Evaluating Management Strategies

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Good and Bad Management Strategies
Why reinvent the wheel?

Overview:

One key element in determining a good long-term investment is the ability for management to make good strategic decisions.

Evaluating Management:

• Assess the companies Economic Margin.
• Evaluate the ability for a company to sustain historical levels of Economic Margin performance.
• Build out future cash flows to better evaluate expected future performance relative to their peer group.
• Look at investment prospects of firms and review how they are growing or shrinking their business.

Economic Margin:

Economic Margin (EM) EM = (Cash Flow - Capital Charge)/ Productive Capital. In simple terms, EM seeks to measure the ability for a company to make money in excess of a risk-adjusted cost of capital. A positive EM means a firm is earning a profit above their cost of capital while a negative EM indicates a firm is earning less than their cost of capital.

Why Economic Margin:

• Economic Margin is designed to correct accounting distortions and properly measure the true profitability a firm is earning.
• AFG’s Economic Margin methodology shows us that earnings are important but are not sufficient to properly measure a company’s operations.
• Economic Margins helps to analyze how well management teams run their business.

AFG Facts:

• AFG’s understanding of corporate performance and valuation has led it to grow its client base to over 200 institutional investment, consulting, and corporate firms around the globe, which directly manage over $300 billion U.S. equities.
• AFG’s methodology is applied to over 4,500 companies and has consistently helped professional money managers make better buy/hold/sell decisions and corporations to better understand how to improve their business operations.

Management Strategies, The Good and the Bad:

Review and Conclusions:

• Many large companies find limited growth opportunities. MSFT has managed to grow their invested capital by 12.7% in their last fiscal year (ended June 30, 2008).
• Microsoft has managed to increase EMs since 2004 while amazingly improving them 70% in a short 4 year period.
• Less then 1% of firms are able to maintain EMs above 10% a year for 10 consecutive years. Microsoft is one of those firms.
• As seen on the chart below, MSFT has continued to grow their invested capital base while increasing their Economic Margin.
  
   

Review and Conclusions:

• Colgate (CL) has consistently maintained very high EMs.
• In the past, one of the major questions for CL is whether or not they could grow their profitable business. In fact, CL had underperformed the market from 1997-2006 (in part because their lack of growth opportunities).
• Over the last three years CL has grown their asset base by 3.5% in 2006, 5.2% in 2007, and 5.5% in the current year while maintaining a very high EM.
• As seen on the chart below, CL has continued to grow their invested capital base while increasing their Economic Margin.

• Since 1999 Rite Aid (RAD) has earned (on average) a negative Economic Margin, which means the firm has been unable to meet or exceed their cost of capital.
• RAD grew their asset base by 47% last year with forecasted negative Economic Margins. Growing an unprofitable business is wealth destroying.
• RAD has grown their business 3 of the last 5 years while not earning a spread above their cost of capital. A clear wealth-destroying strategy.
• RAD should refocus their attention on the products that make their stores profitable while closing stores that have contributed to their history of negative EMs
• As seen on the chart below, RAD has continued to grow their invested capital base while earning a negative Economic Margin.

• CREE has went through the cycle of the Tech bubble and recovered, now they are deploying capital at a time when they should be concentrating on their profitably.
• The last two years the firm has grown their asset base by greater than 10% while earning negative economic margins.
• As seen on the chart below, CREE has continued to grow their invested capital while earning a negative Economic Margin.

Appendix:  Quality Management Strategies

TICKER: FLS

TICKER: ACN

TICKER: FOSL

TICKER: BKR

Appendix: Poor Management Strategies

TICKER: AVX

TICKER: LUV