What are the characteristics we need to look for in company management in order to identify which managers are most likely to lead their companies to success? Good management is a key investing criteria used by the great Warren Buffett (Trades, Portfolio), but what are the traits these managers should ideally demonstrate?
When constructing a portfolio of stocks, the broader your portfolio is in scope, the more performance is going to become correlated to the general market. So, anyone can achieve beta and acquire the same risk and return as the market. However, active investors aim to achieve alpha, meaning we want to beat the market. History shows alpha is extremely hard to achieve over the long term.
The same can be said for corporate managers. It's not uncommon for a manager to achieve a performance roughly in line with the sector, but as investors, we are looking for managers who are going to run companies in a way that outperforms the sector that company is operating in.
Buffett’s, Treynor and Swensen identify key characteristics of successful managers
In 2001, during a conversation with Cynthia H. Milligan, then Dean of the College of Business Administration at the University of Nebraska at Lincoln, Buffett said qualities he seeks in managers for Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) include a high energy level, basic intelligence and high ethical standards.
In 1990, the famous finance researcher Jack Treynor wrote in the Financial Analysts Journal (vol 46, no. 3.) a paper titled The 10 Most Important Questions to Ask in Selecting a Money Manager, which highlighted the importance of two factors: advanced knowledge of investments and a keen focus on the investment process. Successful investors must also love to learn, persistently seeking new information about the latest technologies, economic developments and market sentiment.
In 2000, David F. Swensen, the legendary manager of Yale’s Endowment, explained in his highly influential book "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment" the importance of long-term thinking and individually driven decision making in generating superior performance. He also stressed that a close alignment of interests between the investment manager and the client is a key requirement for future success.
While Treynor and Swensen were mainly talking about money managers, I believe their points hold true for business managers as well.
Below, I have summarized the key managerial traits that these three famous investors and analysts look for:
- Intelligence
- Knowledge
- Focus (ability to focus and the degree of focus)
- Long-term thinking
- Independent thinking
- Alignment of interests (skin in the game)
People, philosophy and process
When choosing an investment manager, or indeed a business manager, these characteristics should be assessed during our research process. This analysis of people, philosophy and process is carried out by sophisticated investors or pension consultants – see Patrick McCurdy’s 2012 white paper titled Understanding Investor Due Diligence and the 2011 report by Towers Watson - now Willis Towers Watson (WTW, Financial) - titled Assessing Investment Skill in Equity Managers.
The aim of our research process is to confirm that an investment organization or company has the expertise to deliver superior performance. Our research should include finding out what is the source of added value and understanding how the manager is going to capture that source within a diversified, live portfolio, after expenses. Things to look for include staff training and experience. After all this, we are still not guaranteed that a manager who satisfies our research criteria will have superior performance, but we have to start somewhere, and it should at least help screen out bad managers.
Quantitative and qualitative characteristics
A lot of what I'm looking for in my review of prospective managers is qualitative characteristics. Is there a way to quantify good management? I think there is. Buffett’s, Treynor’s and Swensen’s key characteristics of successful investment managers can be measured in several ways.
Basic intelligence can be measured using IQ tests, standardized aptitude exams and school grades. Although not perfect, a proxy could be the university attended by the manager as well as which honors they earned while in school.
Knowledge can be assessed by looking at number of years in education, the conferment of advanced degrees, the length and type of work experience, professional qualifications and scores on achievement tests.
Focus is a bit harder but could be proxied by the number of hours in an individual’s work week. Usually, the only people willing to sell their entire lives to a job and work 60+ work weeks are the people who have equity in a company, which is why managers' and executives' compensation plans are often heavily tied to equity with the potential for earning millions from said equity.
Alignment of interests can be proxied by examining the compensation scheme for the manager – are they financially invested in what they manage, and how? Options encourage risk taking, but straight stock gives a linear alignment with outside investors.
Long-term thinking is about the formulation of a strategic process, while independent thinking relates to self-confidence and self-esteem (which enables the manager to have an ability to take contrarian positions which will differentiate the manager from the rest of the market).
Many of these characteristics relate to a manager’s entrepreneurial drive. Ideally this could be measured by studying any interviews the manager has given, as well as press appearances and statements.
Financial researchers have looked extensively at the value of intelligence in financial success and have found that high IQs and superior scores on aptitude tests are positively correlated with financial success and better investment performance. Studies looking at the value of education on performance have yielded mixed results, however.
A manager’s level of focus or work ethic is probably hard to quantify exactly, but academic research on the positive effects of entrepreneurial motivation on business success suggests that organizations with more motivated managers tend to generate superior growth and profits. Research on the importance of thinking long-term looked at the effect of strategic planning on the financial performance of companies. The evidence showed some support for the hypothesis that managers benefit from formal data analysis. The findings indicate that long-term thinking, so long as it does not introduce rigidity or discourages innovation, improves performance. If you stop to think about this, these findings are not too surprising.
Skin in the game has also been researched by academics by assessing incentive-based fee structures, how much managers invest in their own funds and the construction of fund oversight committees. These topics have been researched for both mutual fund and hedge fund managers. The findings suggests that funds with higher levels of manager ownership or higher levels of performance sharing are associated with higher risk-adjusted performance – again this is probably not a surprise.
Summary
Researchers have studied the influence of manager characteristics on company financial performance, including portfolio returns, stock recommendation performance and company profit margins. While each study is unique, here are the statistical relationships:
- Intelligence – positive
- Knowledge – Neutral/positive
- Focus – Neutral
- Long-term thinking – Positive
- Independent thinking – Positive
- Alignment of interests - Positive
This calls for screening for superior managers by intelligence, knowledge, independent thinking and skin in the game. According to Heber Farnsworth and Jonathan Taylor in their 2006 paper Evidence on the Compensation of Portfolio Managers (Journal of Financial Research, Vol 29, no. 3.), these factors are crucial because most portfolio managers’ compensation is determined subjectively and not through more objective performance-based formulas. Skin in the game is related to compensation, so if it possible to understand the calculation of manager bonuses then we should try to do so. I haven’t found empirical evidence that correlates manager performance and their level of focus.
