BI > JULY 1999

Hints on Recognizing Memorable Management

NAIC Principles -- A Focus on Management Characteristics

A Learn and Earn Feature Compiled from the works of George A. Nicholson, Jr. CFA

As Mr. Nicholson commented in 1987, the Guide helps investors to resolve doubts about stock prices. Over the years, when stock prices were high, investors neglected it. When prices were low, they turned to it religiously. As prices fluctuate higher, a few will "cheat" on their "expected low prices" and select them too high. This is a sign that investors are turning into speculators. Danger may lie ahead for backsliders.

He often suggested that the special difference that the Guide makes for NAIC investors is the prompted judgment with respect to management. Join us as we explore some of his thoughts and reasons for discovering both the potential for growth and outstanding management.

All About People

Lest we ever forget, investing is quite simply, all about the people.

As NAIC investors, we're constantly reminded that people are at the very center of commerce and enterprise. This is true whether we consider the consumption of goods and services or if we're engaged in the analysis of a producer. Innovation and capable delivery is essential to the long-term health of any enterprise. Investing is less about ticker tape numbers than it is about understanding the core capabilities and expectations of a company and the people that build and maintain it.

Our Stock Selection Guide (SSG) guides us through a natural inquiry into the characteristics of a business. In his column, "Looking Five Years Ahead with NAIC's Stock Selection Guide," George Nicholson reminded us that investors can, indeed, look five years ahead. The record of the Better Investing cover stocks since 1951 to the present indicates that you can.

The SSG guides our study through five sections. Sections 1 and 2 apply equally to companies owned by a family, such as small privately-held businesses, and those owned by public shareholders. Attitudes on worth differ, unfortunately because of the significance of stock market fluctuations that scare shareholders. Section 3 examines the relationship between stock price and earnings and it takes a longer-term view to do so than most conventional analysis. Section 4 examines RISKS and REWARDS probable over the next five years, and Section 5 develops an expected compound total return, based on the assumptions and judgments that you make.

As our SSG analysis proceeds for a company, certain questions are brought to the fore. For those with the fortitude and stamina, curiosity takes us into new areas. Curiosity is the mark of good investing. With patience and commitment, and a little practice, one of the gifts that NAIC practitioners experience is that SSGs become easier to complete, and the discoveries easier to identify.

For purposes of this discussion, we'll concentrate on the growth and management sections of the SSG. George Nicholson firmly believed that it was essential that these core elements be present before he'd go further with his studies. As a student of economic cycles, and the opportunities that downturns presented, he suggested that, "NAIC investors do well to remember that strong growth companies tend to gain market share in depressions or recessions as competitors contract their businesses." Growth and strength of management should always be a key strategy in the selection of investments.

A Better Mousetrap?

NAIC analysis of stocks differs from the text book approach. Instead of industry analysis, company product studies and comparison of stock values, we first evaluate the driving force and competence of management. Next we look at the price of the stock and its risk and reward prospects over the next five years, and then we apply to stocks "with promise" the traditional considerations of industry and product potentials, business cycle, stock price trends, quality, capitalization and finance criteria, etc. Our approach has much to recommend it because in five years there is likely to be both good and bad business. Only the well managed businesses will be stronger at the end of the period.

It's important to note that Nicholson didn't suggest that we ignore industry trends or new product development. He merely emphasized that it's important to start with the management evaluation first.

Nicholson's World -- 1974

In August 1974, 25 years ago, George Nicholson shared his hints on discovering and becoming familiar with the management of the companies that he considered for investment. Here's what he wrote. (My comments are in italics.)

1. Inflation will separate the sheep from the goats.

Well-managed companies capture business from those that fail to retain it. Sales volume should increase due to both inflation and the inroads that they make via market share.

2. Investors need not be cowed, [or made complacent,] by computers.

One benefit of the 1973-74 stock market decline is that investors learned the painful lesson that "computers can figure but they can't figure out."

3. Wall Street institutions have messed up the stock market again.

The late 1920s and 1960s were similar in the sense that institutions used investment criteria less and speculated more, to the detriment of us all.

4. Main Street, with good American common sense, is starting to reassert itself.

The timely questions that I receive (describing a return to an emphasis on understanding enterprise and management) suggest to me, that the pendulum is swinging back to investment and away from speculation.

Investigating management is fashionable again, and the trend will gain momentum. . . paying off in years ahead.

By living with companies through ups and downs, going to shareholder meetings, talking with people who work in various capacities, and learning company history -- it is possible to investigate management thoroughly.

Start with an understanding of the drivers behind pre-tax profits (SSG Section 2A) and return on equity (SSG Section 2B).

What to look for?

1. A management team that has been tested by competition in good times and bad.

How was the business started? Who founded the business? (Who's running it now? For how much longer?)

