When conducting research for potential investments in a company, many investors typically seek indicators that signal the company’s future growth and success. These indicators often encompass the company’s competitive advantages, growth drivers, and historical financial performance. However, it’s common for investors to overlook the evaluation of a company’s management and their conduct.
A company’s core management team includes the CEO, C-level executives, and the board of directors. They bear the responsibility for guiding the company’s leadership, strategic direction, and overall growth. Effective management can propel a company toward higher revenue, profit, and expansion, while also making positive contributions to society. Conversely, poor management has the potential to lead a company to decline, sometimes even into the realm of bankruptcy, thereby eroding shareholder value.
It may not always be readily apparent how a company’s management is misaligned with the interests of its minority shareholders. On occasion, their actions and behaviour may remain within legal boundaries but raise questions about their intentions. So, how can investors safeguard their interests? Here are four telltale signs that a company’s management may be pulling the wool over investors eyes.
1. Overpaying themselves
Executives should be rewarded when the company performs well and creates value for shareholders. However, when executives receive large bonuses or stock options regardless of the company’s financial health or stock performance, it can suggest a misalignment of incentives. Instead of focusing on driving the company’s success, management may prioritize short-term gains that boost their personal compensation.
Excessive executive compensation can have a direct impact on shareholder value. When a significant portion of company earnings is allocated to executive pay, there may be fewer resources available for reinvestment in the business, debt reduction, or dividend payments to shareholders. This can hinder the company’s growth prospects and reduce the potential returns for investors.
Jeff Immelt’s 16-year leadership of General Electric had a devastating impact on the company. The once-renowned corporation found itself burdened by overwhelming debt and faced immense financial stress. The precipitous downfall of General Electric was primarily attributed to a string of ill-fated decisions, including several poorly-timed acquisitions made by Immelt. Among these, Immelt’s acquisition of Alstom’s power business which forced the company to absorb a staggering US$22 billion charge. For his troubles, Immelt received US$168 million in total compensation since 2006 till he left in 2017.
2. Overselling a growth story
Management can oversell the potential growth of a company to investors by overstating the potential market for the company’s products or services. They may make unrealistic promises of high growth rates, rapid expansion, or unrealistic timelines for new product launches or market penetration.
The management may also focus on short-term successes or wins, while downplaying the challenges or risks that the company faces in the longer term. This can create the impression that the company is on a continuous upward trajectory, when in fact it may be facing significant challenges or risks that could derail its growth.
Finally, management may use buzzwords or jargon that create the impression of innovation, disruption, or cutting-edge technology, even if the company’s products or services are not actually groundbreaking or unique. This can create a sense of excitement or hype around the company, which can be used to justify inflated valuations or investment expectations. In recent times, buzzwords like AI, crypto or blockchain have been used by some companies to generate hype. It is up to the investor to discern whether a company’s claims are based on solid foundations or just hot air.
WeWork, under the leadership of its co-founder and former CEO Adam Neumann, hyped its business growth through a combination of ambitious expansion plans, visionary marketing, and financial manoeuvres. WeWork’s valuation was often compared to that of tech companies rather than traditional real estate companies. This comparison suggested that WeWork was not just a real estate company but a technology-driven platform with significant growth potential. In reality, WeWork’s valuation as a tech company with significant growth potential did not align with its actual financial performance and business model. The company faced several challenges that became apparent as it moved closer to its planned initial public offering (IPO).
3. Overpricing an IPO
The anticipation surrounding an IPO can create a sense of market enthusiasm and optimism. IPOs provide an opportunity for individual investors to become early shareholders in a company that was previously private. This can offer a chance to participate in the growth potential of a company from its early stages.
At the same time, it’s important to bear in mind that an IPO also serves as an exit strategy for existing stakeholders including founders, venture capitalists, and angel investors. It provides them with a means to convert their ownership in the company into cash or publicly traded shares. Consequently, the greater the IPO price of the company’s shares, the greater their potential return on investment.
The management may also overprice an IPO to establish a high valuation for the company. This can create the impression that the company is more valuable than it actually is, which can be used to justify higher stock prices in the future or to attract additional investment. However, overpricing an IPO can have negative consequences, such as limiting investor demand, leading to a decline in stock price after the IPO, or damaging the company’s reputation.
It’s important for prospective investors in an IPO to consider the motivations of early investors who are selling their shares. While certain companies opt for an IPO to raise capital for their growth and expansion initiatives, others may simply be using it as an opportunity to cash out. Although an IPO’s perception as overpriced or underpriced can vary widely, investors should always conduct thorough research, consider the company’s fundamentals, and assess their own investment goals and risk tolerance before participating in any IPO.
Established in 2008, Groupon introduced a simple yet innovative concept: offering group discounts to consumers while introducing new customers to local businesses. Within three years, Groupon skyrocketed to become the fastest-growing startup, extending its operations to 35 countries and amassing a staggering 150 million subscribers to its newsletter. Groupon declined a lucrative acquisition offer of US$6 billion from Google in 2010, instead opting to announce its own IPO in 2011. Groupon went public with a lofty US$17.8 billion market cap, but the stock plummeted soon after. Some early investors, though, cashed out early and walked away with millions. Today, Groupon has lost 99% of its value since its IPO.
4. Questionable acquisitions to showcase growth
Acquisitions can provide a quick and efficient way for a company to expand its operations into new markets or regions. By acquiring an existing business, the company can gain access to established customers, distribution channels, and expertise, which can accelerate its growth and help it achieve economies of scale.
However, investors should take heed when management pursues questionable acquisitions to artificially bolster earnings and share prices. While acquisitions can indeed boost financial metrics and temporarily drive up share prices in the short term, they should ideally align with a company’s broader strategic goals and deliver real, lasting benefits. Poorly executed acquisitions can lead to significant costs and risks, including integration challenges, cultural clashes, and financial losses, which can harm the company’s reputation and growth prospects.
Management may be motivated by financial incentives tied to the acquisition, such as stock options, bonuses, or performance-based compensation. This creates a conflict of interest where executives prioritize their own financial gain over the long-term health of the company.
Valeant Pharmaceuticals was a multinational pharmaceutical and medical device company based in Canada. It was known for its aggressive acquisition strategy and a business model that involved acquiring established pharmaceutical companies and then increasing drug prices substantially. The acquisition spree drove its share price from around $20 per share to as high as $263.81 in July 2015. However, Valeant’s aggressive debt-fuelled acquisition strategy left it heavily leveraged, with a significant amount of debt on its balance sheet. The debt-fuelled, acquisition-led growth strategy was unsustainable and eventually unravelled. Within a year, Valeant’s stock price fell over 90%. The company rebranded itself as Bausch Health in 2018, but its stock has never recovered since.
The fifth perspective
In the world of investing, where numbers and forecasts often take centre stage, it’s imperative to remember that company management plays a pivotal role in a company’s success or failure. While examining financial reports and market trends is crucial, the conduct and decisions of a company’s leadership can significantly impact shareholder value. As investors, we must remain vigilant and proactive, keeping an eye out for the subtle signs that may indicate management’s intentions are not aligned with our best interests.
By recognizing some of the warning signs we’ve discussed—such as excessive self-compensation, overly optimistic growth projections, questionable acquisitions, and IPO pricing strategies—we can better protect our investments from the potential pitfalls of deceptive management practices.
