We believe management quality is the most important single factor to get right when investing in a smaller company for the long term. There are a number of key reasons for this:

• Management make the strategic decisions which will determine a company’s long term growth prospects or lack thereof;
• Management set the tone for a company’s culture – all employees are guided by management thinking and behaviour;
• Employee turnover will be directly impacted by the quality of management – as the saying goes; people don’t leave companies, they leave bosses.
• Management are the face of the company in financial markets and investors will ascribe a higher value to high quality management teams and vice versa;
• Ethical management teams provide effective risk mitigation against a multitude of risks including fraudulent behaviour, misrepresentation, insider trading, etc.

The list could go on. Suffice to say, picking the right management teams to invest in is an important part of our investment process. Now onto the factors we look for in high quality management teams…

In our experience, it is best if management can explain their strategy to investors simply and clearly, and without the use of too many words. This elevator pitch concept is a great way of filtering out complex business models as our best performing stocks have almost always been simple and easy to understand businesses. We believe the simpler the business model to understand, the less moving parts in general, and thus the less unforeseen risks lurking in the background.

Stock example: Joyce Corp (ASX:JYC) management are great example of a clear communicating management team. Whenever we meet management or read through the company’s investor presentations we are 100% clear on where the business is going longer term.

We like to invest with management teams who have worked their way through the ranks of an organisation over an extended period of time. These types of managers tend to understand the business better than newcomers who go straight into a top level executive role. And importantly, long term managers will have seen the business through different economic cycles, and thus tend to understand what needs to be done to manage sustainable long term growth.

Stock example: Pioneer Credit’s (ASX:PNC) CEO and founder, Keith John, has been working in the business since the company’s beginnings and in our opinion knows everything there is to know about his business.

We are looking for management teams who will put their shareholders first which tends to reflect itself in:

• Paying dividends when it is in shareholders’ best interests.
• Returning capital when it is in shareholders’ best interests.
• Regularly consulting with shareholders for honest feedback.
• Factoring shareholder feedback and interests into strategic thinking.

This one seems obvious but it is relatively unusual in our experience. We like to come out of management meetings inspired by management’s energy in the room, and with the feeling that management are having fun in their job. This can only really be gauged through face to face management meetings.

Stock example: (We will need to keep this stock’s name confidential so as not to cause offence.) We recently had a meeting with a management team who were clearly down in the dumps about their business prospects. And importantly, their energy had turned negative after a difficult year whilst their thinking had become defensive. We left the meeting exhausted by the negative energy from the meeting. This is clearly the opposite of what we look for.

The natural state of affairs in capitalism is for prices to fall. These falls in prices drive companies to create new products and to do existing things better to maintain returns on capital. Falling prices are good for consumers since their incomes go further. The drive to create new products is beneficial for all because the capital expenditure and R&D, to create new products and services, drives employment and productivity. Real, or inflation adjusted, growth in productivity is strongly associated with dividend growth from equities. Investors receive dividends and should like them to grow in real terms. In summary the whole thing hangs together and while it has occasional problems it has created significant advances for everyone. To mis-quote Winston Churchill, “Capitalism is the worst possible system for an economy, apart from all the others”.

At the moment though there is a desire, by central banks, to create inflation as though this is going to suddenly produce stronger, more equitable and sustainable, growth, more wage increases and generally lead to a much improved future. The argument is that higher nominal growth facilitated by this inflation, will allow us to reduce the burden of the debt relative to the size of the economy.

The truth however is that if inflation returns, and there are clear signs that inflation expectations have returned in asset prices in some countries, then we are actually in for a rough time. It is arrogant to assume that exactly the right amount and the right sort of inflation can be achieved through constant tinkering.

Let’s try and bring some myths about inflation down to earth first.

