The Rational Management Checklist

The most obvious way to determine the quality of a company's management is to look for rational acts, which include:

Designing Around Jobs-to-be-Done: Avoid overserving by designing products/services around jobs that need done, and by making sure product/service features are necessary and useful. Keep products/services as simple and easy to use as possible. Only make meaningful, useful improvements to a product. See Concepts page and discussion of Clayton Christensen; posts titled "The Importance of Adopting Meaningful Product Improvements" and "Apple's Design Strength Prevents Overserving."

Increasing Differentiation: Compete to be unique and different rather than competing to be the best. Look for ways to enhance the uniqueness and fit of the company's activities. Increase profitability and/or competitive barriers by reducing Michael Porter's five forces (rivalry, buyer power, supplier power, threat of new entrants, and threat of substitutes). See Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Avoid low end disruption by moving downmarket and making the product/service simpler and more affordable when possible, even if it means cannibalizing existing products; it's better to cannibalize existing products than let competitors take the business. Make the product/service more affordable as manufacturing costs decline. Downmarket moves help deter new entrants. Consider reducing margins and increasing sales volumes to further deter new entrants. See Concepts page and discussion of Clayton Christensen.

Keep product differentiating capabilities in-house to prevent subcontracting suppliers from moving upmarket and co-opting key capabilities (thereby undermining the company's entire business). See post titled "How Outsourcing Can Destroy a Company."

Make acquisitions that: (1) enhance the customer experience; (2) enhance the uniqueness and fit of the company's activities; and (3) help defend the company's long term competitive position. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012); see Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Skate to where the puck (the money) is going to be in adding differentiating, unique activities and capabilities.

Operating in a Lean, Decentralized Way That Enhances Returns, Fosters Innovation, and Eliminates Impediments to Communication: Operate in a lean, decentralized way, removing layers of management bureaucracy where possible. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012). Too much bureaucracy stifles communication. Foster innovation by removing impediments to open, candid communication. To come up with the best, most innovative ideas, people must communicate freely and candidly in both teams and across the company. Creativity, Inc., by Ed Catmull (Random House, 2014).

Developing Talent and Effective Teams: Internally develop people so they acquire the experiences needed to succeed. Determine the experiences needed to succeed based on the company's strategy, and the actions the company intends to take in support of this strategy. High Flyers, by Morgan W. McCall, Jr. (Harvard Business School Press, 1998).

Prevent unnecessary, expensive "derailments" and turnover by supporting people in their development efforts. Create a healthy context for development and experience-based learning by avoiding a survival of the fittest or "this is a pass/fail assessment of your skills" mentality. If internal people with the right experiences aren't available, hire outside people with the right experiences. Give outside people time to adjust to the new culture and support them in their efforts (difficulty adjusting to a new culture often causes external hires to derail). Id.

Make internal hires when possible -- too many external hires are a sign the company needs better internal development processes. The best internal development isn't a training course -- it's hands-on experience in the areas needed to advance the company's strategy, and it's mentoring by the organization's best people. First class internal development can be a significant, long term source of competitive advantage. Id.

Remember that people often learn the most through failure (usually repeated), and by overcoming failure or difficult challenges. The learning from these experiences often leads to later success. The response to failure is more relevant than the failure itself. Id.

Look for people with a sense of humility and an eagerness to learn. The desire and ability to learn are the most important innate attributes. Avoid promoting or hiring people based on "right stuff" attributes -- confidence, analytical brilliance, decisiveness, perserverence, courage, flexibility, etc. -- since none of these attributes are foolproof. Too much of any one right stuff attribute (like confidence) can become a weakness (like arrogance), and a right stuff attribute that's a strength in one context can become a weakness in another context. This is the problem with attributes-based promotion and hiring. Id.

Arrogance is the number one cause of manager derailments because it causes the manager/victim to stop listening and learning, and also causes the manager to lose his co-workers' support, help, and loyalty. Id.

You want people with the humility needed to be part of a high functioning team. Individual strengths are relevant, but the ability to listen and give candid, problem-focused input on a high functioning team -- i.e., effectively collaborate -- may be even more important. Creativity, Inc., by Ed Catmull (Random House, 2014). Effective team feedback is additive, not competitive; you're not trying to win a debate. Id. Criticism should be: constructive, specific, empathetic, non-prescriptive, and timely (delivered early enough to help solve the problem). Id. Don't just rip things apart. Candid, constructive criticism helps build something new even as it tears something down; it should inspire the recipient and help him figure out a better solution. Id.

Don't let team candor get stifled because of the hierarchical power or dominant style of one team member; in some cases it may be better to leave these kinds of individuals off the team completely. Id.

Great people are more important than great ideas, because great ideas come from great people and great teams. You also need more than one great idea to succeed: any given product/service is the result of lots of great ideas, and high performing teams with great people are the best way to generate them. Id.

If you want to assess your effectiveness as a manager, look at whether the people on your team are rallying together to solve key problems. If they are, then you're managing well. Id.

Correcting Mistakes and Failures: Respond to mistakes, failures, and problems rationally -- make timely, appropriate corrections in response, and learn from the experience. How leadership responds to a mistake/failure is more important than the mistake/failure itself. High Flyers, by Morgan W. McCall, Jr. (Harvard Business School Press, 1998).

Fail early and fail fast -- be wrong as fast as possible and then learn and grow from the experience. Don't fear failure and try to avoid it. Failure is a sign of exploration, learning, and forward progress, and shows employees that decisions are being made and corrected as necessary. Futile efforts to avoid failure lead to paralysis by analysis and declining employee morale, making failure self-fulfilling. You don't learn to ride a bike without making mistakes -- this analogy is helpful in accepting and learning from mistakes and failures. Creativity, Inc., by Ed Catmull (Random House, 2014).

