X box? Alternatively, what if Microsoft had allocated just some of its multi-billion dollar annual R&D budget to a smart-phone concept five years ago? Ultimately, how and where a company spends its money determines whether any particular management's view of the future has a chance of coming true.

Also consider the case of conglomerates and Berkshire Hathaway. Typically conglomerates trade at a lower valuation than the sum of the parts would imply - a so-called “conglomerate discount” that recognizes that most management teams make suboptimal decisions and misallocate capital over their unwieldy collection of businesses. Under Warren Buffet's leadership, however, Berkshire Hathaway trades at a premium to many well-run and profitable insurance businesses due in part to his reputation as a top-tier allocator of capital.

Executes the Plan

Brilliant plans are all well and good, but there is also undeniable value in management teams that are capable of executing the plans they create. Since 1995, Nucor, AK Steel and U.S. Steel have all basically been in the business of selling steel - and yet, Nucor has done substantially better for its shareholders over that time-frame. Moreover, Nucor has returned more than the S&P 500, and that is something that materials companies aren't supposed to do. A lot of this can be laid at the feet of the operational excellence of Nucor's management.

Likewise, it is difficult to say that the differences in the fortunes of Boston Scientific and St. Jude can be chalked up solely to different visions or plans. Both companies have had to navigate significant slowdowns in their core markets (pacemakers and ICDs), competition, and changes to insurance reimbursement and FDA policy. Yet, St. Jude has shown itself to be far more adroit in navigating this tricky market.

The Right People Are Worth Billions

Taking a step back, investors need only consider the fortunes of McDonald's, Burger King and YUM! Brands - or Southwest Airlines versus practically the entire airline industry - to see the ultimate value of good management. There was no obvious or inherent reason that McDonald's and YUM should have emerged as global giants in quick-service restaurants, while Burger King is little more than an afterthought. Instead, McDonald's and Yum prospered because they had management teams with clear and far-reaching visions, sound capital allocation priorities and the ability to execute on their plans.

Likewise, Southwest Airlines was regarded as a joke when it launched with its air hostesses in hot-pants and go-go boots. Now Southwest is second only to LAN in terms of market cap in the airline industry and has not gone through the serial bankruptcies of its rivals. This was not the product of chance. Southwest had a distinct vision (low-cost service to under-utilized airfields), disciplined capital strategies (using older aircraft) and solid execution (including excellent customer service metrics).

The Bottom Line

Since Apple's CEO took another medical leave of absence and Google's CEO stepped down, those two companies have lost billions in market capitalization. Even allowing for the general decline in the market during the same time, both stocks have lost more than they otherwise should; suggesting that investors realize that those prior CEOs were worth potentially billions to shareholders.

Looking around the board, that seems like a reasonable assessment. After all, top-flight management can fairly be expected to produce at least a few extra points of return on invested capital relative to industry averages. Leverage that over a few billion dollars of invested capital and a few years, and the differences in profits, free cash flow and investor value add up very quickly. 

Simply put, the question of whether your company has great management may very well be a billion-dollar question. Over time, companies whose managers excel in seeing the future of their industry, allocating capital to the right projects and prospects, and actually running the business with disciplined efficiency ultimately create valuation gaps over their rivals that can be measured in the billions of dollars. That, then, is certainly justification for investors to go the extra mile and ferret out those companies led by top-notch management teams, and particularly those that are not yet widely known and appreciated by Wall Street institutions.