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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.
Tutorial: Behavioral Finance
The Job of Management
A strong management is the backbone of any successful company. This is not to
say that employees are not also 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. Management is to 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 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 managements that stick with their companies for the long term. (Learn
more in Management Strategies From A Top CEO.)
Strategy and Goals
Ask yourself, what kind 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 buzz words 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 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.
Compensation
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 managements 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.
by Investopedia Staff