Quite recently, activist investors wrote an open letter to shareholders of a company I own in my portfolio. Activist investors traditionally buy shares in the hope of stirring up change and cashing in on an improved valuation. Nelson Peltz is a high-profile example. You may have read about his recent battles with management at Disney (NYS:DIS) and Unilever (XLON:ULVR). Carl Icahn, the classic “corporate raider”, is another.

Activist letters rarely sing management’s praises. In fact, they can be downright scathing. Another famous activist, Dan Loeb, once called the CEO of Star Gas “one of the most dangerous and incompetent executives in America”. Loeb even expressed sympathy for those awarded the business school scholarship in his name. Nice.

This situation was a bit different. The investor had intended to be a passive investor but has “gone activist” due to poor share price performance. Their letter was also a lot more reserved, but it highlighted issues I should have been aware of before investing. By not paying these issues enough mind, I ignored one of Warren Buffett’s main criteria for buying a business – and I don’t think I’m alone.

Buffett’s business buying criteria

I recently bought the Kindle version of Buffett’s annual letters. For the price of some beef jerky, I now have every letter he's written to Berkshire Hathaway (NYS:BRK.A) shareholders since 1965. After reading a few letters from the 1990s, I quickly realised two things:

  1. Buffett’s basic approach to buying companies hasn’t changed for years.
  2. The Buffett you see in his most famous soundbites is not the Buffett you see in his longer form writing. Or, for that matter, in his track record.

Take this classic Buffettism, for example:

“Buy a business so good an idiot could run it, because one day an idiot will.”

If you take this quote in isolation, it puts all the emphasis on business quality. By doing so, it minimises a huge part of Buffett’s investment approach – the purchase of good businesses ran by honest and able management. One is rarely mentioned without the other.

In fact, it appears that Buffett was often more willing to sacrifice on business quality. For example, Berkshire added significantly to their empire of furniture and jewelry stores in the nineties. I don’t think an idiot could run a retailer. Neither did Buffett. In his 1994 letter, he said that “buying a retailer without good management is like buying the Eiffel Tower without a lift”.

As shareholders, we rely on management to realise the potential of companies we invest in. If we ignore their role in doing that, we can end up wondering why an investment that ticked every other box – like quality and value – failed to perform. So, how might we assess if they are the right people to invest in?

5 questions to ask about management

Do they have suitable experience?

This chimes with the “able” part of Buffett’s two criteria for management teams. Do key management figures like the CEO and board of directors have a strong track record in the business or in a closely related one? If you have bought into a company that faces short-term headwinds, have the management team solved these kinds of issues before?

A positive example here was Patrick Doyle’s appointment as Executive Chairman of Restaurant Brands International (NYS:QSR). You probably know them as the owner of brands like Tim Hortons and Burger King – sorry, Hungry Jacks. Doyle famously oversaw huge improvements and excellent share price performance at Dominos (ASX:DPM). As a result, investors were confident he could do the same at RBI.

When it comes to judging management who have been at the company a while, the past record is your friend. What have they promised to achieve in the past, and did they deliver?

Is their compensation reasonable?

You can find details of management’s compensation in the Proxy Statement filed before the firm’s Annual General Meeting. Your job, which I ignored but won’t again, is to ask whether the size and structure of that compensation seems reasonable.

For the base pay, trust your gut. Is it suitable for managing a company of its size? For bonuses, you want to see that the criteria have been crafted with shareholders in mind. Do they relate to ambitious (yet achievable) goals that benefit shareholders? Or are they easy hurdles designed purely to make management rich. Also take a look at how financial goals are worded in these documents. If the wording is fluffy or has the word “adjusted” attached to every metric, be careful.

Compensation was one of the main reasons the company I invested in came under fire.

I won’t reveal the name but it is a land asset that is taking a long time to be developed. The company has earned around USD 25 million in net income since 2021. That isn't a perfect measure of the value being created but the CEO has taken home around USD 7.5 million in total compensation over the same period. That seems like a huge percentage of the company’s earning power. It gets worse when you look at the bonus milestones. To me, a lot of them look more like day-to-day duties instead of meanginful goals.

Are their incentives aligned with your goals?

As a shareholder your goals from an investment might include healthy long-term business growth, a growing dividend and long-term share price appreciation. Unfortunately, the terms of an executive's compensation agreement can incentivise them to seek outcomes that don’t align with your goals at all.

Imagine that management's contract included special bonuses in the case of a takeover, regardless of price. Would they really be prepared to reject a stink bid on behalf of shareholders? As Charlie Munger said: “show me the incentives and I’ll show you the outcome.”

Finding management teams that are incentivised to share your goals is not enough. You want them to share your goals and face similar downside risk to you. Stellar returns aside, this is a big reason that Berkshire Hathaway shareholders have trusted Warren Buffett implicitly. He didn’t have a nil-cost options plan. He bought and owns the same shares they do – downside and all.

Are management taking the biscuit?

Looking at a company’s Related Party Transactions can help you sniff out managers that put their own interests over those of shareholders. Has the company made any loans to management or people close to them? Or maybe they’ve awarded a contract to a member of the family. Treat any transactions like this with caution.

My friend and former colleague Stephen Clapham refers to this as management using shareholder money as their own piggy bank, which is the opposite of what we want.

Would you trust them in real life?

It's also probably a good idea to watch or listen to a few earnings calls and interviews with management. Do they come across as genuine, intelligent and trustworthy?

I think most people have a good nose for these things. Be careful, though. People who have worked their way up to these positions are likely to be more charming than most. If you can, it’s a good idea to compare what they’ve said in the past to what they delivered later.

Addressing my blindspot

My experience with a potentially greedy management team came without the fall in share price that accompanies many investing lessons. But I’m annoyed I didn’t spot these problems before the activist investor called them out. Even worse, I didn't look for them.

I was clearly so focused on the apparent discount to asset value that I failed to ask important questions elsewhere. By doing so, I invested in what was probably a classic value trap. Hopefully asking these five questions will help you avoid a similar error.