Searching for Rational Management

Through the rambling course we’ve taken on this blog, we’ve highlighted a few businesses with wide economic moats. Some offer products that satisfy basic and enduring needs; others sell a commodity product—like insurance or suit liners—but with the lowest cost structure in the industry.  Elsewhere, we seen wide moat businesses with a network advantage that makes their service difficult to replicate—like Craigslist or eBay.

However, I am increasingly persuaded that the caliber and experience of management is the most important criterion for determining the width of an economic moat. Given today’s rapid pace of innovation and competition, even the best businesses will require excellent strategic decision-making and creative problem-solving to survive and thrive. As we saw in Only the Paranoid Survive, competitive forces could have sunk Intel had Andrew Grove not boldly broken their old habits. If such crisis points arrive even more frequently for business managers of our future, a strong case can be made that strong management is the best tool for widening a business’ moat.

To say as much is largely uncontroversial. The real crux is: what are the characteristics of strong management, and what tools can an investor use to reliably find them? For Warren Buffett, strong management concentrates its focus on daily increasing a business’ intrinsic value. From an expense standpoint, that means using each retained dollar in projects that provide an adequate return. It means growing revenues, but only when the projected profits far exceed other available alternatives (which may include buying shares of competitors in the public markets). It means returning capital to shareholders—in the form of share buybacks or dividends—when adequate returns cannot be found internally. The rational manager repurchases shares only when its price resides far below its intrinsic value.

With recent stock market declines, I had hoped to use this opportunity to filter out those management teams who buy high and pause repurchases when prices fall.  But few management teams have taken advantage of the recent declines. And perhaps even more interesting, April saw insiders’ stock sales outnumber purchases by more than 8 to 1! Though some interpret these sales as tax related, call me unpersuaded.  For one, management insiders are often higher net worth individuals, a group that regularly files for tax extensions, so as to not pay until at least October. And second, tax losses are really most valuable when paired with offsetting gains. To justify the level of insider selling we’ve seen, the tax losses would have to be paired with some very long term capital gains, as anyone who has bought and held the market over the last decade would have few gains. Without such capital gains, such selling is excessive for the mere $3000 claim.

Needless to say, I’ve been rather surprised by these findings (consider me naïve). Not only are many companies slowing their share repurchases, many managers seem to be tossing their ownership stakes aside. So the final question is—are they being rational or irrational? Today’s optimist believes that the stock market offers abundant bargains, and would chastise these crazed sellers for their depressive and irrational behavior. The pessimist though sees rationality in these insider sales, for what has fallen down can fall again, and again. Though I’d like to be an optimist, sitting on the other side of 8 to 1 odds can be a bit uncomfortable.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.