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New Year’s resolution No. 2 for investors – Follow in the footsteps of Warren Buffett

In part one of this four-part series on how Warren Buffett identifies potential investments I discussed author Roger Hagstrom’s suggestion that Buffett has 12 tenets he looks to identify in any investment. The first group of those tenets (which we discussed in part one) were Business Tenets, here we turn our attention to the second group – Management Tenets.

1) Is management rational?

When investors buy shares in a company they are putting a significant amount of trust in both the board they elect and the management to run the company with shareholders’ best interests in mind. While the type of company an investor buys will certainly have a bearing on results, the influence management wields over results is substantial as well.

Identifying managers who understand how to enhance shareholder value and to allocate capital based on achieving a return above the cost of capital is vitally important. Management at Wesfarmers (ASX: WES) and Brambles (ASX: BXB) are two examples of firms where performance is discussed with reference to returns on capital.

2) Is management candid with its shareholders?

The list of companies with management teams who gloss over bad news is sadly a long one. From reporting results in the ‘best light’, to changing the yardsticks by which management suggests shareholders measure their performance, to providing minimal details and information about the true state of the company. All are examples of management teams not being candid with shareholders.

In contrast there are some management teams who are impressively candid, for example the presentations by Brickworks (ASX: BKW) and Origin Energy (ASX: ORG) provide shareholders with detailed information to use in their analysis of the companies.

3) Does management resist the institutional imperative?

The institutional imperative is a term used to describe the tendency for managers to imitate other managers even when the behaviour is irrational. This tendency to copy others can ultimately lead to major problems such as the Global Financial Crisis – what might start as lax lending standards at one financial institution can soon spread to other institutions! The institutional imperative is also evident when managers become ‘empire builders’. The desire to run a larger organisation (to build an empire) – regardless of whether bigger will be better for shareholders – is a desire too strong for some managers to resist.

One way to hopefully avoid the institutional imperative is to seek out companies run by their founders. Companies such as  Flight Centre (ASX: FLT) and Blackmores (ASX: BKL) are run by founders who are also substantial shareholders, this scenario can help keep the management team focused on maximising shareholder value rather than being lured by the institutional imperative.

Foolish takeaway

While judging the skill of management may at first glance appear to be a harder task than judging a company based on its financials, in reality significant insight into management can be determined by how they communicate with shareholders and also by reviewing their record with respect to returns on capital.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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