How We Find the World's Best Companies

"Once, after interviewing a CEO in person, I wanted to sell the stock so quickly that I risked a speeding ticket driving back to the office!"

That's what a fund manager once told Tom Gardner and me when we were chatting about how to best evaluate a company's management team.

Luckily, you don't need face-to-face visits to determine management's strength and competency.

Eat your OATS
Although face-to-face meetings can be helpful, you can glean a lot of the same information with a little armchair research.

Here's a checklist Tom and I use when evaluating possible recommendations for Motley Fool Stock Advisor members.

1. [O]wnership
We here in Fooldom believe in insider ownership. We like it when managers own significant chunks of the company they're running. The reason is quite simple: We believe there is no greater motivator than having management's net worth strongly tied up in the ship it's steering.

That alignment of management with the shareholders causes these executives to make decisions based on what's absolutely best for the company in the long term. And, as investors, that's exactly what we want.

The alternative is a little too familiar these days. Much of our economy's pain can be tied to managers who were incentivized to only think about the short term and who couldn't have cared less if the decisions they made wreaked havoc a few years down the road.

2. [A]llocation
Warren Buffett has said that the allocation of capital is management's most important function. What is running a company, after all, but turning cash into more cash?

To measure how effectively management does this, check out the metrics that begin with "return on": return on invested capital (ROIC), return on equity (ROE), and return on assets (ROA).

ROIC is probably the best of these, but it involves quite a few assumptions and a lengthy calculation. If you're short on time or calculating mojo, ROE and ROA serve as good substitutes and are readily available on your favorite quotes page.

The higher the ROE and ROA figures, the better return the company's managers are providing on the investments. One year's numbers are interesting, but the trend is what you want to pay attention to. Don't forget to compare those numbers with other companies in the same industry.

3. [T]enure
A fascinating study in the book Secrets of Greatness shows that the world's greatest athletes, chess players, musicians, and businesspeople have (1) spent at least 10 years at their craft, and (2) practiced it constantly. There's almost no getting around these two rules.

As you've guessed by now, great management includes having had a lot of practice -- competing through all the economic ups and downs and constantly thinking about the business plan, products, and competitors every day for years.

4. [S]tewardship
A good steward is a careful and responsible manager. We have a golden rule of investing: We want our managers to treat shareholders just as they'd like to be treated if the roles were reversed.

This includes running an open and transparent operation when it comes to shareholder relations. It means no exorbitant salaries that are out of line with value created. It means using stock options as a valuable recruitment and retention tool, not a wealth-creating machine that dilutes other shareholders.

There's no number or metric available that sums up the quality of stewardship, but it's worth a bit of research to find out.

What's out there now?
I ran a screen similar to the one that Tom and I use to identify well-managed companies for Stock Advisor. It looks for companies with insider ownership greater than 5%, return on equity better than 15%, and well-seasoned managers.

Here are a few of the companies it found:

Data from Capital IQ and MSN Money.

Of course these aren't formal recommendations, but great management is a good place to start further research.

Beating the market
Great management isn't the only important attribute of a great investment, but it's an important one. Our OATS checklist has helped Tom and David Gardner outperform the S&P 500 by 44 percentage points since Stock Advisor was launched seven years ago. Right now, a 30-day free trial will show you all the stocks they've recommended, including their five best buys now. Click here for more information.

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Rex Moore has set aside next Thursday to ponder the mysteries of the universe and the meaning of life. He owns shares of Microsoft. Green Mountain Coffee Roasters and Google are Motley Fool Rule Breakers picks. Amazon.com is a Stock Advisor selection. Microsoft is an Inside Value selection. The Fool has a disclosure policy.