Asset vs Earnings Managers

Value investors can spend a lot of time evaluating the quality of a company's management. We look at management's track record, and attempt to gauge the level of management's candor in providing information to shareholders.


But when it comes to companies that trade at large discounts to their net assets, is this exercise worthwhile? Thanks to our capitalist system, managers who are not getting the most out of company assets will often be replaced, a process which can often serve as the catalyst that helps a stock's price converge with its intrinsic value. By avoiding the companies with poorly performing managers, shareholders may be missing out on the potential for large gains.

Consider RCM Technologies (RCMT), a company we discussed about a couple of years ago as one that traded at a deep discount to its net assets despite a flexible cost structure and therefore a decent earnings outlook. Nevertheless, management's poor capital allocation decisions in the past and their seeming intentions to continue to "build empires" had me avoiding the company.

But those who were willing to take the plunge despite the management situation would be rewarded. The company subsequently received a buy-out offer at a price which is about twice that of what it was when it was brought up on the site. This is a classic case of getting rewarded for buying assets for less than they are worth.

For companies expected/required to generate above-average returns on capital, the management team is likely a very important factor in determining whether the investment makes sense. But perhaps we place too much emphasis on the management team when it comes to companies trading at large discounts to their assets. After all, management teams can be replaced, and shareholders can get rewarded in the process. On the other hand, buyouts are difficult to predict and may not occur with enough frequency to remove every poorly performing management in a timely manner.

The right decision is not always clear, but investors should keep in mind that the importance placed on the management team in weighing an investment decision may change according to the type of investment (e.g. an earnings play vs an asset play) being made.

Disclosure: None

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the feed.