The following was published at RealMoney on April 20th, 2007:

The Changing Business Environment

What do you think is the most important change happening in the competitive environment at present?

This query can highlight emerging issues and demonstrate how the company is adjusting to the changes. Again, you need to compare the answers of various managers against each other; an odd answer could either be ahead of the pack or out of touch. If you think the answer makes sense, it can open up new questions that further enhance your understanding of the industry and the role that the company you are interviewing plays in it.

After Hurricane Katrina and other storms in 2005, ratings agencies toughened up their risk models, and catastrophe modeling companies increased their frequency and severity estimates. This created an even greater squeeze in the 2006 property reinsurance markets than what the losses of capital alone would have caused, as happened to the 2005 property reinsurance market from losses suffered in 2004. New entrants in the reinsuring property risk space found that they could write only half of the premium that their more seasoned competitors from the class of 2001 could. Further, property-centric writers found the capital required went up more for them than for their more diversified competitors.

There was less effective capital in property reinsurance at the end of 2005 than at the end of 2004, even though surplus levels were higher on net. Those who recognized the change in the rules of the game caught the rally in the stock prices as the price for reinsurance went up more rapidly than most expected for the 2006 renewal season.

What laws, regulations, or pseudo-regulations (such as debt ratings criteria) would you most like to see changed?

This is another attempt to understand what most constrains the growth of the enterprise (see Part 1 for a different angle on the question). The answer should be something that is reasonably probable, or else the management is just dreaming.

For an investment bank like Goldman Sachs (GS), an answer could be, “We want the ratings agencies to agree with our view of our risk management models, so that we can get a ratings upgrade and lower our funding costs.”

For a steel company in the early 2000s, the answer could have been, “The government needs to enforce the antidumping duties better.”

A media or branded goods company today might say, “Better efforts by the government to reduce piracy both here and abroad.”

For companies under cost pressure, such as General Motors (GM) and Ford (F), the answer could be, “A better labor agreement that includes changes in the union rules, so that we can improve productivity.”

What technological changes are most driving your business now?

Technology often benefits its users more than its creators. Prior to computers, it took a lot more people to run banks and insurance companies. Now financial companies are a lot more efficient and hire fewer people than they used to as a result of the change. You as the analyst want to know about the next technological change that will lower costs or create new products in order to forecast increases in growth of profitability.

There are other technological changes, but the biggest one recently in business terms is the Internet. The creation of the Internet has changed the way people search for information. World Book Encyclopedia was owned by Berkshire Hathaway (BRK.A), which thought it had a pretty good franchise until Microsoft (MSFT) and others came out with their own cheaper encyclopedias on a CD-ROM. Now even these are getting competed away by Wikipedia.

Who else is being harmed by the Internet? Newspapers are under threat from all sides. Classified ads have been marginalized by eBay (EBAY), Craigslist, Monster (MNST), etc. Regular advertising has been siphoned off by Google (GOOG), Yahoo! (YHOO) and others.

What cultural changes are most driving your business now?

Cultural changes affect demand for products. As more and more women entered the workforce, demand increased for prepared foods and dining out options. Demand decreased for Tupperware parties and things sold door-to-door.

Cultural changes can also lower the costs of an operation. Outsourcing has lowered costs and improved time coverage for call centers, computer programming and many other service functions. The willingness of nations to embrace the cultural change of capitalism creates new markets that previously did not exist.

One more example, again from insurance: Insurance became a growth product when extended family ties weakened and nuclear families became the standard. Now as nuclear families break down and are replaced by a greater proportion of singles without children, some insurance markets are weakening (life) and others are strengthening (annuities, personal lines, individual heath and disability).

What regulatory changes are most driving your business now?

Before you talk to management, you should know the answer to this one. But what matters here is that you know that they know, too, and more importantly, are building that into the plans for the business.

To get you started, consider the possible impacts of some changes on a few industries. For a pharmaceutical company such as Merck (MRK) or Pfizer (PFE), this could be a change in the way that drugs get approved. It might be a larger political change, such as the recent election of the Democrats, which is expected to produce a change in Medicare reimbursement rates.

Increases in environmental regulation can affect the profits of extraction businesses significantly, whether agriculture, mining, silviculture, energy exploration and production and more. If it becomes easier to unionize, that can affect wage rates and productivity even more as work rules bite into effectiveness and flexibility of work; both of these can lower profits in labor-intensive businesses.

Now, these are pretty obvious examples, and most examples here will be obvious, because most regulation is done openly. The answers that a management gives can be a test as to whether they themselves know what is going on.

Sometimes the answers get a little more subtle. In personal lines insurance, it took analysts a long time to catch up with the safety trends that were bringing down the frequency and severity of losses, particularly graduated licensing for young drivers. Internally, the companies had figured it out long before they told the analyst community. The analysts who asked why severity and frequency of loss were so good and got an answer that allowed them to “connect the dots” to the regulatory change realized that there was a secular, not cyclical, change going on. Thus they were able to make money buying personal auto insurers, because the trend was likely to extend to more states.

Mergers and Acquisitions

Without naming names, what types of business alliances do you think could be most valuable in the future?

This helps flesh out competitive strategy. Managements will be reluctant to part with details, but usually are willing to explain their approach to supplier agreements, joint ventures and so on.

