Institutional Investors

Deconstructing Quality, Part III

Our Deconstructing Quality series explores the three categories Burgundy assesses in our search for worthwhile companies. Part I looked into the business characteristics that help define a quality business.  Part II considered the financial attributes that make for attractive investments. In Part III, our final segment, we will investigate management assessment, the least quantifiable piece that requires the most judgment.

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Deconstructing Quality

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In a public company, the management team’s purpose is to create value for the shareholders. It can be argued, however, that management’s decision-making responsibilities extend beyond the interests of shareholders to include other stakeholders, such as employees, customers and the communities in which they operate.

When assessing the management team of a company, we often focus on four key criteria:

  1. Are they capable and honest?
  2. Do they have a strong record of capital allocation decisions?
  3. Do they have equity ownership?
  4. Do they practice good corporate governance?

Every investor wants to be aligned with a capable and honest management team. No investment firm is going to tell their clients that they are allocating client capital to a company run by incompetent crooks. So, setting aside the obvious, how do we determine whether a management team is capable and honest?

Fundamental research often provides the answer. We interview management to understand their thoughts on the business and its future. We also interview the company’s customers, suppliers and competitors, along with industry experts, to see if management truly understands their market and the environment in which they operate.

Warren Buffett once said,

“I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

While we search for the same types of businesses at Burgundy, they are few and far between. Even if we find one of these wonderful businesses, we still prefer to have competent management at the helm. The addition of strong management to a strong business model can convert a good business into a great investment. This process is often facilitated through good capital allocation decisions.

Suncor’s purchase of Canadian Oil Sands in 2016 is an example of effective capital allocation. We owned Canadian Oil Sands on behalf of our investors in our Canadian equity mandates. Since we believed there was more money to be made in Canadian Oil Sands, we were disappointed with the acquisition. By the same token, if we were in Suncor management’s shoes at that time we would have done the exact same thing. It was a pure “value investor” purchase made in a contrarian fashion when energy was out of favour for assets that, in our opinion, were priced below their intrinsic value. To us, this purchase represented a good capital allocation decision for Suncor.

We like to invest alongside management teams that have material equity stakes in the companies they manage (not stock options, but real common stock interest). This equity ownership aligns the decision-making behaviour of management with the long-term interests of shareholders.

This brings us to our last area of management assessment: corporate governance. We seek out companies where Boards of Directors act as the fiduciary to shareholders. The Boards must not represent a cadre of friends and business associates who simply act as a rubber stamp to management’s actions. It is therefore critical to have separation between the Chairman of the Board and CEO roles combined with strong participation from independent directors.

The answers to the four guiding questions above assist us in judging the capabilities and motivations of management. The information derived from the management portion is critical, working in conjunction with our assessment of the business characteristics and financial attributes. Together, these components are critical to understanding Burgundy’s approach to deconstructing quality.

Article By Greg Dowdall, Burgundy Asset Management

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