In short, deflation in goods and service prices is not a problem, but asset price deflation is very dangerous and asset bubbles need to be avoided. Guess what endless rounds of QE have done? Yup that’s right – created a variety of asset bubbles which are now dangerous to prick. You couldn’t have got a worse response to the GFC than a decade of zero interest rates and central bank interference in capital market prices! Well done lads, you have brought about the very condition which under no circumstances should you allow to occur. Not only have you allowed it to occur but you were cheerleaders for it. Enjoy academia and the lecture circuit while we pick up the pieces from the results of your unelected experimentation.

We actually think that Amazon is a great business but that its success lies less in its skill and strategy and more in its tax planning and the inadequacies of the current corporation tax system. Amazon pays a fraction of the corporation tax that its competitors pay and consequently has more retained and free cashflow available to reinvest back into a price reduction and volume strategy. Its tax policies are common practice and there are many versions, but it is currently legal and produces remarkably low rates of tax relative to headline rates and to what their competitors pay.

It is the absence of a level and fair playing field that concerns us. Once the high street retailers decide they can’t compete and close, then local municipalities lose their revenues from the tax base and the multiplier effect means other business on the high street suffer too, such as cafes and restaurants. Amazon is the Death Star in retailing propelled by clever tax planning and the tacit support of bureaucrats who need to wake up and be braver in changing and uniformly applying policy.

Until this anomaly in taxation is removed there will be no level playing field and the creative destruction of capitalism will be mostly destruction because of the inability of competing firms to fight back while hampered by unequal taxation and less retained cashflow. A global arbitrage whereby larger companies can pay minimal tax hampers smaller companies which cannot do this and the importance of smaller companies in providing employment is well documented. We are on the way to a monopoly in certain areas of economic activity because our civil servants haven’t woken up to the need to bring accounting and policy into the internet era; if they are awake they aren’t brave enough and they are not performing their part of the bargain in what is known as the Social Contract. This will also be referred to later under Thomas Hobbes.

We would actually prefer all companies paid less tax but if you do want to raise tax from corporate activity, at least make it roughly equal and then companies compete on innovation, service, value for money, and execution of strategy? That is capitalism but what we have right now is biased.

We find it bemusing that Australian investors can be so keen on Socially Responsible Investing Principles (SRI) and see no problem with divesting from coal mines, that provide employment, on the basis that is anti-social, yet remain invested in companies that are frankly anti-social in their active and complex planning to avoid paying what everyone else does. This non-payment of course places a burden on either others to pay more or services to be cut. Does no one else find the Google BHAG “Do no evil” ironic?
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Governments love bribing you with your own money and so like raising lots of it. We suspect that governments desperate for revenue, will be looking at non payment of tax in quite a lot of detail. We would prefer they went after companies rather than individuals because we as individuals already pay quite a lot, but that requires bravery. This is a serious risk to Amazon and other companies, and let’s hope our bureaucrats and politicians wake up to the internet era, and to their role in the Social Contract.

The point about the Social Contract is that it is a deal whereby citizens believe that their elected (and unelected) legislators will be looking out for them. No one likes to feel they are stranded at the bottom and especially not that their children will not be better off than they. If this social contract continues inviolate then the system of capitalism will carry on with the occasional hiccup as it has for a few hundred years. If this contact is broken and the bureaucrats stuff up with very poor policy and/or become beholden to the corporations, then we are in for a problem. We fear this contract is at risk and this is the source of the political changes (or ‘populism’ if you are a ‘liberal’ and want to sneer). We believe folks have been quite patient but have finally snapped and that we could see either a return to sensible policies or something more dangerous. We currently look at the capital markets, wealth inequality; economic and social policy and give the bureaucrats and politicians a ‘Fail’ grade. We wish them to stop trying to set asset prices. We wish them to bring corporate regulation and policy up to date so we have a level playing field. We wish them to reduce social engineering and create equal opportunity but not equal outcomes. Once they have done that – we wish they would then make themselves invisible. As Ronald Reagan said “Government isn’t the solution, it’s the problem”

And that is how we managed to mix our views on myths about deflation, Amazon and Socially Responsible Investing, and some folks that died a few hundred years ago.