How to Spot Model Management

If you have children, know children, or have dined with children, then you've witnessed this pre-meal exchange:

Parent: Did you wash your hands?
Children: Yes.
Parent: Can I smell your hands?
Children: We'll be right back.

A simple and effective way to trust ... but verify.

Management's paws
There's an investing parallel here.

Think about what traits you want to see in a company before you buy shares. If nothing immediately pops into your mind, consider what master investor Warren Buffett looks for:

1. Profits.
2. Consistent growth.
3. Good returns on equity.
4. Understandable business plan.
5. Committed management.

I'm not one to put words in the Oracle of Omaha's mouth, but it seems to me that that last trait -- committed management -- is the most important of all. After all, they're the ones responsible for any profits, growth, returns on equity, and future business plans.

But how can an investor know whether management is committed to the business?

Here's how to smell their hands
A CEO who's motivated to reward a company's employees, customers, and shareholders is the best kind of CEO. The only way he or she can do so is to be an employee, a customer, and a shareholder.

This sounds easy enough, sure, but it doesn't always happen. So before you invest in any stock, check to see whether a company's insiders own shares, and if so, how many. You might also check whether they have been buying large amounts of stock (generally a positive indicator) or selling large amounts (generally a negative indicator).

After all, if management has its wealth tied up in the firm's future, they at least have some incentive to help the company and shareholders succeed.

Some examples ...
Now, not all insider ownership is created equal. To prove it, here are five companies with high levels of insider ownership, according to a screen I ran on Yahoo! Finance:

Wal-Mart looks like it has a huge amount of insider ownership, but those shares are actually held by Helen Walton, the widow of Wal-Mart founder Sam Walton. While Wal-Mart was very much an insider-driven business many years ago, Mrs. Walton is not active in the company's day-to-day operations.

Oracle, eBay, and Infosys are good examples of companies that were built into giants by founding entrepreneurs. The founders who own stakes in each of these companies remain involved with operations, but these companies are enormous today, and it's much harder for management to impart its passion throughout the company.

Crocs is an interesting example, because insiders own a good percentage of the shares, yet the company remains relatively small (market cap of $3.4 billion). Insiders, however, have been doing a lot of selling recently -- a trend that should give investors pause.

In short, insider ownership is more than a percentage. It's just as important to look at who owns shares, what they do at the company, and what they've been doing with those shares lately.

It's Foolish, too
At our Motley Fool Hidden Gems small-cap investing service, Fool co-founder Tom Gardner and co-advisor Bill Mann make committed management one of their primary criteria. As Tom has said, "What we look for in our small companies is rising demand for their products, a great business model, a firm financial foundation, and forthright managements that hold a significant stake in their business."

To see all of the stocks they've found that meet those criteria, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart and eBay. Wal-Mart is a Motley Fool Inside Value recommendation. eBay is a Motley Fool Stock Advisor recommendation. The Motley Fool is Fools writing for Fools.