Assessing a management team's quality is notoriously difficult. Take Enron, which was hailed for years as the "most innovative" company among the Fortune 500. (Most innovative for financial trickery, perhaps.) As a result, many investors throw up their hands in frustration and simply judge management based on the quality of financial results. That's not a bad route to take. But there are other tools at your disposal, including what I believe to be the most underutilized financial statement of all: the proxy statement.
The proxy, codenamed DEF-14A (don't ask), can sometimes reveal significant clues about whether management is acting in the best interest of shareholders. This SEC-required document is filed once a year shortly after the 10-K annual report. In the proxy, you'll find managers' professional backgrounds, compensation (including options grants), inside ownership, and more.
I make the proxy part of my required-reading list whenever doing serious due diligence. It's the best readily available resource I know of for getting an idea of whether management has the best interests of shareholders in mind. What follows are some of the more-interesting findings from a handful of small-cap company proxies I've looked at in the recent past. None of the companies mentioned below is a Foolish 8 candidate, but their lessons apply to any small company you might be considering for investment.
Managers who behave like owners
One of the best aspects of the proxy is that it allows you to follow the money. Compensation for managers, directors, and auditors is all laid out. I especially pay attention to management compensation and bonuses and check to see if pay is in line with performance.
Taking a look at the proxy of online advertiser ValueClick (Nasdaq: VCLK), here's an interesting tidbit I discovered about their CEO, James Zarley: During 2000, Mr. Zarley earned a base salary of $252,083 and no bonus. According to a footnote, his salary decreased in August 2000 from $300,000 to $200,000. Later on in the proxy, I discovered this very interesting explanation about the salary decrease: "In August 2000, Mr. Zarley volunteered to reduce his base salary from $300,000 to $200,000 in order to help ValueClick reduce its operating expenses." That's the type of shareholder-friendly salary decision that I like to see. (This type of decision making, along with other attractive aspects of the company's valuation, are why I own the stock.)
Egregious employment agreements
Another application of "following the money" is checking the reasonableness of a company's executive employment contracts. Not only are today's executives getting paid exorbitant sums, but sometimes they're locked into contracts that allow them to earn multiples of their annual compensation in the case of death or change of company ownership. Such was the case when I looked at the 1/29/01 proxy of Resource America (Nasdaq: REXI), a $125 million (revenue) financial services firm.
In September 2000, Mr. Daniel Cohen resigned his position as president and chief operating officer upon the sale of Resource America's equipment leasing operations. As a result, he received severance compensation (according to the terms of his employment contract) of $2.2 million. This sum is especially outrageous when you consider that the company only earned $18.2 million in net income for all of fiscal 2000. In essence, shareholders took a 10% hit in that year's earnings because of the overly generous employment contract.
Reading the details of these employment contracts can be a great way to determine whether the small-cap company you're looking at is interested in building shareholder value or just serving as a conduit through which management can pay itself huge salaries.
Related party transactions
Finally, here's an example from the "Hmmm, something smells funny here" department. The "Relationships with Related Parties" section near the bottom of most proxies is something you'll always want to give close inspection to. For Titanium Metals (NYSE: TIE) -- a $570 million (revenue) producer of titanium -- this section revealed a slew of suspicious-looking relationships. According to the filing, Mr. Harold C. Simmons owns a controlling interest (47%) in the company through a complex web of related companies, all of which are party to intercorporate transactions.
Here are two short excerpts from the proxy that I think will give you a flavor for what a bizarre situation this represents:
Harold C. Simmons is Chairman of the Board and Chief Executive Officer of TGI, Valhi, VGI, National, NOA, Dixie Holding, Dixie Rice, Southwest and Contran. Mr. Simmons is also Chairman of the Board and Chief Executive Officer of NL and a director of Tremont. By virtue of the holding of the offices, the stock ownership, and his service as trustee, all as described above, Mr. Simmons may be deemed to control the entities described above, and Mr. Simmons and certain of such entities may be deemed to possess indirect beneficial ownership of the shares of Tremont, Valhi, NL and TIMET [Titanium Metals] Common Stock held directly by certain of such other entities....
TIMET [Titanium Metals] may be deemed to be controlled by Harold C. Simmons. Tremont and other entities that may be deemed to be controlled by or related to Mr. Simmons sometimes engage in (a) intercorporate transactions with related companies such as guarantees, management and expense sharing arrangements, shared fee arrangements, tax sharing agreements, joint ventures, partnerships, loans, options, advances of funds on open account, and sales, leases and exchanges of assets... which transactions have involved both related and unrelated parties and have included transactions that resulted in the acquisition by one related party of a publicly held, minority equity interest in another related party.
So we have a CEO who runs nine different companies, all of which "sometimes engage" in a whole host of potentially unsavory financial transactions. While I haven't done enough research to determine whether this situation is as seedy as it looks, I steer clear of companies like this that have such blatant potential for funny business.
Conclusion
This is no April Fool's joke -- for a publicly available document, the proxy provides a remarkably frank view of management and its dealings. One successful small-cap fund manager I know says he uses the proxy as his first means of discerning whether a company might be an attractive investment prospect. It makes sense -- if there's dirt to be found on a company, oftentimes it's right there waiting to be found in the proxy.
Matt Richey is a senior writer-analyst for The Motley Fool. He welcomes your feedback at [email protected]. At the time of publication, Matt owned shares of ValueClick. The Motley Fool is investors writing for investors.
