Does This Brokerage Stock Meet Your Standards?

With over 5,000 publicly traded stocks to choose from, researching a winner can feel more difficult than finding your soul mate. To help you pick from the thousands of potential matches for your portfolio, you should read an annual company filing usually overlooked by investors because of its lack of hard financials: the proxy statement.  Let's take a look at E*TRADE's (Nasdaq: ETFC) most recent proxy as an example.

The proxy statement, also known as the DEF 14A, gives you an up-close look at top management. Think of it as a "first date" with the board of directors. Specifically, look for:

• How is management compensated and incentivized?
• How much is management personally invested (insider ownership)?
• What experience does the CEO have?
• Who is on the board of directors?

These facts provide you with an impression of whether you should trust E*TRADE's management with your hard-earned cash and a long-term relationship. And because it's difficult to measure management with one simple ratio to screen, this gives you an edge over the rest of the market.

1. How is management compensated and incentivized?
First, managers' salaries should be reasonable relative to revenue's or profits. You don't want a relationship with a company that spends your money frivolously on pearls and golf outings.

In his first year as E*TRADE's CEO, Steven Freiberg took home $738,000 in 2010 salary and $3 million in total compensation. In future years, his salary will be an even $1 million. This compares to competitor TD Ameritrade's (Nasdaq: AMTD) CEO Fredric Tomczyk earning a 2010 base salary of $500,000 and total compensation of $5.97 million. E*TRADE seems to pass the reasonability test when one compares total revenue to salary and compensation with its competitor:

 Source: Companies' most recent proxy filings and financial statements.

A majority of the compensation might be outside of the base salary, which is great if the other compensation aligns the CEO closer with stockholders, like stock awards. Just beware that the company is not heavily diluting shares through these large stock awards.

Along with reasonable salaries, the bonus structure should be constructed to maximize shareholders' benefit for the long-term. This means giving management goals with metrics that they can control and that are not easily manipulated, like revenue, cash flow, or return-on-equity. These metrics are better than something like earnings per share, which can be massaged through creative accounting or stock buybacks.

In E*TRADE's case, management's bonuses depended on operating income, controlling unallocated corporate costs (overhead), and a much more vague metric of strategic and qualitative performance. Operating income can be somewhat manipulated by management to achieve a goal, so it's not the best metric for bonuses. Additionally, the strategic and qualitative performance metric does not set specific targets, instead relying on the discretion and whims of the compensation committee. How can management achieve a goal without a goal being set? In the end, E*TRADE could choose better bonus metrics.

2. How much is management personally invested?
Would you want a relationship with a company that didn't share your interests? Of course not. Referred to as insider ownership, this is one of Fool co-founder Tom Gardner's favorite metrics. Found under the “Security Ownership of Certain Beneficial Owners and Management” or a similar heading, you can get a quick view of how much management has riding on the success of the company.

For E*TRADE and its competitors:

Source: S&P Capital IQ.

Typically, insider ownership higher than 5% is good, but these financial companies are in a special sector where founders usually own a large stake. For example, Charles Schwab owns 15.2% [DN12] of his company, Thomas James owns 17.6% of the company his father founded (Raymond James) and Michael Gooch owns 40.9% of the company he founded, (GFI Group).

For E*TRADE, 9.6% of the 10.3% of insider ownership is board member Kenneth Griffith's and his firm Citadel, which helped E*TRADE through the financial crisis by purchasing its subprime mortgage portfolio. Last summer, Citadel actually called for E*TRADE to sell itself, showing that its ownership is more about shareholder value than passion or pride in the company. But E*TRADE CEO Freiberg is actually required to hold equity five times his base salary, which is a hefty personal investment that shows he holds the same interest as shareholders – beyond just long walks on the beach.

3. What experience does the CEO have?
This is the "small talk" section of the proxy statement. For E*TRADE, Freiberg worked at Citigroup for 30 years, and was Co-CEO of its Global Consumer Group as well as CEO of its Investment Products Division. This gives him industry experience through many business cycles and changes in trading technology. Investors can trust that Freiburg knows a little about the financial services industry.

4. Who is on the board of directors?
Like a significant other's friends, the board of directors must approve the company's major decisions, like distributing dividends. At E*TRADE, there is a balance of financial experience and technological expertise with directors from JPMorgan, the FDIC, an e-commerce firm, and even an Internet-based electronic health record firm.

Overall, other proxy statements have shown us a better time than E*TRADE's. Although management keeps compensation reasonable, incentives could be better defined, and the largest insider owner seems to be looking for a profitable exit for the company.

Now that you are prepared to enter the world of proxy statements to find that one special company, what better stock to use your new moves on than our pick for the top stock pick for 2012? Find out what that stock is in this free report!