Roger McKinney | On October 12, 2015

(Photo by Making Money) (CC BY) Resized/Cropped)

Investors with the time will want to imitate Warren Buffet and invest in a few good companies rather than put up with a host of losers in an index fund, but analyzing individual companies in the way that Ben Graham taught is time consuming. Several experts have developed algorithms that examine financial data that helps weed out the worst.

But if an investor is going to marry a business he must become familiar with the quality of its management. Good management can turn a bad company around and value investors often want to buy shares in a company when it has hit rock bottom and has the potential to turn around.
Of course, investors also want to avoid bad managers and Jim Collins’ 2009 book How the Mighty Fall: and why some companies never give in offers a great deal of help. Collins highlights companies that have flown in the stratosphere and then crashed. They typically go through five stages: 1) Hubris born of success; 2) Undisciplined pursuit of more; 3) Denial of risk; 4) Grasping for salvation; finally, 5) Capitulation. If there are lucky, a sixth stage exists in which the company recovers and learns to fly again.

Collins maintains a web site at jimcollins.com that offers diagnostic tools for assessing a company’s management through the criteria he and his colleagues have developed. Any investor who wants to concentrate funds in a few good companies probably needs to visit Collins’ web site and read his books.

A lot goes into choosing a good CEO, but at one point in his book Collins locks onto what I consider one of his most important points – promoting from within. He wrote this:

Our research across multiple studies (Good to Great, Built to Last, How the Mighty Fall, and our ongoing research into what it takes to prevail in turbulent environments) shows a distinct negative correlation between building great companies and going outside for a CEO. Eight of the eleven fallen companies in this analysis went for an outside CEO during their era of decline, whereas only one of the success contrasts went outside during the eras of comparison. Now you might be thinking, “But wouldn’t companies in trouble need to go outside?” Perhaps, but keep in mind, in this analysis of decline, performance generally worsened under saviors from the outside. And in our previous research, over 90 percent of the CEOs that led companies from good to great come from inside; meanwhile, over two-thirds of the comparison companies in that study hired a CEO from outside yet failed to make a comparable leap. (Page 95)

Preparing for his successor is one of the CEO’s most important tasks. If he fails, he forces the board to look outside the company for a replacement. Investors should focus on companies that have a culture of growing CEOs from within. If the board chooses to turn over the reins to an outsider, investors should flee from the stock as if it had the plague. You’ll be wrong occasionally, as is the case with any investing principle, but most of the time you will not regret it.

Collins’ advice on promoting from within agrees with an older book written by a jaundiced professor in an MBA program, Henry Mintzberg. After twenty years of teaching in an MBA program he recognized that something was wrong with the curriculum so he took a sabbatical to analyze the problem. He realized that when MBA students take a new job they fixate on marketing and finance because those disciplines transfer easily to any company. But those same students would not take the time to learn the nuts and bolts of the business and industry they competed in. Often their marketing and finance expertise did not fit the industry and they destroyed companies.

Mintzberg’s restructured the MBA program into  a distance learning program for executives who had worked at a company for several years already. The assignments required them to apply what they learned in class to their own company. He even changed the name of the program to a master of science in business. The book Managers not MBAs (2004) contained his wisdom.

Warren Buffet’s alpha consists mostly of discovering good management. Metrics help, but at some point investors who want to follow him will have to get to know the management of the companies they want to invest in.

A curious aspect of Collins’ stages of collapse is how they coordinate with stages of a business cycle. The economy as a whole goes through the same stages with the similar attitudes for most business. It begins with the central bank reducing the market rate for short term debt, which in turn reduces other interest rates across the board. That causes unjustified confidence and excessive expansion in the capital goods industries. Finally, the sign of the impending collapse is the euphoria at the top of the cycle. The best indicator of bad times to come is unusually good times.

Roger McKinney