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Talking to Management, Part 1: The Big Questions

To give another example, Allstate (ALL - Get Report) and Progressive (PGR - Get Report) are leaders in customer segmentation, leading to individualized pricing of personal lines coverage. Other major personal lines companies are playing catch-up, and the smaller mutual companies are losing many of their most profitable customers.

So these companies have a clear advantage, which management should be able to communicate quickly.

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:
  • insufficient demand at current prices
  • insufficient talent for some critical labor resource at current prices
  • insufficient supply from some critical resource supplier at current prices (the "commodity" in question could be iron ore, unionized labor contracts, etc.)
  • insufficient fixed capital (e.g., "We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we're just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.")
  • insufficient financial capital (e.g., "We're opening new stores as fast as we can, but we don't feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.")

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

How are you planning on growing the top line?

This can be a trick question, particularly for industries in which pricing power is nonexistent. When there is no pricing power, the right answer is to focus on the bottom line and not sell underpriced business. The answer here can reveal whether the executive is a rational competitor and whether he has the courage to be honest with the analyst.

The sell side has a bias toward top-line growth, which is wrong in my opinion. Actions that improve the expense structure are just as important as new sales. Good managements have a consistent focus on the bottom line, whether it grows the top line or not.

Particularly in financial businesses, there is a tradeoff between quality, quantity and price. In good markets, you can get two out of three. In bad markets, you can only get one out of three, and if that one is growth in sales or origination, watch out. That business is a candidate for profit shrinkage, and possibly insolvency.

Good managements know when to step back from their markets when competition is irrational. In the short run, that may hurt the stock price, but in the intermediate term, it will keep them in the game. In the long run, it will help the stock price when the pricing cycle finally turns and a few stupid competitors are weakened or bankrupt from their past mispricing of business.

Key Points:
  • Analyze the quality of a management team and you'll have an edge.
  • Sell-side analysts tend to lob 'softball' questions.
  • Test your team on competitive advantage, constraints and (tricky) top-line growth.

Editor's note: We're pleased to present David Merkel's five-part series on questions to ask the management of a public company. Click here for Part 2, key financial questions.
At the time of publication, Merkel and/or his fund was long Assurant and Allstate, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.
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