Mini Lecture on Evaluating Operating Skills of Business Managers

Transcript

Hey guys and girls! Good morning. I am back at my favorite place — Lodhi Gardens. You can look, I love this place. It’s like a jungle inside the city. So quiet…

Today I want to talk to you about management quality. And, in fact, I want to talk about just one of the dimensions pertaining to management quality. There are three dimensions here. Dimension number one is operating skills. Dimension number two is about capital allocation skills. And the third dimension is about integrity. And all of these three dimensions are important if you want to be a successful long-term investor in businesses.

But, today, I want to only talk about the first dimension, which is to do with operating skills of managers. And I think there are a few misconceptions about evaluating operating skills of managers. How does one go about identifying the misconceptions?

Well what we really trying to determine is how good or bad the manager is in running the business. And clearly this is not going to be an easy task if you’re looking across various industries. I mean, the best guy in the cotton yarn business may have the best return on capital employed in his industry, but that ROCE could be insignificant as compared to that earned by the best guy in the FMCG business. And so, when we are evaluating operating skills of manages, we have to compare people in the same industry.

And of course, everybody knows that, right? But how does one go about making that comparison? So what are the various ways in which people think about operating skills? 

Well, they use ratio analysis. What usually happens is that they pick up the guy who have the highest operating profit margins or who have the highest return on capital employed or both.

Now, there is a problem with that kind of thinking. To be sure, more often than not, the people who have the highest operating profit margins are also the best operators in the industry. But that’s not always the case. In fact, there are situations where businesses which have a lower operating profit margin might actually be run by a fellow who’s got better operating skills.

How can that be? How can a guy with a lower profit margin may be a better manager than the other guy having a higher profit margin?

Let me explain. In some businesses, there is the element of pricing power. Now the guy who is giving into greed and his desire to maximise short term profits might use his pricing power to exploit his customers by charging them a high price. But the guy who’s thinking long-term, is think about maximizing, not short-term profits, but long-term wealth, by building brand loyalty and gaining market share, might actually charge a lower price. And if he charges a lower price than the other guy, assuming that their costs are the same, he will earn a lower profit margin.

So who do you think is the smarter of the two? The one who charges a higher price or the one who charges a lower price? And that depends. It depends on what happens next. It depends on how customers will react. It depends upon how competitors will react.

In many cases, customers have no choice. They’ll keep buying from the guy who is charging the higher price. In some cases, there are strong entry barriers. There is no way a competitor can enter the industry.

But these conditions are not always there. Sometimes you have situations where if you charge a high place, you will attract competition. Philip Fisher talked about it in his book. He likened high operating profit margins to an open jar of honey which will attract bees which is competition.

And that’s exactly how competition works, right? People want to go into a business where operating profit margin is high. But, if you keep operating profit margin low and still have high capital turns, which will still allow you to earn a superior return on capital employed, perhaps you will deter competition.

There are two ways to think about competitors. People who are already in the business and they’re competing with you and people who are not in your business, but might contemplate entering it. Now, the second category of these people would not even contemplate entering into an industry where there are wafer-thin operating profit margins.

And that’s important because at the end of the day, what a business should do is to maximize long-term wealth and to do that you have to think about the longevity of the business — the period over which you can earn superior returns on capital employed. And sometimes, to do that, you have to have a lower operating profit margin and not a higher one.

So, that was my first point. 

What about the second component of the return on capital employed? The capital turns? So obviously if you look at how the math works out in the Du Post formula, to maximize your ROCE, you can do that by reducing the denominator. And if you are able to do that, the ROCE will go up. And one way to reduce the denominator is to reduce working capital. And you can accomplish this by reducing inventory, for example, or by delaying payments to your vendors.

Obviously, techniques like these, will result in lower working capital employed which still boost the ROCE for now. But that doesn’t really make sense?

Consider the guy who is thinking truly long-term. He wants reliable vendors. He wants vendors who want work with him forever. He understands the power of the principle of reciprocity. He also never wants his customers to be turned away because he did not have the right inventory item to sell to them — something they wanted to buy. He knows that if they are turned away, they will go to a competitor and may never return to him and he does not want that to happen. So, he keeps more inventory. His is an inventory-heavy model, meant to give choice to the customer and he expects this to build customer loyalty over time. But, at this time, by keeping inventory levels high, the denominator in ROCE is increased which will pull down the ROCE as compared to the guy who has far less inventory.

Looked from this perspective, what you should really be trying to do is to create long-term value, not short term earnings or free cashflow. If your focus is on near term earnings or free cash flow or return on capital employed, your operating decisions sometimes will be contrary to what is required to create long-term value.

And I find this interesting because I have students who use tools like ratio analysis and databases. And if I ask them a question — can you identify the best company in an industry? — they use the tools of ratio analysis. They go and quickly run a screen on an industry and find out the guy with the highest operating profit margin, or the highest ROCE blah, blah, blah…

And, they come up with the name, and they automatically assume that the guy with the highest profit margin at present or the highest return on capital employed at present is the guy with the best operating skills. Well, the big lesson here is that it’s too easy to be too judgmental too quickly about these things.

When evaluating the operating skills of a manager, you have to think like a businessman. You have to think about what it takes for you to create long term value. And one of the things that are required to create truly enduring long-term value is happy customers and happy vendors. And when you put those things in context, you start thinking: “Well, maybe I’m going wrong and maybe the guy with the highest operating margins is not the guy with the best operating skills and maybe the guy with the second highest or the third highest operating profit margins could be the smartest guy in the room.”

And so the lesson here, I think, is that while ratio analysis is useful, there are elements about evaluating management, which go beyond ratio analysis. And it’s important to keep that in mind.

Thank you.

Sanjay Bakshi

September 15, 2020

New Delhi