How to Identify Quality Management

Oftentimes when we are evaluating a stock to purchase, we focus most of our attention on the more tangible aspects of the business. We look at how well the company has performed in the past financially, how healthy the balance sheet is, the future prospects of the company and the industry outlook. While these factors are important, it is also essential to assess the captain and crew that are steering the ship. Management is often overlooked because either a) its quality is too difficult to quantify or b) we figure that we can infer its level of quality from past results. While there is some truth to these statements, I believe that with a bit of sleuthing, we can identify certain characteristics that make up a good management team.

Performance

The simplest metric by which we can evaluate management is how well the company has performed under its tenure. As I've mentioned previously, a good management team is able to increase the per-share intrinsic value of the company by consistently employing larger and larger amounts of capital at high rates of return (see my previous post on evaluating businesses for more details). Simply increasing earnings while proportionately increasing the capital employed at the same rate is no special feat. If the management team has been able to consistently capitalize on increasingly profitable growth opportunities, then this will be reflected in the financial statements. Only then should the managers be praised.

Compensation

On the 10-K report that all public companies must submit to the SEC (which can be found here), there is a section detailing how the executives are compensated. Normally, this is a combination of a base salary, an annual incentive bonus, and some form of stock or options. This last form of compensation is used to "alight the interests of management and shareholders," but investors should be wary of excessive option grants. Stock options are like free lottery tickets that offer all upside and no downside; true shareholders experience the lows as well as the highs. Furthermore, long term, fixed-price options provide incentives for withholding dividends and repurchasing stock to drive up per-share earnings, rather than creating value for shareholders. Use common sense when you evaluate the compensation packages and make sure the incentives are truly in line with improving business performance.

Stock Ownership

You want managers that walk in the shoes of owners. By investing in companies that have significant insider ownership, you are paying for a management team that has its interests aligned with yours. You can easily determine who owns how much and view track recent insider transactions on Yahoo! Finance and other sites. If you are looking at a larger company worth several billion dollars, you're less likely to find management that owns a large percentage of the outstanding shares, however you can still find managers who have a large percentage of their net worth invested in the business.

Past Experience

Lastly, since you likely won't be able to physically meet or speak with the management team, you should, at the very least, look into the background of the CEO. If he has been with the company for less than five years, look to see how he has performed at his previous jobs. See if he has always been involved in the industry or if he gained his expertise in some other field. Also, while you don't have to do a full background check, see if he has been directly or indirectly involved in any lawsuits or scandals. If you see any red flags as to the integrity of the chief executive or the CFO (the man in charge of accounting...), then you may want to reconsider investing.