Lessons: Over-reliance on Management

The last couple of years have been very hard on those that invest in South African small cap stocks. Unfortunately, me, the Alpha Prime Small & Mid Cap Fund and my (incredibly resilient) investors have been no exception to this.

Since the FTSE/JSE Small Cap Index’s high in 2017, the index has dropped by a third (-30%!) to the current intra-day spot price on the date of my writing this. From a valuation perspective, this index’s relative valuation peaked in around 2014 and it has been steadily de-rating since then (only hidden by profit growth for the first couple years that eventually dissipated and saw actual price downside thereafter) to such a point that it is the cheapest equity index in the world right now (Cheapest Equity Index in the World).

This drop is even more brutal when considered against the Top 40’s more resilient performance and the roaring double-digit annual gains across most global, developed markets!

Normally, when taking carefully considered, multi-year risk, you should be rewarded for it, but across the last three to five years in our domestic small cap market, the opposite has been true.

That is the context, but I am not going to blame “the market”. Rather, I am starting a series of long-form essays to try and explore and–more importantly–learn from the investing mistakes that I may have made over the last couple of years. While most professionals will not admit to this, we are all always just students in the market and we need to constantly be learning and improving.

Hopefully, this series will be of value to you too.

Over-reliance on Management: Explanations versus Facts

Typically, professionals in the market have good access to management of listed companies. This allows them to not just pose questions and glean a better understanding of both the business(es) and the current environment, but also to get a sense of management themselves, their competence, drive and direction.

Sometimes this can be an invaluable edge, but other times this can actually distort judgement via persuasion and personality bias. After all, management often has an incentive to put their and their company’s best foot forward and typically will have an overly-optimistic view of the quality of their business, their own brilliance at managing it and the valuation their stock should demand in the market.

Do not forget: much like pessimism, optimism is also a cognitive bias. Investors should strive to be neither, aiming rather for realism as a true, thorough and honest view of the world.

South Africa’s market has been rocked by a number of (let’s be honest) management-led scandals. From Steinhoff (SNH) to Tongaat Hulett (TON), these management teams were either clueless or actively deceptive in their communications with the market.

Perhaps as a reaction to this, a growing number of investors I regularly speak to tell me that they are stopping talking to management at all. Full stop. This will completely remove the risk that management lies to their faces, but it will not remove the risk that management has lied via their accounting and reporting… Likewise, it will leave blank spots in their understanding of businesses that may translate in incorrectly weighting valuations and judgement of risks and prospects.

I propose that a better approach is to openly and readily engage with management. Ask them all and every question on your mind and let them fill in any blanks or drive any narrative that they want.

But–and this is the key–do not simply believe it. Look for direct and third-party evidence that any assertions made by management are correct and likely honest. Work through the Group’s financial results and see if the numbers agree with management narrative. Look at customer reviews, track down suppliers and even speak to competitors to get a sense of what may be going on. If the business is a retail-facing one, then pop your head in and see if the shops, hotels, restaurants, banks, etc are full and/or busy. Even talk to the secretaries and ask them if this is true of most days or not. This is amongst a range of other sources of information.

As an example, I have done a fair bit of verification on Santova Logistics (SNV). I have spoken to a large range other logistics players, even unlisted direct competitors and it has always been very reassuring that even the direct competitors consider Santova a good business in their space. Likewise, in these self-same conversations and each time I am on a logistics or fleet site visit, I always ask about the fleet tracking provider they use and why? The telematics providers may differ between fleets, but the answers are consistent: the telematics companies and their products are all the same. Price is all that matters. This is in direct contrast to each telematics management team you meet who have long and complex reasons for why their product is the best…

Another example I could use is Ascendis Health (ASC). Despite a glowing narrative from the management years ago, a deep and thorough unpacking of their financials painted a very bleak picture. As usual, the facts outlasted the narrative and Ascendis Health is currently basically a zombie stock.

Finally, where management explanations and narrative diverge from the evidence and facts, trust the evidence and facts more.

There is a Russian proverb that says it best and translates as, “Trust but verify.

Over-reliance on Management: Promises versus Execution

Another challenge that comes with close encounters with management is that sometimes–despite their best efforts–they still fail. This is the gap between promises and execution, and this gap can be very wide indeed.

Business is difficult and sometimes things go wrong. Sometimes these things that go wrong are external in nature (natural disasters, industry/country/legislative changes, fires, unionized labour unrest, etc.), but sometimes they are internal in nature and could have been avoided by better management execution.

While a really good (and lucky) management team may actually see external problems before they happen and build solutions to handle them in advance, most likely this will not be the case. In fact, these external risks are really in the realm of the investor to see, call and position themselves for or against.

For example, is it really a PGM mining management team’s fault if all cars went electronic tomorrow and the PGM basket basically became worthless? No. Their job is mine PGM’s as cheaply and risklessly as possible. It is really the investor’s job to decide whether they invest in a PGM miner or not.

Therefore, I tend to be a bit lenient on management regarding external problems. I may be harsh on myself for these, but that is another story…

That said, internal problems are something else: avoidable by management.

I, as an investor, cannot ensure acquisitions are cleverly made, well-integrated and the businesses are properly managed, amongst countless other internal matters that are predominantly related to either day-to-day operations or high-level capital allocation. These things are very, very firmly in the realm of management.

Firstly, I really try to find businesses that do not overly-rely on management execution to work. In reality, every business relies on their management, but not always to the same degree. Consider, for example, ADvTech (ADH) that has a profitable, thriving educational group with good cash flows, good profits and pretty full schools and campuses, while Stadio (SDO) has a long list of promises and plans that management are executing on.

While ADvTech’s management have (some) room for error (although I would still hope they execute well!), if Stadio’s management fail in their execution, their shareholders will hardly have a business worth mentioning. Second-hand promises tend not to retail for much.

Secondly, when management fail, I try to do two things:

  1. Understand why they failed,
  2. Judge if they have learned from or adapted to it.

Thus, if (1) and (2) are not positive, I would consider the quality of the investment degraded and consider exiting. While success may breed success, failure tends to do the same. If the same execution has fallen short and management are not at least honest about how they messed up, then how are they going to fix it? And, even if they are honest about the mess up, if they just keep doing the same thing then surely they should get the same result as before?

Conclusion: Trust but Verify, Listen but Watch Closely

At the heart of small cap investing is backing a great management team in a great business at a great valuation and ages before anyone else realizes this. Herein lie the majority of double-digit-multi-baggers.

But, despite temptation and persuasion, management cannot be taken at face value. Be sceptical when management narrative and facts diverge. Be careful when management promises do not materialize. And, finally, do your own research and form your own opinion, whether or not it agrees with management.

After all, they are only human.

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