Management Traits in Potential Multibaggers
Let’s learn about management, and specifically, how we can analyse the types of managers who run companies, and the impact their skill sets and backgrounds can have on driving business growth.
There are two types of manager: Owner Operators and Outsider CEO’s.
Owner Operators - these are the founders or the buyers of a business. They have ‘skin in the game’. They’ve got vision and passion, but they might lack experience. They may lack the financial skill or other important skills if they are new to the game.
Outsider CEO’s - who have been hired to run a company for the owners. They can bring a new perspective and often are skilled capital allocators. However, they do bring in the principal-agent problem, which is that they are not necessarily the owners of the business and thus do not bear the consequences of their decisions. They are simply the agents managing that business and may have other incentives. They may want to grow the business so they can actually get paid more, rather than growing the shareholder value on a per-share basis.
When we analysed the top ten multibaggers of the last decade, we came out with some interesting results.
We found that 50% of the top ten multibaggers were led by founders. Only 33% of IPOs are led by founders while only 7% of all globally listed stocks above a 500 million dollar market cap are run by founders. So, the fact that five of the top ten multi baggers were led by founders either in the CEO role or an executive chairman role is extremely telling. Founders are the keepers of the vision. They often invest heavily in research and development, and they tend to drive growth and outperform more than outsiders.
What about Outsider CEO’s? We actually found that they were most often internally promoted and had up to or more than twenty years in-house tenure. All except for CVS Group’s CEO, Simon Innes, who was hired straight in twenty years before having had some great experience in scaling a similar operation elsewhere. All the others had been internally promoted. So evidently, tenure and in house experience was very valuable in creating sustained share price growth. They maybe have the frontline operational or financial experience, which brings skill in capital allocation.
What is Capital Allocation?
In a business, you're always going to have a source of capital.
In the early days, it may be raised from investors or lenders by issuing shares or borrowing. Once a business is in operation, its source of capital comes, ideally, from its operating cash flow.
A business can also sell a subsidiary if they no longer need it. But most of the time it's going to be operating cash flow that a CEO or the management team will be deploying.
And that means they've got to use the capital.
There are really only five places that capital can be used.
Make an acquisition
Invest in current operations
Pay out dividends
Buy back shares
ay off borrowings.
All of these have different forms of expectation when a manager is investing in them. It takes an excellent manager to allocate that capital to the highest return area at any point in time.
If there are no good acquisitions, a manager should not go and overpay for a company. They may want to invest in their current operations, but if there are no good avenues for growth, no good R&D to do, and no good Capital Expenditures (CapEx) to do, then they may be better paying out that capital to investors as dividends. But if their share price is cheap, an even better route may be for the management to buy back their shares on the open market (a share buyback).
Capital allocation is a skill which the best managers are good at.
One thing we found is that across six of the ten multibaggers, they used consistent acquisitions to grow. So acquisitions were part of the strategy to drive expansion and returns. We, also, found that ‘bolt-on’ operational deals fare better than transformational deals. For example, the London Stock Exchange buying Refinitiv, turning it from a stock exchange business into a data business, carries much more risk than Safestore acquiring Space Maker in 2017, adding 12 stores to the UK operation.
The opposite of an acquisition is a divestiture, spinning off or divesting a business that is non-core to a strategy. This can raise capital and increase corporate focus. Jet2, which used to be called Dart Group sold its refrigeration logistics arm, Fowler Welch, in 2020 to focus on its leisure travel business, Jet2. Since then, it has significantly increased its returns on capital as a result.
If a company is buying back shares, make sure that it stops buying shares when the shares are overvalued. Make sure that a company is making acquisitions for a good earnings enhancing price.
What to look for in good Capital Allocation
Management Candor on Acquisitions
This is where you can look into management communications and look for straightforward language and candor. This is an example from Judge Scientific who in their regulatory news announcement announced an acquisition where they actually stated that the board expects the acquisition to be immediately earnings enhancing.
Earnings enhancing means that they have acquired a company at a lower valuation than the acquiring company is valued at. This form of transparency on the acquisition price of the acquired company is something to look for when reading acquisition announcements.
Above, Judges Scientific acquired CoolLED for an initial cash consideration of 3.5 million with an earn out for the management act at another million, so up to 4.5 million pounds depending on certain criteria. However, the operating profits were £1m which is only 4.5x multiple that the acquiring company was paying. Meanwhile, Judge's Scientific was on a far higher valuation and made the acquisition earnings enhancing. Always look out for those words when a company does acquire. It should be stated that some companies do make acquisitions for strategic purposes, to buy in a new capability into the business, but often companies don't state what the price was.
Honest Communication of Strategy
Another thing to look out for is honest communication of strategy. The best example of this in the market is Games Workshop. They have annual reports that use simple, plain language. It is not glossy. There is no PR fluff or corporate waffle. If a company is doing a presentation online or in an AGM, look for them admitting mistakes, look for clear answers to questions and avoid companies that are extremely inconsistent. Clear communication is so valuable for businesses.
Financial Evidence of Good Management
When assessing the financial management of a company, look for low accruals of earnings. Accruals in the top ten multibaggers were consistently negative, meaning that free cashflow was consistently higher than reported earnings. Conservative accounting is a positive sign of financial management. You do not want to see evidence of businesses cooking the books and inflating their earnings.
All the companies we have looked at paid dividends at the start of the journey to multibagging - a commitment to returning surplus cash to shareholders. Also, doing share buybacks can be evidence of good capital discipline - as long as the price is favourable. If companies are committed to their shareholders, that can be an excellent sign.
Potential multi baggers should have management with an owner's mindset. The benefits of long tenure and founder ownership stakes cannot be underestimated. Rational capital allocation in continuing operations, bolt-on acquisitions and dividend payouts are all things to look for. Finally, you want to see candid, straightforward communication about strategy details and issues.
In our final bonus article, we are going to look at the potential traps that lead to the end a multibagger’s journey!