5 Points to Look For When Evaluating Management

Stock analysis involves a number of investigative points. Many are objective and tangible, such as determining if return on capital is and has been above average, and if the company has a reasonable debt load. Others are more subjective, such as determining what is a reasonable expectation for long term profit growth. Today's article falls more into the subjective category, but it is an important component of finding successful investments: finding great management teams.

It doesn't take much digging to see why management is so important. In fact, it's one of the major and primary factors super investor Warren Buffett looks for in prospective investments, either through the purchase of entire businesses or through stock buys on the open market (see the compilation of his annual notes to shareholders in The Essays of Warren Buffett: Lessons for Corporate America). Great leadership, like Roberto Goizueta at Coca-Cola (KO), or John Chambers at Cisco (CSCO), can produce great results year after year, creating wealth for their shareholders. On the other hand, dishonest and greedy management such as the crooks that ran Enron or Worldcom can destroy the fortunes of millions. Clearly, management must be a major consideration before taking an investment position in any company.

While we can never be absolutely sure of anything, here are 5 points to look for when evaluating management and the board of directors. If a company meets most of these criteria, chances are you are dealing with an effective and shareholder friendly team that will give you the best opportunities to make money.

1. Sustained Results

What could be a better measure of management than business results? A management team that has been in place for a good period of time (5 years or more) and has delivered sustained and profitable growth over that period is likely to be solid. All of the standard financial metrics apply here. Has revenue been growing at a steady pace? Have margins been steady or increasing? Has free cash flow been growing? If you can say "yes" to these questions over a reasonable time period, chances are the management team has exceptional business acumen.

2. Focus on Return on Capital

Boiled down to the essence, the purpose of management teams is to efficiently allocate the capital allotted to the firm - be it equity capital, debt capital, or operating free cash flow. This can mean different things depending on a company's stage in the business cycle. Clearly, for firms with lots of organic growth potential, capital is best allocated by re-investing it in the business. On the other hand, businesses that dominate their sector and have realized most growth potential can best use capital by paying out dividends and buying back shares (instead of, for example, overpaying for acquisitions that don't fit the core competencies of the firm). The best way to measure return on capital is by using the "traditional" return on capital equation, including goodwill and intangible assets, which penalize over-payments for acquisitions in the past. If this figure has been at or above 20% over the tenure of current management, you can be sure that return on capital is a primary focus (more on ROIC in next week's article). On the other hand, be wary if current management has shown a penchant for spending big bucks on businesses that don't fit well with current operations.

3. Reasonable and Shareholder Friendly Compensation Guidelines

Many people, and investors, focus more on amounts when looking at compensation, but it's more instructive to actually read the compensation guidelines instead. What kind of targets does management have to meet to earn their bonuses? Good targets are discrete (real numbers), and focus on such things as meeting a return on capital benchmark, growing operating earnings, and growing free cash flow. Questionable targets are often vague or focus on such things as revenue growth or earnings per share growth. A revenue growth focus is particularly onerous... it encourages managers to grow sales at any cost, even if that means overpaying for acquisition or stuffing retail channels towards the end of the reporting period. You can always find compensation policies spelled out in a company's proxy statement (form DEF14A on the SEC website).

I should also mention the composition as well. The best, and most shareholder friendly, ways of compensating management are through cash and restricted stock. Cash is cash - it can't be hidden or estimated out of the firm's results, so unreasonable amounts affect cash flow. Restricted stock is a great form of compensation in most cases. First, it does not vest until certain conditions are met, usually results-based. Second, when it does vest it adds to the executive's personal stake in the business, aligning his or her interests with those of shareholders.

One last thing to look out for here are perquisites, or "perks". You'll see some companies that grant their CEO personal use of company aircraft, country club memberships, a vehicle allowance, personal security, and plenty of other things. These guys make plenty of money to pay for these kinds of things... including them as part of compensation is stealing from shareholders.

4. A Personal Stake in the Business

A CEO with a lot of personal wealth in the company he runs is certainly more likely to run it honestly and run it to increase it's value. Look for dollar figures here instead of percentage of ownership - large, 100 year old firms are very unlikely to have anyone that holds a significant portion of the shares. However, if your CEO owns $50 million in stock, and makes $1 million a year in compensation, you can be sure his/her interests are aligned with yours. This one is particularly important with smaller firms. The best small caps are controlled by founders who still run the business and have most if not all of their family's wealth attached to it's performance.

5. A Truly Independent Board of Directors

This is probably the most difficult to find. The Board is important - they are entrusted with evaluating the CEO, determining his/her compensation, and ensuring that he or she is operating with shareholder interests in mind. #3 is one sign of an effective Board. Some other signs: the CEO and Chairman roles are separated, the lack of bonus payments after a down year, no or very minor perquisites, and non-staggered elections (all board members are re-elected at the same time).

Evaluating management is important and should always be a part of equity analysis. While these 5 points are not comprehensive, they are usually good enough to ensure that the executive team won't run you into the ground.

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