Invest in companies that focuses on increasing shareholders value

When it comes to Investment, Warren Buffett stands tall than any of his compatriots. I was reading the book by Robert G. Hagstrom called “The Warren Buffett Way” and I would like to keep a note of important things I have read in this book:

Page- 81 to 101

“When considering a new investment or a business acquisition, Buffett looks very hard at the quality of management. He tells us that the companies or stocks Berkshire purchases must be operated by honest and competent managers whom he can admire and trust.” 

But the question is how to identify and evaluate the quality of management? It’s not easy and prudent to make statements on “honesty of manager and their admiration I the eyes of others”. So can we say that Warren Buffett has made it more difficult for investors by asking them to evaluate management?

The answer to the above question is very straightforward; Warren Buffett has always considered “buying stocks means buying business”. The master does not consider stocks as mere piece of paper which can be sold (any time) to make profit. Warren Buffett buys shares with a mind of owning the responsibilities and staying afloat with the organization in the moments of crisis. He works ‘with’ the organization, in turn making huge amount of money in good times. Warren Buffett does not invest in stocks; he always focuses on investing in business. With this thinking of Warren Buffett, it becomes extremely important for investors to know the management of the company they are investing in. If you are not looking at stocks it is like joining a job at attractive an attractive salary, but ignoring to identify how big is the brand name? Who owns the business? What is the organization structure? Who will be your boss? How professional are the colleagues?

Warren Buffett is a firm believer that a management who focuses on “increasing shareholders value” will be worth investing. Shareholders value is financial jargon which in plain and simple terms means “market value of a share”. Management must take actions internally to ensure that shareholders money should be used to earn a higher return as compared to when the same shareholders invests their in other assets having the same amount of risk. Suppose a shareholder invests $100 in company X (say in steel sector) for 5 years. At the end of 5 years the market value of the share climbed to $150 giving the investor a return of 50%. If the same investor would have invested $100 in company Y (of the same sector) and after five years the market value has climbed only to $145, it means company X has ensured better stockholders value as compared to company Y.

A management who shows the following attributes can be considered as a management interested on increasing the shareholders equity: 

1. Rationality (In terms of investing its extra cash)
2. Candid (In terms of frank financial reporting)

Rationality

Warren Buffett gives a lot of importance to rationality of the management. When talks about rationality he means, how a company rationally decides the utilization of its extra cash. The concept of “extra cash’ becomes more predominant when the business has matured and its growth rate slows down. Every company does some thing or the other for the sake of expansion and modernization of its existing set-up. But the extra cash generated by the company is more than the requirement its growth and modernization projects. “At that point, the question arises: How should those earnings allocated?”

A company generating excess cash has three options: 

1. Invest extra cash to fund their growth and modernization. But it must be understood that the invested capital should give above average returns i.e. more than cost of capital (cost of buying)
2. They can buy growth. Buying growth means mergers or acquisitions. This always happens after step-1 (normally). A company generating enough cash, but continues investment in growth/modernization projects generating below average returns sees its stock price falling down. To divert the attention of investors companies always try to fool the investors by buying other companies. Investors get confused by assuming that acquisition will enhance the performance of the company. But such acquisitions or merger asks for massive reorganization, self integration. Such acquisitions are often dreadful.
3. They can return the money to shareholders. Returning money to share holders can be in the form of “better dividends” or “buying back shares”. Distributing dividends is the easiest thing that can be done if the company is generating excess cash. But step-1 should be considered first. If earnings of the company is retained and reinvested in companies growth and modernization, then this will give maximum support in “increasing shareholders value” in long run.

So rationality of management in investing its extra cash is very important.

Candid

The management can be considered reliable and worthy if they do their financial reporting in a candid and honest manner. If they have done something wrong that has brought down the shareholders value then it must be reported clearly in the report. Similarly the good things should be reported with full facts and figures. In nutshell you can say, a business run with lot of introspection, realization of mistakes and achievements, and simultaneously translating this into a transparent financial reporting shall be worth investing in.

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