“A man got to have a code.” – Omar Little, The Wire
Many quality-focused investors say that integrity is a characteristic they seek in management teams. In the Venn diagram below that summarizes our investment approach, you can see that integrity is one of our key management considerations.
Evaluating integrity seems prudent, of course – don’t knowingly invest with crooks is self-evident. But what do we mean by “integrity,” and how do we integrate it into our investing process?
Merriam-Webster defines integrity as “Firm adherence to a code of especially moral or artistic values.”
People who consistently live by a strict code have integrity. However, depending on their values, it may not be the type of integrity you desire.
We must first define, then, which values we seek. Only then can we determine the extent to which management exhibits integrity toward those values.
First and foremost, we cannot reasonably and consistently assess the personal morals of dozens of CEOs of large global corporations. Even if we could, we wonder if it would help us to identify alpha-generating opportunities.
To be certain, if we took a majority stake in a business and relied on managers to run our day-to-day affairs, it would be incumbent upon us to know them on a more personal level. As public market investors, however, we can more easily vote with our feet if we are worried about a manager’s integrity.
What we want management to do is increase the per share value of their companies in a sustainable manner. The following values are best suited to meet those ends: authenticity, transparency, and stewardship.
We want to avoid managers who are “all hat and no cattle” or talk one game and play another. Instead, we look for managers who make and keep their promises and live the company’s mission.
Vanguard founder John C. (Jack) Bogle famously flew coach and stayed in economy hotels while traveling for business. Bogle’s thriftiness aligned with Vanguard’s low-cost mission. His example emanated across the firm’s culture, pushing costs lower still and adding to the firm’s competitive advantage.
In our own portfolio, we believe Masimo founder, chairman and CEO Joe Kiani is authentic in his mission to improve patient outcomes and reduce cost of care. There’s a current debate in the investing community about how the Sound United acquisition will play out. Still, even the harshest critics would be hard-pressed to conclude that Kiani wasn’t passionate about solving critical problems in the healthcare industry from an innovative, first-principles basis.
Management teams that view shareholders as partners will provide regular and valuable business-level metrics to help them evaluate the company’s progress.
For more than two decades, Costco has published in its annual report the table shown below, which illustrates how cohorts of warehouses opened each year perform over time. This transparency empowers Costco shareholders with useful unit-level data with which they can hold management accountable.
Source: Costco 1997 Annual Report
In our collective experience, we have found it’s far more common for companies to archive non-current investor communications such as investor presentations and glossy annual reports that are not mandatory SEC filings. Companies are also prone to obscuring segment or geographic performance by merging or restructuring historical reporting classifications. Such moves can indeed be innocuous, but it does make it harder for investors to hold management accountable. All else equal, we prefer management teams that provide information consistently across time.
Legendary investor Philip Fisher advised in his classic book Common Stocks and Uncommon Profits, that to protect yourself against management teams of questionable integrity, an investor should:
“Confine investments to companies the managements of which have a highly developed sense of trusteeship and moral responsibility to the stockholders.”
We would replace “stockholders” with “stakeholders,” but firmly agree with Fisher that you want leaders who view themselves as stewards or trustees of the business. To paraphrase John F. Kennedy, they ask not what the company can do for them, but what they can do for the company. Ideally, they’re looking beyond their tenure when making capital allocation decisions.
Ferrari, for example, could generate far more current profit than it does if the CEO decided to double production over the next two years. Instead, they forgo those near-term profits to ensure the brand maintains its luxury status for decades.
Why bother with integrity?
In summary, company management has integrity when they consistently act as stewards of our capital and are authentic and transparent. When those factors are combined with an exceptional business, good things tend to happen.
Even with an evaluation process for integrity, we will at times be challenged to reconsider our assumptions. Well-intentioned management teams make mistakes that can call their integrity or judgement into question.
When those situations occur, we must determine whether we still consider management to be of high integrity that made a poor decision or if our view of their integrity has changed. We can be forgiving about the former, not about the latter.
The ideal setup for one of our investments is to have all three pillars that we insist upon – moat, management, and forecastability –working together to increase the company’s value. A business with a strong moat may be able to carry a low-integrity management team for a while, but this ultimately creates an off-balance sheet liability, and it’s only a matter of time before that risk manifests itself.
As such, it’s essential to have an opinion about management integrity as we make investment decisions because when adverse events occur – and they do – we need to be prepared to make a judgment call to determine if we remain shareholders.