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Your Buffett guide to wealth creation in 2016

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.

In a recent article, I discussed author Roger Hagstrom’s suggestion that Buffett has 12 tenets he looks for when identifying an investment.

The first group of those were Business Tenets, in this article we turn our attention to the second set – Management Tenets.

Is management rational?

When an investor buys shares in a company he or she is putting a significant amount of trust in the Board and the management to run the company with shareholders’ best interests in mind.

While the type of company acquired certainly has an impact 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 Ltd (ASX: WES) and Brambles Limited (ASX: BXB) are two examples of firms where performance is discussed with reference to the returns on capital.

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. These are all 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 Limited (ASX: BKW) provide shareholders with detailed information with which they can analyse the business’ operations.

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 have started as lax lending standards at one financial institution can soon spread to encompass many 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 managers who harbour the institutional imperative is to seek out companies run by their founders such as Flight Centre Travel Group Ltd (ASX: FLT). This scenario can help keep the management team focused on maximising shareholder value rather than being lured into focusing on other factors which could ultimately destroy shareholder value.

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Motley Fool contributor Tim McArthur has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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