Jeff Bezos had sometime back said that there are two kinds of managements, those that create wealth for their shareholders and those who don’t.
Hardly revealing right? After all, why would someone put in hours of labor and humongous amount of resources only to risk it going all the way down to zero?
But each one of us have come across companies or people who does the very same thing – work every day (usually in some wrong direction) to put themselves into trouble.
Think about those inflexible trade unions in an already dying industry. They would fight for a wage hike irrespective of the fact that doing so which reduce company’s life from a couple of years to a couple of months.
Or the management operating within that industry. They would commit further capital in form of machinery upgradation to get an edge over their sick counterparts. Probably because some of their peers are already doing so. They may seem to oblivious to the fact that they are into some kind of an ‘endgame’
From the lenses of Psychology
As a long term investor, there is hardly anything worse that can happen than the management whom you have entrusted your capital gives itself away to short-termism. Prioritizing near term (and hence usually insignificant) achievements over those hard long term oriented resource allocation decisions.
Publicly traded companies more often fall for this trap. Ask any company executive ‘what would you do differently if your company was not publicly traded?’ More often than not you will come across some interestingly revealing answers.
Studying the psychology of human mis-judgement can reveal some useful answers.
(i) Incentives: Every decision is right or wrong based on the time horizon one is looking at. In cricket, for example, aggressive shots from batsman is an absolute must in a T20 game but could be a bane in test cricket. Similarly, if the top executives are paid for scoring high in form of near term earnings, long term investments would be deferred to the extent possible. This would give your rational competitor an important lead. As the saying goes ‘penny wise and pound foolish‘. If managers are paid only for hitting sixes, rest assured you would be losing the gruelling test match.
(ii) Social Proof: A listed company of desent size will generally be chased by several analysts and fund managers. And given that most of these participants like celebrating ‘the quarterly results fest’ as religiously as they can, what invariably follows is a mental pressure of ‘beating the expectations’ every quarter. This is what social proof is – we judge whether a particular behavior is right or not based on other peoples reaction to it. Add to this the fact that your peer group is also into playing this type of quarterly beauty contest and you would know what you have to do.
(iii) Deprival Syndrome: Sometimes you are so accustomed to a particular way of doing business that its very difficult to leave it for something even better. Sam Walton in his biography mentions that ‘variety’ store owners were so attached to earning 45-60% kind of margins that they couldn’t even think of getting into discount retailing with 30% kind of margins. Despite it being a much superior business model and had a clear preference of buyers towards it. Its very difficult to see your revenues or margins go down. Even if that’s the only way ahead for building a sustainable business.
(iv) Cognitive Dissonance: Business landscape is all full of potholes. And then there are these occasional sharp turns. If one such turn means that you need to part away with your competitive advantage in order to survive, more often you will find that turn would not be taken up. They would continue to drive thinking it as the regular highway! The result – a fatal crash. At the time of iPhone’s launch in 2007, almost all of the top executives at Nokia thought iPhone would not be able to dent Nokia’s market share. We all know what followed.
What’s our way out?
As business owners with long time horizon in our minds, we need to find not only those businesses which are strong & trading at attractive prices but also need to know something about the guys who are running it. Having like-minded guys up at the realm is what one needs.
There are couple of things we can do.
(i) Know how they are incentivised: As Munger says ‘tell me how someone is incentivised and I will tell you how would he behave’. Are those ESOPs have a tenure, on average, of 1-2 years or are long term in nature (>5 years)? How much is the stake of current management into the company? Are they investing a sizable portion of their compensation back into company?
(ii) Past decision-making track record: Have they delayed an important capital expenditure to the extent they could or are they preemptively allocating resources? Have they pro-actively took a toll on their earnings in order to create a stronger business?
(iii) Quarterly results: How do they feel about their quarterly hits & misses? Personally, I would respect someone who can keep himself calm over short term gyrations.
Running a public company is not easy. There are hundreds of people with different attitudes towards wealth creation tracking you every time. This leads to multiple interpretations of the very same facts. It is in the backdrop of this high decibel noise in which managers need to prove their conviction. What we need as long term investors is to partner with those types which have their attitudes and, more importantly, incentives aligned with us.
In a world which is increasingly getting obsessed with short-termism, as falling average holding periods would convey (down from 3-5 years couple of decades back to <12 months now), ability to think about longer time periods is an advantage in itself.