I check for large changes in the historical income statements, and search for explanations.

2. A management that expands [at an acceptable sales growth rate] taking company size as a consideration.

On sales, I always note changes in management. I draw arrows on my Stock Selection Guide to denote any such changes.

3. Pay special attention to companies that seem, by your judgment, to be capable of being stronger five years from now -- NOT the world-beater over the next six months.

4. Beware management that rides an industry wave or a product cycle which obscures the ability of management to meet competition. An "industry" is a [characteristic] of a business, not a driving force.

Preparation and Method

How do I conduct my company studies?

1. I read S&P, Value Line, and the company's 10-K.

2. I complete a Stock Selection Guide.

3. I work out SSG Section 2A and 2B, paying special attention to pre-tax margins. I form expectations for future profit margins and use this to better understand what management is doing or not doing. Where and why were any big changes made?

On pre-tax margins and ROE, I try to get explanations of changes. Some will relate to management, others to competition, the business cycle and a host of others that are bound to arise. (The important aspect is that time is spent considering the influences.)

4. My last step is to review the questions in the Stock Selection Guide and Report, to make sure that I spend time with all considerations. I want to think about the company's competitors and how they compare with others in their industry group.

I pay some attention to the "dreams" of sales managers -- and to important products knowing few will really affect profits.

I give more weight to a relatively new president that has clearly taken hold of the challenges in a "firm manner."

(Insights should be sought as to their thoughts and strategies in the Management Discussion & Analysis portion of the company's 10-K filing and annual report.) Be HIGHLY skeptical of management reports that downplay challenges or suggest under-estimation of competition.)

Evaluation of Management

Just how close did George Nicholson examine management? In his column, "Big Entrepreneurials Versus Conglomerates," from August, 1985, he suggested that investors were returning to the stock market. In his view, the prodigal event promised rewards due to two prevailing factors: an emerging worldwide stock market, and a new formula of corporate management involving entrepreneurialism.

For what seemed an eternity, American companies had been investing abroad and embracing the notion that creating conglomerates solved all problems and mysteries. A boom period in the stock market (late 1960s and early 1970s) had been followed by years of disillusionment. Considerable damage was effected upon the psychology of many investors, inhibiting their participation for many years.

Nicholson's vision, which has proven out on a massive scale, was that "a new boom is emerging. Corporations thought 'too big' to grow will be transformed into growth stocks again." Conventional thinking was that investors should identify "good industries and buy the best companies in them." George disagreed. The application of NAIC principles should, over time, lead to selection of companies that will be stronger and better five years from now because of management. He referred to himself as a "biological aspects of management analyst."

In this column, he specifically explored the outlook for W.R. Grace, Dana Corporation and Masco. His analysis included personal studies of Peter Grace of W.R. Grace & Co., Rene McPherson of Dana, and Richard Manoogian of Masco. Nicholson suggested that all three leaders pioneered the entrepreneurial strategy for the bigger corporation. He studied what they said. He studied what they wrote. He studied what they did. All three were different, executed different strategies and all delivered excellence and shareholder value.

Practicing What He Preached

One of Mr. Nicholson's more entertaining contributions was the annual column that he referred to as "Bargain Hunting." This feature appeared regularly in December or January, and it was his premise that year-end tax selling couldn't help but generate opportunities for long-term investors.

I decided to take a closer look at his attitude and thoughts following the October, 1987 correction. Looking back today, the drop on the price charts seems so much less ominous, hardly noticeable. This may be true, but as Ken Janke cautions, the plummet was quite real and extremely noticeable. Corrections are inevitable, and it's always our challenge to continue to invest in leadership growth companies in the wake of such turbulence.

What was on George's mind at the time?

"The remaining years of the 20th century -- logically and without euphoria over small signs -- should establish new investment records based on growing global businesses. Business should be steadier because in my view growth and risk-reward ratios are improving as the year 2000 approaches and are better than they have been for the previous 87 years."

George proceeded to recommend that NAIC investors conduct personal stock studies of the following companies: Dayton Hudson, Kmart, Mead Corporation, Exxon, W.H. Grace & Co., AFLAC, Dana Corporation, NBD (now Bank One), Colgate-Palmolive, Citicorp and RPM.

In Search of Legendary Management

George Nicholson advised, "I suspect that it was easier to find value and promise in 1932, (and 1999 presents its own new challenges) but concentrating on management will yield the same solid results as it did when the NAIC was taking shape in the 1940s and 1950s. The decision to investigate management instead of fleeting product and industry trends is part of the foundation of NAIC principles."

NAIC investors have discovered fortuitous rewards, using our Stock Selection Guide methods, over decades. "The more we practice, the luckier we get." -- Certain apologies to Bart Starr.

Thanks for the memories, George Nicholson. You were simply the best.