Do Your Stocks Have This Vital Component?

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"In any great adventure that you don't want to lose, victory depends upon the people that you choose."
-- Brave Sir Robin in Monty Python's Spamalot

Warren Buffett once warned, "Beware of geeks bearing formulas." However, I'm confident that the formula I'm about to share with you is one even he would cherish.

After all, this formula is based on the way the Oracle of Omaha himself operates when running Berkshire Hathaway (NYSE: BRK-A), as well as on characteristics he demands in companies he's looking to purchase.

In a word, it's management. But the specific formula I'm about to outline for you -- created by the team of analysts at the real-money Motley Fool Million Dollar Portfolio (more on that in a moment) -- will give you all the qualities you must thoroughly vet before adding another stock to your portfolio.

1. Ownership
It's no surprise that insider ownership is critical in a discussion of management. After all, you want the CEO to experience success only when you are successful, making money when the stock is doing well.

High insider ownership usually coincides with conservative management tactics. When a manager has most of his net worth tied up in the stock of his company, you can be sure he will not take careless risks. Which means that you can sleep at night.

There's no set number to go by here, but it's a good idea to look at companies with CEOs who own 10% or more of their company -- like Google (Nasdaq: GOOG), Oracle (Nasdaq: ORCL), and even foreign giants like ArcelorMittal (NYSE: MT).

But ownership alone is not enough. Even CEOs with their net worth on the line can -- and do -- get greedy and careless. Which is why you also need the remaining three parts of the formula.

2. Allocation
As Robert Hagstrom Jr. writes in The Warren Buffett Way, "The most important management act is the allocation of the company's capital ... [A]llocation of capital, over time, determines shareholder value."

The metric that clearly shows just how much economic value a manager is generating is return on invested capital (ROIC). You could also check out return on equity (ROE), but the ROIC calculation takes a company's debt load into consideration, meaning a company is not rewarded for a highly levered balance sheet.

3. Tenure
The Million Dollar Portfolio team admits this one seems simple, but they say it's also the one management quality that is overlooked the most: You want a management team with experience. Forbes says mastery takes at least 10 years to develop, so that's the minimum you should look for.

A decade's worth of running a business should give the CEO knowledge of its long-term cycles, as well as experience with how to manage the company through both up markets and down.

A management team that passes the test here includes the CEO and COO at Leucadia National (NYSE: LUK), who took over management of the company in the 1970s. A company that would not pass this screen is Hewlett-Packard (NYSE: HPQ), whose CEO has been running the show only since 2005.  

4. Stewardship
This last quality to look for in managers takes more digging, but it is essential. It involves searching to see whether the CEO is more concerned about making himself wildly rich, or protecting -- and growing -- your invested capital.

Be on the lookout for things like a compensation package that dishes out options handily whether the executives outperform or not. It's much better to see executives getting rewarded in cash when they grow free cash flow, rather than making money from growing GAAP earnings (which can be manipulated).

One manager who clearly stands out here -- who, in my opinion, is one of the most respectable capitalists of our day -- is Costco's (Nasdaq: COST) Jim Sinegal.

Just how worthy of admiration is Sinegal? In 2006, when "imprecision" in its stock-option granting process surfaced (nothing criminal, mind you, just an inaccurate calculation), Sinegal voluntarily forfeited his $200,000 bonus that year to show solidarity with the common shareholder. Imagine what the economy might look like if bank CEOs took similar responsibility for the decisions they made!

Putting it all together
Running through all these management qualities is a smart exercise when vetting any candidate for your portfolio. The Motley Fool Million Dollar Portfolio team values it so much that often, "poor corporate governance might be enough to disqualify a company from being included in our portfolio."

Truth is, this is just one of many proprietary formulas the team at MDP has created. They also have one for finding new stock ideas, one for valuing companies, even one for ranking stocks to determine which offers the most attractive buying opportunity for new money.

Unfortunately, out of respect for current Million Dollar Portfolio members, I can't share all these formulas with you right now. But we are reopening the doors to the service for the first time in more than a year, in just a few days. Which means you can not only see these proprietary formulas, but you can also track the team's portfolio advice and see which stocks are deserving of the Fool's real money. Just enter your email address in the box below for more information.