The One Thing You Must Know About IBM

I know it sounds ludicrous, but investors often overlook the people in charge of protecting their investments. The idea of gauging a company's leadership plays second-fiddle to other categories of analysis. However, at Fool.com we believe careful study of effective leadership is one of the most important areas of evaluating long-term winning investments.

We like CEOs who actually work for shareholders like us. After all, we're the true owners of the business. When you're deciding whether to invest in a company, failing to vet its CEO is a big mistake. In fact, if you've overlooked the study of a company's leadership, then that's the one important area you should know about before finalizing your investment in the company.

After reviewing thousands of companies over dozens of years, we've found several crucial characteristics of quality management. Today, we'll size up the recent performance of IBM's (NYSE: IBM) leadership.

How much skin do they have in the game?
Are IBM CEO Samuel Palmisano's interests aligned with shareholders? Here's how the IBM CEO's ownership compares to that of other companies in the industry.

Source: Capital IQ, a division of Standard & Poor's. Shares are common stock equivalents only and do not include options, awards, and other forms of compensation.

Samuel Palmisano actually owns $48 million worth of IBM, or 0.03% of shares outstanding. We Fools prefer CEOs who have higher ownership stakes in their businesses, since that better aligns their interests with shareholders'. However, while we think high insider ownership is a good sign, low insider ownership isn't necessarily a bad one. CEOs may be relatively new, or may have a low percent of shares outstanding, but a high total value of ownership.

How well are they using your money?
Return on equity can help investors determine how adeptly management gets the job done. This metric combines how well management is expanding profitability, managing assets, and using financial leverage, all in one ratio. While return on equity isn't foolproof -- managers can manipulate it with excessive leverage, for example -- it does an excellent job of suggesting how effective managers are, and how well they can generate high returns on investors' capital.

Despite difficult economic conditions, IBM managed to grow return on equity beyond its five-year average. Consistently increasing return on equity suggests that management is either adept at cutting costs and managing assets, or is moving the company into new high-return areas. In IBM's case, the company has moved out of hardware and created a business that's more focused on software and services. Additionally, Palmisano uses his balance sheet better than any other megacap tech company. IBM's not afraid to take on reasonable amounts of debt to make bolt-on acquisitions that contribute to the company's hardware-plus-software-plus-services model or buy back shares.

How productive are their workers?
Revenue per employee provides another way to gauge a CEO's effectiveness. If this metric is declining, the company might have a bloated organizational structure, or too many extra employees toiling away at new initiatives that just aren't working out. Either possibility would hint that management isn't effectively running the organization.

Source: Capital IQ, a division of Standard & Poor's.

As you can see, IBM's revenue per employee has moved below its five-year average. This might mean that the company's hiring too many people, or spending too much. To better see whether IBM's cost controls are actually deficient, let's compare the company to its peer group once again:

Source: Capital IQ, a division of Standard & Poor's. Dollar figures in thousands.

IBM's trailing its peer group in this category over the past five years. Shareholders should keep a wary eye on this in the coming quarters. However, note that IBM's peers have much lower revenue per employee. Especially as companies hire overseas workers for outsourcing, it pushes down their revenue per employee. When looking at IBM from an operational perspective, it has become much more efficient over the last five years.

In the end, management aims to return capital to shareholders, especially if the company can't adequately find new high-growth areas to invest in. So we're pleased to see that:

• Dividends have increased by 25.5% annually. The company's current dividend yield stands at 2%.
• Its outstanding share count has dropped over the past five years. While CEOs are often tempted to retain key talent through lavish stock option awards, this tactic can dilute current shareholders if it's used excessively. If the company's stock isn't overvalued, buying back its own shares is a very tax-effective way to return capital to shareholders.

These are just a few of the factors we look for in a company's management. If you can find leaders who continually give shareholders high returns on their capital, and align their interests with yours, you've got a better chance to enjoy market-beating returns for the long haul.