Create a corporate culture where mistakes and failures are expected, and where employees are supported in fixing and recovering from mistakes/failures. This kind of culture fosters employee trust, instead of fear of failure, which leads to risk-taking and creative exploration. Id.

Allocating Capital Rationally: Buy back shares when: (1) the stock is undervalued or fairly valued; (2) working capital needs are met; (3) property, plant, and equipment (PP&E) maintenance needs are met; and (4) the company can't earn an attractive return elsewhere either through additional investments in PP&E or through acquisition. Buybacks are generally more tax efficient than dividends. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and stock valuation.

The prudent use of low interest debt to buy back undervalued or fairly valued stock can be an attractive option. Surplus cash and cash flows (beyond that needed for working capital, PP&E, and future acquisitions) can also be used to make buybacks.

A company buying back its own overvalued stock is wasting the shareholder's proportionate share of the company's cash. For this reason, shareholders are better off receiving dividends when the stock is overvalued, which they can then use to purchase other companies trading at more reasonable valuations. When the stock is overvalued, working capital needs are met, PP&E maintenance needs are met, and the company can't earn an attractive return elsewhere either through additional investments in PP&E or through acquisition, then dividends are appropriate.

In most cases issuing new debt to pay dividends probably isn't appropriate; Apple recently illustrated an arguable exception to this when it issued low interest debt to fund dividends and buybacks and to avoid paying domestic U.S. taxes on foreign cash it would otherwise have to repatriate. Surplus cash and cash flows (beyond that needed for working capital, PP&E, and future acquisitions) can be used to pay dividends.

Buybacks or dividends often make sense as a business matures and revenues/earnings stop growing, because flat or declining revenues/earnings make it harder to generate an attractive return on any capital invested in new, improved PP&E; plant and equipment improvements that benefit a declining existing business often don't make financial sense. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012).

Buybacks decrease a company's outstanding shares and increase a shareholder's proportionate share of earnings and cash flows. Higher EPS and cash flow per share -- due to buybacks -- can increase a company's discounted cash flow value (on a per share basis), ultimately leading to a higher stock price even for companies with flat sales and earnings (as noted in Chapter 9 of The Outsiders, titled "Radical Rationality”). Id.

In making buybacks, acquisitions, and PP&E investments, try to deploy capital in a contrarian, opportunistic way. Be greedy when others are fearful and fearful when others are greedy. Take advantage of depressed markets, buying at attractive prices and using acquisitions and PP&E investments to enhance the uniqueness and fit of the company's activities (even as competitors are reigning in acquisitions, capital investment, and buybacks due to fear, uncertainty, and temporary market conditions). Id.; see Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs." 

Issue stock to help pay for acquisitions when your company's stock is overvalued and the acquiree's stock is undervalued, using your company's high priced stock, relative to earnings and cash flow, to buy the acquiree's low priced stock, relative to earnings and cash flow; take advantage of these kinds of arbitrage situations. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012). Avoid issuing stock to pay for acquisitions when your company's stock is undervalued and the acquiree's stock is overvalued. Id. Prudently use low interest debt to help pay for acquisitions.

In addition to acquisitions, look for opportunities to invest in complementary joint ventures that can benefit from the company's size or capabilities. These kind of equity investments can provide very attractive capital returns in addition to enhancing the uniqueness and fit of the company's activities. An example might be investing in a joint venture with a component supplier to create an important new product, and then using the company's size, scale, and distribution network to drive sales of the new product. Id.

Sell assets or spin off businesses that have consistently failed to provide an attractive return on invested capital, and apply the proceeds to more attractive alternatives (whether it's investing in more profitable core businesses, making an attractive acquisition, investing in a joint venture, buying back shares, or paying dividends). Id.

Alternatively, spin off high return, high profit businesses when the company's remaining operations no longer provide attractive returns/profits. When a large, controlling company with low profits spins off a promising and highly profitable business, it allows investors to buy shares of the spinoff based on a multiple of the spinoff's high EPS and high cash flow per share. Investors no longer have to buy shares of the less profitable controlling entity -- which trades at a multiple of the controlling entity's low EPS and low cash flow per share -- just to own the more promising and profitable business. As a result spinoffs tend to create value for shareholders of the low profit company doing the spinoff, since these shareholders get an ownership stake in the spinoff (through a stock dividend or stock exchange) that can now be directly valued based on the spinoff's higher EPS and higher cash flow per share.

In allocating capital rationally, look for legal ways to minimize taxes: sell assets or businesses in exchange for stock, use past net operating losses to shield any cash gains from asset or business sales, and so on. Minimize taxes to enhance returns. Id.

Allocate capital rationally to steadily increase EPS and cash flow per share over time, even if it sometimes means shrinking the size of the overall business. Id.

Planting Seeds: Look for opportunities to invest in new products/services that squarely address jobs that need done; in doing so be impatient for profit and patient for growth. New ventures should generally start small so that the new product/service and the business model/strategy can be tested, improved, and abandoned as necessary without large capital outlays. See Concepts page and discussion of Clayton Christensen.

Don't lose focus by doggedly funding an unprofitable new product/service; insist on early profits and cycle between deliberate and emergent business strategies until a profitable product/service is developed. See post titled "How Successful Strategies Develop and When Subsidies Make Sense." Early profits: (1) allow a new venture to sustain itself and fund its own future growth; and (2) test whether the new product/service has market appeal and effectively solves a job that needs done. After an initial break-even period new ventures should be able to earn an attractive return on the capital invested. See Concepts page and discussion of Clayton Christensen.

Don't waste time, talent, and capital on unprofitable ventures or ventures that don't provide an attractive return on the capital invested. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012); see Concepts page and discussion of Clayton Christensen.

The author owns stock shares of Apple.