The Art of Management

Capital efficiency

In principle at least, the main function of management is the efficient use of capital in everyday decision making. Managers have to satisfy three main beneficiaries of the company, namely the employees, bondholders, and the investors. Company employees benefit by earning a salary, while bondholders gain by receiving interest on their held bonds. However, both these beneficiaries are more concerned with short term gains, whereas investors, who are the residual owners of the company, are more concerned with long term gains. Investors receive benefit from the company by either receiving a cash dividend, and/or capital gains on the price of the stock.

In order to align the long term focus of the investors with the management compensation structure, many US companies introduced a stock-based compensation formula for CEOs. This led to the increase of stock based compensation from less than 1 percent of CEOs’ remuneration in 1970, to over 50 percent by 2000. However, since this also motivated some CEOs to take more risk in the form of debt, it also increased the number of bankruptcies. The fact remains that the 10 largest American bankruptcies in history have all occurred in the last decade: Lehman Brothers, Washington Mutual, WorldCom, General Motors, CIT, Enron, Conseco, MF Global, Chrysler, and Thornburg Mortgage, with an accumulative sum of over $1.5 trillion.

All these bankruptcies have three key similarities: well-compensated CEOs with long tenures, too large of a debt on their respective balance sheets, and accounting policies that allowed them to hide losses. More importantly, it also indicates that the board of directors does not function properly as a body of advocates for the investor at these critical times. Thus, the burden remains on the savvy investor to sift through a company’s financials for elements of capital efficiency, in order to clarify the focus of management even before valuing the company.

One such illustrative example is that of TiVo. TiVo is a US innovative company that produced great products in the digital video recording technology. In 2011 they brought in $238 million in revenue, but spent $130 million in selling, general, and administrative expenses, which is nearly 55 percent of its revenue. Additionally, they spent another $110 million in research and development, which hardly produced any new products. That alone is a poster child example of how management can completely destroy an otherwise good company with great products, by overspending its revenue on staff who do not add value, and research that is unnecessary.

Compare this to Apple Inc., which spends only 7 percent of its revenue on selling, general, and administrative expenses, and in the process has produced the world’s largest company by market capitalization, producing products that most people want. It is also noteworthy to mention that Apple Inc. carries no debt on its balance sheet, as it boasts nearly $26 billion in cash and short term investments.

 

Long term management

It is paramount for any investor or owner of a business to keep tabs on the management’s focus, and how efficient it manages the capital of the company in respect to its employees, debt holders, and investors. Therein lays the crux of the matter in the principal-agent problem, whereby agents, namely management, have an inherent incentive to work for their own benefit rather than for their principals.

Roger Martin, the Dean of Joseph L. Rotman School of Management at the University of Toronto, commented on this in his latest book “Fixing the Game” (Harvard Business Review Press, 2011). Martin criticized the stock-based compensation system of CEOs for shifting the focus from the actual business to the stock market which is merely an expectations game. In practice, CEOs became fixated on answering the expectations of the stock market rather than solving business problems, and aligning their business processes with their customers’ needs.

In essence, the business world should dominate the stock market, rather than vice versa. The management’s proper goal should be the creation of long-term business value, which would supersede long-term shareholder value. It can be further argued that large companies such as Johnson & Johnson, Proctor & Gamble, Google, as well as Apple, have all focused on satisfying the needs of their customers, and thereby brought sustainable solid returns for their shareholders in the process. It is these business goals that need to be identified to hold management responsible for achieving business targets such as sales size, customer base, market share, customer satisfaction, and employee efficiency. This is not seeking utopia, but rather learning from large corporations in order to build sustainable wealth, one company at a time, for the benefit of all stakeholders, be it employees, debt holders, investors, customers, suppliers, community, environment, and others.

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