5 Points to Look For When Evaluating Management - 6 Apr 2009

5 Points to Look For When Evaluating Management

April 06, 2009
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RELATED TICKERS: KO
, CSCO

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.

Disclosure: Steve owns CSCO