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
Also be aware of different share classes and their limitations. Google's
Management loyalty
We like managers who are loyal to a company. Jack Welch's reign at General Electric
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
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
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
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 a Motley Fool Stock Advisor pick. Tyco has been recommended in Inside 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.
