What’s the most important aspect of equities to analyse?

Think of Apple’s success and you credit the genius of Steve Jobs. Microsoft’s founder was the just-as-talented Bill Gates. News Corporation wouldn’t be what it is today without Rupert Murdoch.

It is this people factor that represents a key difference between investing in equities compared with other asset classes.

With other investments, whether you invest in securities with future earning streams (property or bonds) or without (gold or artwork); you are only investing in assets, not businesses. With stocks, the assets of a business evolve over time under the influence of a team of people.

A business, in its simplest terms, is a collection of assets that is operated by a management team to deliver a stream of future cash flows. So to understand how, and by how much, the value of the assets will evolve you need to understand what management intend to do with those assets.

It is not easy to assess management, though. Investors’ perceptions of management are coloured by the current performance of companies.

The key thing to note about management teams is that they comprise, of course, people. And humans can be unpredictable. But, equally, people can be predictable. They tend to do what they are paid to do.

Part of due diligence on a company is to understand what management’s remuneration hurdles are. If, for example, the company and its management target is earnings-per-share growth, expect management to boost earnings per share. Though be aware that this might, perhaps, be at the risk of borrowing too much or some other risky strategy.

If the target is total shareholder returns, expect some management teams to make bold strategic moves in an attempt to propel their company’s share price.

We have found that the best managers are those who are focused on long-term value creation, who take the tough decisions when required.

We have, for example, a high regard for several executives in the resources sectors, industries where management decisions have a long life. It’s no easy task to invest billions of dollars to create assets that will reliably generate value for several decades despite volatile commodity prices. Management teams and boards that do this successfully and consistently are truly exceptional.

The best way to understand a management team is to peer beyond current performance and look at its track record.

Do the actions of management show that it is pursuing initiatives that will grow the value of the company? Or is management intent on building an empire regardless of value creation; for example, by buying other companies at inflated prices?

There are often significant short-term pressures on company management. Those that can step away from these to focus on long-term value creation are the management teams and boards that deliver for shareholders.

These will generally be the companies that can grow market share even in difficult times. These are the managers to back.

We conduct over 500 meetings with Australian management teams every year, and through this process we can compare executive teams. Most CEOs are credible and charismatic. So you have to step back and ask yourself if the reality matches the rhetoric you hear in a meeting.

So as well as meeting with management, we go through a due-diligence process where we talk to lower levels of management, visit plants and factory floors and even talk to competitors and suppliers.

For practical reasons, most non-professional investors can’t do this. But there is a guide they can turn to: a company’s annual report.

Management’s annual reports serve as an indispensable guide to the financial health of a business. There are three areas to scrutinise.

The first is the quality of the board. Who is on the board? Are the people qualified and credible? Does the company follow corporate governance standards? Do executive pay structures and levels seem reasonable or excessive? The answers to these questions indicate whether a board is likely to provide sensible checks and balances to a CEO, or just rubberstamp plans.

The second area is strategy. The first question to pose is: what strategy is the CEO pursuing? Can these plans be easily understood? Are these strategies likely to add value, or simply make the company bigger? What will the management team be rewarded for? Do remuneration metrics align with the stated strategy?

The third area concerns financial integrity. Does the company have a habit of taking financial items “below the line”? What’s happening to depreciation costs – has management extended the accounting life of assets to reduce depreciation charges and boost earnings?

The people side is what makes investing in equities special. It’s why the most famous quote of the world’s most famous investor, Warren Buffet, relates to management: “You do not know who is swimming naked until the tide goes out.” His friend Gates, Jobs and Murdoch would no doubt agree.

This document is issued by FIL Investment Management (Australia) Limited ABN 34 006 773 575, AFSL No. 237865 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS is available at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is Perpetual Trust Services Limited (“Perpetual”) ABN 48 000 142 049. Perpetual is not the publisher of this document and takes no responsibility for its content. Reference to ($) are in Australian dollars unless stated otherwise. © 2011 FIL Investment Management (Australia) Limited.  Fidelity, Fidelity International and the Fidelity International and Pyramid logos are trademarks of FIL Limited.

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