Identifying Effective Management

Would you walk up to a guy on the street and ask him to manage your life savings? Why, then, would you invest in a company without investigating its management?

Identifying a strong management team is not always easy, but it's well worth your time. Here are some things to consider.

Managing costs
The costs we are most interested in fall under the "selling, general, and administrative" (SG&A) heading in the company's income statement. SG&A varies by industry, but generally the category includes all direct and indirect sales costs -- such as commissions, advertising, and travel -- plus management salaries and compensation, rent, and utilities. Companies have significant control over SG&A, so it's a good metric of how efficiently a company operates.

SG&A divided by total sales tells us how much the company spends to bring in each dollar of revenue. We like to see low numbers here. And a ratio that declines over time indicates a company that's generating revenue more efficiently. However, be wary of companies that cut costs without increasing revenue. Revenue growth is repeatable; cost cuts are not.

Return on invested capital
Return on invested capital (ROIC) adds significant muscle to return on equity (ROE). ROIC paints a clear picture of how well management is allocating all of the cash that shareholders and lenders have invested. The basic equation is:

ROIC = after-tax operating earnings / invested capital

Declining ROIC is a warning sign -- it means that management is investing in projects with decreasing returns. It's also important to compare ROIC with the cost of capital. A company that's paying more for its capital than the returns generated on that capital is destroying shareholder value.

Calculating ROIC takes a little work. But the Fool helps you understand it as part of its Foolish Fundamentals series.

Management ownership
Management teams that own a significant portion of the company themselves -- say 10% to 40% -- are more likely to run the company for the benefit of shareholders and less likely to engage in practices that threaten shareholder value.

However, when majority ownership is concentrated in the hands of a few, be wary: Their incentives may differ from your own. Steve Jobs, for example, owns 50.5% of Pixar's (Nasdaq: PIXR  ) outstanding shares. So when Disney (NYSE: DIS  ) came knocking, the only shareholder it had to win over was Jobs, who negotiated a deal pricing Pixar shares at a very small premium to their current value below the recent high. Investors may wonder whether some attractive personal incentives, including becoming Disney's largest shareholder and gaining a seat on the Disney board, may have persuaded Jobs to ink a deal quickly.

Also be aware of different share classes and their limitations. Google's (Nasdaq: GOOG  ) B-class shares, owned almost exclusively by the founders and other insiders, grant 10 times as many votes per share as the A-class shares do -- and those are the ones that public investors own. As a result, insiders control more than 80% of the voting rights. With such little collective say, A-class holders essentially cede complete control of their investments. That's not necessarily bad, but it is worth your time to do some extra homework to make sure that you trust management's motives and philosophy.

Management loyalty
We like managers who are loyal to a company. Jack Welch's reign at General Electric (NYSE: GE  ) is a prime example. He spent 21 years at GE before becoming CEO. Through his service, Welch learned about the strengths and weaknesses of the company's operations and built relationships with employees at all levels. This knowledge was instrumental to his success as CEO. As a result, between 1981 and 2001, he oversaw a nearly fivefold increase in revenues and helped build GE into the largest company in the world.

Warren Buffett rarely considers investments in companies without strong and loyal management teams. The Nebraska Furniture Mart is a prime example. In 1983, Berkshire Hathaway (NYSE: BRKa  ) purchased 90% of the store from the Blumkin family, but Buffett kept the family management team. After all, who would know the business better than the people who had started and grown it for 46 years?

Management compensation
Compensation should reflect management's contributions to the successes, not the failures, of a company. Let me relate a short fable about compensation excess. Once upon a time, in a land not so far away -- OK, in 2001 in San Francisco -- E*Trade (NYSE: ET  ) was ruled by a CEO named Christos Cotsakos. In the course of a year, Cotsakos guided the company from a $19 million profit to a $242 million loss. To acknowledge such an amazing feat, the E*Trade board increased his salary and bonuses by 150% to nearly $5 million. Believing that Cotsakos might still feel underappreciated, the board awarded him an additional $80 million in other compensation. And everyone lived happily ever after.

Well, not quite. In 2002, under a flurry of investor backlash, E*Trade lost 56% of its market value. And in January of 2003, Cotsakos "resigned" -- but don't feel bad for him. He got $4 million in severance and millions more annually from his retirement plan.

Among the myriad problems with such outrageous payouts, here are two: First, executives who receive lavish compensation, especially after poor performance, have distorted incentives. Some executives, fueled by egos and limited board oversight, forsake shareholders and make the company their personal ATM.

Second, boards that approve large compensation packages are often overly beholden to management and are therefore unlikely to protect shareholders from greedy hands. The WorldCom board, ruled tightly by CEO Bernie Ebbers, granted $400 million in "loans" to Ebbers, for example, while failing to identify dangerous investment practices and accounting irregularities. Ebbers' mismanagement led to one of the largest bankruptcies in corporate history. Similarly, Tyco (NYSE: TYC  ) CEO Dennis Kozlowski and CFO Mark Swartz skipped board approval altogether in allocating themselves $120 million in bonuses -- part of the reason for their matching eight-year prison terms. Tyco managed to survive, but investors lost billions of dollars.

Conclusion
Management deserves to be rewarded for great performance, but they should never forget that they manage the company for the shareholders, not for their own enrichment.

Remember, when you invest your capital in stocks, managers are responsible for it. So always make sure you see:

1. Low SG&A expenses relative to revenue.

2. High ROIC relative to cost of capital.

3. Management that has a significant interest (10% or more) in the company, though management that owns a controlling stake (more than 50%) warrants further investigation.

4. Executives who have spent many years with the company. They will have a better understanding of the product, company operations, and market, and they will generally exhibit stronger loyalty to the company and its shareholders.

5. Reasonable executive compensation and active, independent boards. Excessive compensation is a good indication that the board may not have shareholders' interests at heart.

Your hard work should be duly rewarded over the long run.

Related Foolish content awaits:

Pixar is aMotley Fool Stock Advisorpick. Tyco has been recommended inInside Value. Check out any of our investing newsletters free for 30 days.

Please send Jim Schoettler your comments or questions on this article. He does not own shares in any of the companies that appear in this article -- though he did a stint at E*Trade in the late '90s. The Motley Fool has a disclosure policy.


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