The answer to this question can also highlight the “missing pieces” for the current business, and how the management team is trying to source them. It can also shine a light on new products and services that management is considering.

Is it cheaper at present to grow organically or through acquisitions?

The right answer is almost always organic growth. Acquirers usually overpay, particularly in acquiring scale. Intelligent acquisitions are usually small and often private firms, where the sale is negotiated and not an auction. The goal is to gain new core competencies or markets that can grow profits in concert with the capital and other resources that the company can add to their new acquisition.

If a company answers “through acquisitions,” there had better be a reason it has an advantage in acquiring companies that its competitors don’t, which is rare. If it’s the only public company rolling up a sector (again rare), there should be some logic as to what discipline the company exercises in not overpaying for acquisitions.

In the early phase of a roll-up, prices are typically reasonable for the small firms being purchased. As the roll-up proceeds, the acquisitions that are easy, logical and cheap get done first. In later phases, if there is a mania, the hard, illogical and more expensive acquisitions get done.

It’s rare to have a roll-up in which some party doesn’t start overpaying badly at the end. Sometimes that signals the end of the roll-up phase, with a decline in the share price of the overpayer, destroying the value of the currency that it is using to acquire small entities; namely, its stock price.

How important is scale when you consider acquisitions?

Again, acquirers usually overpay for scale. The right answer is usually that it is not important, unless it is a commodity business and the acquirer is the low-cost competitor, and will wrench expenses out of the target company to make the target as efficient as the acquirer.

Summary

The difference between my approach and the approach of most analysts is that I think about the business and its strategy rather than the next quarter or year’s earnings. My methods probably won’t help you make money in the short run but will help you make money in the long run as you identify intelligent management teams that understand how to compete for the long term, rather than those that can manage only next quarter’s GAAP earnings.

Two additional side benefits to doing it my way: First, the management teams will like talking with you. I can’t tell you how many times managers have said they appreciated my businesslike approach to analyzing their companies. Second, it will translate back into an improved understanding of the business you presently work in, as you think about strategic issues there.

This was originally published on RealMoney on April 16, 2007:

“I am a better investor because I am a businessman, and a better businessman because I am an investor.” — Warren Buffett

One of the things I try to do in my investing is analyze the quality of a management team. Though this is a squishy discipline, if I can be approximately right in this endeavor, I can add a lot of value.

I want to share with you the questions I ask management and the reasons I ask them because I believe they’re useful even if you never come face-to-face with a real live C-suite dweller. They cover six major areas:

• general topics
• financial
• competition
• pricing and products
• changing environment
• mergers and acquisitions

I try to analyze sustainable competitive advantage and the ability of managements to generate and use free cash flow, among other factors. (As an aside, in the insurance industry, I can kind of tell management quality by “feel.” I have worked for good and bad managements, and I know their characteristics intuitively.) I try to see if managements are economically rational, are focused on building long-term profitability and act in the interests of the outside passive minority investors who own their shares.

Personally, I am in favor of small-shareholder capitalism. By this, I mean that small investors should have the same access to management, not least of all through quarterly (and other) conference calls held. This view is partly driven by the inadequate questions asked by sell-side analysts.

Too often, sell-side analysts focus on the short run and qualitative variables in their models. The short term is overanalyzed, so I try to look to the longer term. That means most of my questions are about strategy. I try to figure out if the managements in question are — again — economically rational, focused on building long-term profitability and acting in the interests of the outside passive minority investors who own their shares. Or do they act for reasons other than maximizing value for mom and pop, a.k.a. you and me?

Though most of us are outside passive minority investors, pretend for a moment that you are a private-equity investor. There’s value to be had in understanding how an investor in the business would benefit in the absence of a secondary market for ownership interests. The value derived by a private-equity investor feeds slowly to the public equity investor in the short run but directly in the long run.

Then sit back and read through these questions. Prepare to ask them of the managements of the companies in which you are currently a shareholder. Imagine the answers, or even try to get them.

And adjust your holdings accordingly.

General Questions

What sustainable competitive advantages do you have vs. your competitors?

As with most of my questions, I usually have a reasonable idea of what the answer is likely to be. Part of my question is to test the competence and veracity of management. If it trots out some answer that is nonsense, that is a big red flag to me.

Given that most of the time I invest in mature industries, I want to hear answers that tell me the company has an expense advantage over competitors. That can be easily verified. Other possible answers include exclusive distribution agreements, patents, technological advantages and company culture.

Once I hear the answer, I try to analyze how much it makes sense. Has the company really created a “moat” that protects its profits from competition, or is it trying to fool me? I don’t always get a sharp answer, but the exercise is always valuable. Uncertainty leads to doing nothing or to a smaller position, which is always appropriate when you don’t have a big edge.

For instance, longtime readers know that I am a long-term bull on the diversified insurance company Assurant (AIZ). In most of Assurant’s business lines, it is the No. 1 or No. 2 provider in the businesses in which it chooses to compete. Part of that stems from locking up exclusive distribution arrangements, some from proprietary technology that would be difficult and prohibitively expensive to reverse-engineer.

To give another example, Allstate (ALL) and Progressive (PGR) 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.

Full Disclosure: long AIZ