HOW TO INVEST: MANAGEMENT IS OWNER ORIENTED

Welcome to the introduction to Rule #1 course, I’m Phil Town and this is Tutorial 5: Management- Owner Oriented.

This is part 5 of a 9-part series on How to Invest using Rule #1 strategies
Part 1: Rule #1 Strategy- Overview of the Basics
Part 2: Meaning- The Three Circles
Part 3: Moat- A Durable Advantage
Part 4: Moat- The Big Four
Part 5 [You are Here]: Management- Owner Oriented
Part 6: Margin of Safety- The Growth Rate
Part 7: Margin of Safety- Sticker Price and MOS
Part 8: Margin of Safety- Payback Time
Part 9: Zombie Value- Tangible Book Value

 

Company Management: CEO’s are Passionate

Management as far as I’m concerned is the CEO, and I want my CEO’s to be passionate, honest, and owner-oriented.

Passion in a CEO means that they have a big audacious goal. They have some kind of great challenge that they are putting out for the troops that they’re excited about, which motivates the whole company to move forward and accomplish the impossible. This is where we get some major home runs.

Four Types of a CEO’s Big Audacious Business Goals

There are four types of these big audacious goals a CEO can have for their company:

1) Common Foe Big Audacious Goal. You’ve understood this from other companies, like when Phillip Morris took on R.j Reynolds, Nike took on Adidas, and Apple took on I.B.M.

2) Target Big Audacious Goal. This is when Sony decided it was going to turn “Made in Japan” from something that meant poor quality, into something that means great quality.

3) Role Model Big Audacious Goal. “Let’s go be like those guys.” Let’s be like Nike, but we’re going to do it in the cycling industry.

4) Internal Transformation Big Audacious Goal. That’s where we’re going to change our company completely from say a defense contractor, into a highly diversified high tech company.

How Do You Know if the Company Has a CEO with Big Audacious Goals?

How would we know if we have a company where the CEO has a big audacious goal? Let me show you one. With any company that we’re going to look at, remember it’s not a recommendation or advice to invest. Lets look at JC Penny. Take a look at the “investors tab” on any company on their website. Click that tab and you should see the big audacious goal happen really quickly if it’s a big audacious goals type company.

Looking in the first paragraph of JC Penny’s website, we see that it says,

“Today rooted in its rich heritage, JC Penny Company is reimagining every aspect of its business in order to reclaim its birthright and become America’s favorite store.”

Now that is a big audacious goal.

Company Management: CEO’s are Honest

The next trait of a good CEO after passion is honesty. Does the CEO tell you about the problems the company is having and spell out the solutions? Do they take the blame when there are mistakes? Do they give the information that you need in order to know the value of the business?

Let me give you an example of a CEO who does exactly that.

On the Whole Foods Market website, I’m going to go to their investor page by finding investor relations where you can find their annual reports.

On the investor relations page and I go to annual reports right there, and then I’m going to scroll down and find an old report and start reading forward from here. I’ll start in 2007 or 2008, looking for the chairman’s letter. Click on it and begin reading. I’m trying to find information that tells me how to value this business. You can see there are financial highlights that help me, it shows how they’re dealing with problems and where they implemented certain cost containment measures at the global regional store level. They also talk about their core values. I love CEO’s that share values with me. John Mackey has a great set of values that he runs his company with. They make sure to point those out in the annual report.

If your CEO is an honest CEO, they are going to have all the information in this annual letter that you will need to figure out whether this is a great company, whether they’re dealing with problems correctly and what the value of the business is.

Company Management: CEO’s are Owner Oriented

And last but not least is owner oriented CEO that means that the CEO runs the business for our benefit. Now there’s three key numbers here that really help us know the CEO is really running it for our benefit.

1) The first is return on equity, that’s how much money they make on the equity of the company.

2) Next is return on invested capital, that’s how much money they make on the equity of the company plus what they borrow.

3) And then finally, how much debt they have.

We like return on equity to be greater than 10% percent and 15% percent is wonderful. Return on invested capital (ROIC) should be 10% percent or better, and debt at three years or less of earnings.

Where would we get these numbers? Go over to ruleoneinvesting.com, click on numbers and scroll to management and you’ll see this form right here telling you what return on equity, return on invested capital, and debt are and how well they score on a Rule #1 management score.

Now you’ll notice we’re looking at 10 years, seven years, five years, three years, and one year. We want to see these numbers staying about the same, or even growing over time. So it’s the over-time thing that’s most important here. Let’s take a look at the website and I’ll show you how to do this live. Here we are at Rule #1 and I’m going to put in Whole Foods Market symbol and click on numbers.

This is going to take me to an evaluation of the management numbers that gives us an objective view of how owner oriented this management team is. First, return on equity we see is running very consistently, not huge numbers, but for a grocery store chain they’re huge. ROIC went down a little bit, but now it’s coming back up. Again, not as high as we’d like to see these numbers, but for a grocery store chain, it’s huge. Debt is awesome, almost at zero.

Overall, we get a pretty good Rule #1 management score. That’s how we analyze a company with an objective view of owner-orientation. This is an owner-oriented company.

Insider Trading: A Possible Red Flag of a CEO

Insider trading is when the guys who run the company are actively buying their own stock. It’s legal, as long as they report it on an SEC form on the SEC website. We can find out if a CEO is unloading shares of his own company from the Rule #1 toolbox.

In this case let’s go over to Moody’s (MCO). We’re going to insider trading and what comes up are all the insider trades done at Moody’s. How cool is that? As we scroll down we can look for Ray McDonald the CEO. He’s dumping shares like crazy. There’s also a name that’s familiar, Berkshire Hathaway. Warren Buffett is selling, thousands and thousands and thousands of dollars’ worth of stock. That’s very entertaining, when we see Warren Buffett getting out, what do you think we ought to be doing?

Conclusion

Let’s summarize what we’ve learned about management.

1) First, we’re looking for passion, honesty, and owner orientation.

2) We’re going to be sure there’s no insider trading. If there is, we understand what it’s all about.

3) We’ll get the great management numbers from Rule #1 investing by going over to ruleoneinvesting.com.

Here’s your homework. Go to ruleoneinvesting.com and find the management score for your big moat company. Look at insider trading and see if the CEO is selling. And then go on to Tutorial 6: Margin of Safety (Part 1)- The Growth Rate.

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Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.