Most investors realize that it's important for a company to have a good management team. The problem is that evaluating management is difficult. So many aspects of the job are intangible. It's clear that investors can't always be sure of a company by only poring over financial statements. Fallouts such as Enron, Worldcom, and Imclone have demonstrated the importance of emphasizing the qualitative aspects of a company.
- There is no magic formula for evaluating management, but there are factors to which you should pay attention. In this article, we'll discuss some of these signs.
- When evaluating an equity investment, understanding the quality and skill of a company's management is key to estimating future success and profitability.
- Looking at the stock price alone, however, can give false signals. In fact, several high-flyers such as Enron and Worldcom, has soaring stock prices despite corrupt and inept management operating behind the scenes.
- Look to indirect metrics such as how long the managers have worked there and what type of compensation they get as well as factors like stock buybacks to see how well management is doing.
The Job of Management
Strong management is the backbone of any successful company. Employees are also very important, but it is management that ultimately makes the strategic decisions. You can think of management as the captain of a ship. While not physically driving the boat, he or she directs others to look after all the factors that ensure a safe trip. (For further reading, see Lifting The Lid On CEO Compensation.)
Theoretically, the management of a publicly traded company is in charge of creating value for shareholders. Thus, management should have the business smarts to run a company in the interest of the owners. Of course, it is unrealistic to believe that management only thinks about the shareholders. Managers are people, too, and are, like anybody else, looking for personal gain. Problems arise when the interests of the managers are different from the interests of the shareholders. The theory behind the tendency for this to occur is called agency theory. It says that conflict will occur unless the compensation of management is tied together somehow with the interests of shareholders. Don't be naive by thinking that the board of directors will always come to the shareholders' rescue. Management must have some actual reason to be beneficial to shareholders.
Stock Price Isn't Always a Reflection of Good Management
Some say that qualitative factors are pointless because the true value of management will be reflected in the bottom line and the stock price. There is some truth to this over the long run, but a strong performance in the short run doesn't guarantee good management. The best example is the downfall of dotcoms. For a period of time, everybody was talking about how the new entrepreneurs were going to change the rules of business. The stock price was deemed as a sure indication of success. The market, however, behaves strangely in the short term. Strong stock performance alone doesn't mean you can assume the management is of high quality.
Length of Tenure
One good indicator is how long the CEO and top management has been serving the company. A great example is General Electric whose former CEO, Jack Welch, was with the company for around 20 years before he retired. Many herald him as being one of the best managers of all time.
Warren Buffett has also talked about Berkshire Hathaway's superb record of management retention. One of Buffett's investment criteria is to look for solid, stable management that stick with their companies for the long term. (Learn more in Management Strategies From A Top CEO.)
Strategy and Goals
Ask yourself, what kinds of goals has the management set out for the company? Does the company have a mission statement? How concise is the mission statement? A good mission statement creates goals for management, employees, stockholders, and even partners. It's a bad sign when companies lace their mission statement with the latest buzzwords and corporate jargon.
Insider Buying and Stock Buybacks
If insiders are buying shares in their own companies, it's usually because they know something that normal investors do not. Insiders buying stock regularly show investors that managers are willing to put their money where their mouths are. The key here is to pay attention to how long the management holds shares. Flipping shares to make a quick buck is one thing; investing for the long term is another.
The same can be said for share buybacks. If you ask the management of a company about buybacks, it will likely tell you that a buyback is the logical use of a company's resources. After all, the goal of a firm's management is to maximize return for shareholders. A buyback increases shareholder value if the company is truly undervalued.
High-level executives pull in six or seven figures per year, and rightly so. Good management pays for itself time and time again by increasing shareholder value. But knowing what level of compensation is too high is a difficult thing to determine.
One thing to consider is that management in different industries take in different amounts. For example, CEOs in the banking industry take in more than $20 million per year, whereas a CEO of a retail or food service company may only make $1 million. As a general rule, you want to make sure that CEOs in the same industries have similar compensation. (Learn more in Whom Should Corporations Please?)
You have to be suspicious if a manager makes an obscene amount of money while the company suffers. If a manager really cares about the shareholders in the long term, would this manager be paying him/herself exorbitant amounts of money during tough times? It all comes down to the agency problem. If a CEO is making millions of dollars when the company is going bankrupt, what incentive does he or she have to do a good job?
You can't talk about compensation without mentioning stock options. A few years back, many praised options as the solution to ensuring that management increases shareholder value. The theory sounds good but doesn't work as well in reality. It's true that options tie compensation to performance, but not necessarily for the benefit of long-term investors. Many executives simply did whatever it took to drive up the share price so they could vest their options to make a quick buck. Investors then realized the books had been cooked, so share prices plummeted back down while management made out with millions. Also, stock options aren't free, so the money has to come from somewhere, usually the dilution of existing shareholder's stock.
As with stock ownership, look to see whether management is using options as a way to get rich or if it is actually tied to increasing value over the long run. You can sometimes find this in the notes to the financial statements. (For more on this, see Footnotes: Start Reading The Fine Print.)
If not, take a look in the EDGAR database for a Form 14A. The 14A will list, among other factors, background information on the managers, their compensation (including options grants) and inside ownership.
The Bottom Line
There is no single template for evaluating a company's management, but we hope the issues we've discussed in this article will give you some ideas for analyzing a company.
Looking at the financial results each quarter is important, but it doesn't tell the whole story. Spend a little time investigating the people who fill those financial statements with numbers.