Even though talking to CEOs is helpful, I don’t think it’s required in order to get an idea of how shareholder friendly they are. Last year I added a section to my investment checklist called “Management intangibles” where I go through a number of things that give hints as to what type of CEO I’m looking at. I like asking myself these questions because the answers to all of them are public information and/or fact-based. When talking to a highly charismatic CEO who is a natural salesman, it’s easy for the halo effect to take over and to think higher of them than I should. The halo effect is when we take one attribute of someone (this CEO is knowledgeable and talks with confidence) and assign them other unrelated positive attributes because of it (this CEO is shareholder friendly and a good capital allocator). It’s a human bias that we’re all guilty of (most commonly with attractive women) so it’s a good idea to try and counteract it.
I think combining these list items with my impressions from talking to the CEO leads me to a less biased opinion that’s more rooted in facts. So below is a list of all the things I go through in my intangibles checklist. None of these are deal killers and virtually all CEOs have the “wrong” answer on a few of them, but looking at them as a whole can give a decent picture as to what the CEO is like.
What is the annual report or 10-K like?
Most 10-Ks read like they were written by a (very boring) lawyer. I always appreciate 10-Ks that at the very least have a letter from the CEO (assuming the letter includes real content, not a bunch of fluff) or a section called Industry Outlook or Looking Forward or something like that. Basically any section that gives real commentary on the business and its outlook is helpful. I recently read the BrainJuicer annual report and I think it was the most refreshing report I’ve ever read. First, the entire thing is written in plain English. The three executives (CEO, CFO, COO) each write letters that clearly update investors on their part of the company. They give an actual overview of the business, including things that haven’t worked or areas they’re struggling in. My response to this annual report was that this is a company run by real humans that actually want to communicate a business update to me, not just do the bare minimum of what they’re legally required to do.
Do they report GAAP or non-GAAP earnings?
Plenty of companies have genuine reasons to report non-GAAP earnings, but most take advantage of this to report “earnings” that are not anywhere close to what you would count as earnings if you owned the entire business. The most common example of this is adjusted EBITDA that doesn’t include their egregious stock grants or “one-time” restructuring costs that magically appear every year. Another common example is acquisitive companies that leave out all acquisition-related expenses. A company that makes its first bolt-on acquisition in ten years can legitimately exclude those acquisition costs when reporting what their core business earned. On the other hand, if acquiring others is a core part of a company’s strategy, then those expenses are genuine costs of running that business and need to be included (or normalized over many years if you’re analyzing them).
How many non-essential press releases have they put out in the past year? I’m not talking about quarterly earnings announcements or major acquisitions or anything like that. I’m talking about press releases to announce a new customer that’s meaningless to the overall story, some small award they win (Top 10 Homebuilder in Detroit!), etc. The fewer press releases the better in my opinion. A CEO who’s putting out one or more press releases per week is more worried about how Wall Street views his company as opposed to just growing the company and letting Wall Street come to him.
Another example of bucking the Wall Street trend, CEOs who refuse to give guidance are a wonderful, but unfortunately rare, thing. When they do give guidance, the longer term the better (full year vs quarterly guidance). Giving quarterly guidance forces Wall Street to focus on quarterly results and thus the company employees will as well. I like the analogy of a treadmill. Once a company gets on an expectations treadmill there’s no way to get off it and there’s no easy way to manage expectations down.
When they do give guidance, pay attention to how often they meet and miss their guidance. There’s nothing wrong with missing their own guidance (CEOs and entrepreneurs in general are overly optimistic), but do they adjust going forward? If a CEO misses his own quarterly guidance six straight quarters I’m going to start thinking he’s clueless about his business and is unable to adjust his own expectations to reality.
How the CEO talks
I wrote an entire blog post called Shut Up About Creating Shareholder Value. Related to the press release point, overly promotional CEOs drive me nuts. When I talk to a manager (or listen to conference calls) one of the main things I pay attention to is how straightforward they communicate. Are they full of jargon selling an image of this perfect, rosy company whose future is all rainbows and unicorns or do they talk like a normal human being and aren’t afraid to discuss mistakes they’ve made or areas they’re struggling in?
CEO-speak that annoys me, Exhibit A: “Just a most incredible time that we’re having right now. Phenomenal opportunities that we’re so excited about and I must admit, I’m exceptionally proud of my team right now and the accomplishments that we’ve done thus far… Our management advisory team, very incredible. As a matter of fact, we’re holding a very strategic meeting on Monday in which case we have some very influential people that we’ll be meeting with.” I can only assume that CEO went to Trump University.
A CEO who owns a lot of stock is almost always going to care more about the stock price than one who doesn’t. It’s basic incentives. But there are different ways for a CEO to acquire shares. By far the best option (in my opinion) is a founder who’s owned a meaningful chunk (10-30%) from the beginning. Following that are open market purchases (also great) and then shares gifted to them by the company. I definitely look at share ownership via options as worse than the other two, but it’s better than nothing. Often hand in hand with insider ownership is how willing has the CEO been to dilute shareholders? A CEO that rarely dilutes shareholders is another wonderful, but unfortunately rare, thing.
How did they grow the company?
Not applicable to all situations, but I look at a lot of small and micro-caps that are, or were recently, in the growth phase where they were unable to fund their own growth. The number of companies that do private placements below market value and the number of management teams that loan their companies money at extremely high interest rates is depressing. These are not shareholder friendly actions.
Is the CEO also the Chairman? Is the board staggered? Is there a poison pill to stop shareholder activism? Have they invited major shareholders to sit on the board? Has every director been there 20 years or are there fresh faces every few years? How much are directors paid? Do they hire compensation consultants? That last one pisses me off every single time I see it—such a waste of company funds.