The quality of a company's management is one of the hardest things investors must evaluate when researching a stock. In order to simplify that process, the Fool's Million Dollar Portfolio has developed a powerful framework based on just four characteristics, against which you can assess any CEO and executive management using easily obtainable information. Becoming familiar with this framework can help you become a better investor.
Does the CEO have any skin in the game? A high level of stock ownership helps to align the CEO's interests with those of shareholders , so that leaders become partners, rather than hired guns. Furthermore, as I described here, a high ownership stake is an excellent indicator of stock outperformance.
Marc Benioff, the co-founder and CEO of salesforce.com (Nasdaq: CRM ) , remains the company's second-largest shareholder with an 8.2% stake. Fred Smith owns almost 5% of the delivery and logistics giant FedEx (NYSE: FDX ) . Both stocks have routed the S&P 500 since they went public; I expect they will continue to outperform over long periods (however, Salesforce.com's current valuation looks dissuasive, at 84 times the next 12 months' earnings).
Allocation of capital
One of the CEO's most important responsibilities – arguably the most important -- is the allocation of shareholders' capital. Over the long term, stock returns will match the economic return the firm earns on its equity capital (assuming insiders are not appropriating these gains for themselves; we'll get to that in "Stewardship" below). As such, the CEO's capital allocation decisions will have a vital impact on investor returns.
No need to complicate things here: Just look at the returns a company has historically achieved as a result of its decisions. Return on equity (ROE), return on assets (ROA) and return on invested capital (ROIC) figures are all useful in this respect.
Over the past five years, food distributor Sysco (NYSE: SYY ) and conglomerate 3M (NYSE: MMM ) have achieved average returns on capital of 24% and 21%, respectively. Anything greater than 15% over a sustained period is excellent by any standard, and those numbers put both companies within the top 20% of their respective sectors. During this period, Sysco took advantage of the downturn and its low cost of financing to buy smaller competitors. As the economy improves, those acquisitions will turbocharge growth, validating a very smart use of capital.
Tenure, or the length of time the CEO has served in that role, is tightly linked to performance. For example, a long tenure increases a CEO's managerial freedom, thanks to the credibility and trust he or she has built with the board of directors.
Firms in which the CEO has more leeway exhibit a wider range of performance than those in which the CEO has less discretion. In other words, a powerful, competent CEO will make a larger positive impact on the company's performance. (It goes without saying that you should give a wide berth to companies run by powerful, incompetent CEOs.)
Recently, executive search firm Spencer Stuart found that, excluding founders, only 28 CEOs of S&P 500 companies have been in place for more than 15 years. Of those 28 companies, 25 have beaten the index during the CEO's tenure. Two superstars among this elite group include top performer Peter Rose at Expeditors International (NYSE: EXPD ) (start year: 1988), and Daniel Amos at insurer Aflac (NYSE: AFL ) (start year: 1990).
The last characteristic, stewardship, is the most difficult to assess. You're looking for a CEOs who clearly understand and respect their fiduciary relationship with their shareholders. The CEO is entrusted with shareholders' capital and has nothing less than a moral obligation toward them. This may sound quaint, but I've found that when a CEO sounds a bit old school in discussing his/ her responsibilities, it's usually an excellent indicator.
Berkshire Hathaway (NYSE: BRK-B ) CEO Warren Buffett sets the standard on this measure. Buffett's annual Chairman's Letter is a model of clear and informative communication; he receives a modest salary; and he has never awarded himself a single option that would dilute shareholders. In short, he treats his shareholders as genuine partners, not lambs to be fleeced.
Putting it all together
Companies with CEOs who score highly on all four criteria are very rare. Berkshire is among them, so it's no surprise that it is one of the largest positions in the Million Dollar Portfolio's real-money portfolio. The service, which selects the best stocks from across The Motley Fool's newsletters, opened to new members during a short period starting yesterday – the first opportunity to join in more than a year. If you'd like to find out more about putting the team's market-beating approach to work for you, simply enter your email address in the box below.