Bad management can make a good business look lousy, and corrupt management can make a terrible business look great, which is even worse.
Unfortunately, bad management can be difficult to detect. While you can see deteriorating margins by looking at financial statements, there's no balance sheet item that says, "Management Integrity: 2/10." And even if there were, would you trust management's disclosure of such a metric?
Six signs that something is wrong
One way to approach the problem is to look for warning signs. These are some of the questions I ask:
1. Is the business impossible to understand? The management of a multibillion-dollar business should always understand how their business makes money. Management should also have good communications skills. If the company's leaders are unable to effectively communicate (through SEC filings) what their business is, what risks it faces, and how it makes money, be suspicious.
Do they not understand the business, or rather do they not want to communicate with shareholders because they might be hiding something? Neither of these options gives me a warm fuzzy feeling. One of the first signs that Enron wasn't what it seemed was that analysts couldn't figure out how it made money.
A variant of this flaw is when the numbers don't make sense. For instance, if a business constantly shows profits but never shows positive cash flow, that can be a warning sign. WorldCom, for instance, had capital expenditures far above its depreciation, partly because it was incorrectly booking day-to-day expenses as capital expenditures, inflating that number.
2. Does the company have questionable business practices? If the company repeatedly makes dreadful business decisions or decisions based on short-term factors, that's a sign that management is inept, not focused on maximizing the value of the business, or simply trying to deceive shareholders. Questionable business practices come in all shapes -- stuffing channels to meet quarterly projections, advisor kickbacks for directing business to certain parties, hiding balance-sheet debt, and so on.
3. Is management compensation unreasonable? If management compensation seems unreasonably high, then it can be a sign that management is looking after its own interests first and foremost, leaving shareholders in the dust. In general, compensation should be judged relative to the company size and standard industry practices. DHB Industries (AMEX:DHB) has been noteworthy in this area. For seven years, its CEO received 10% of the firm's profits. In 2004, he made $73 million, mostly from options -- which was almost 50% more than the company's profits. DHB evidently felt this wasn't enough, because it then awarded him warrants to purchase 5 million shares at a buck each, significantly below market price.
4. Is management less than candid? Management should be willing to speak honestly with shareholders about the performance of the business and their plans to address any problems. Management should not constantly make excuses for poor performance. Rather, they should address troubling issues in a comprehensive way. The financials should be easy to understand, not clouded by suspiciously recurring "one-time" charges. Pro forma results should be used to provide insight into operations, not to sweep the bad stuff under the carpet.
5. Does management fail to follow through? If management makes promises but fails to follow through, or simply makes excuses for their performance, that's worrisome. Take HRPT Properties Trust's (NYSE:HRP) waffling around share repurchases. In December 1999, the company announced that it was selling part interest in its properties to repurchase shares because management believed the "value of its common shares does not reflect the higher value of its underlying real estate and operations." Six months later, with the stock price even lower -- presumably more attractive than before -- the company decided not to bother with the repurchase.
That's unusual, but perhaps not so surprising considering that the company is managed by an external company compensated based on HRPT's acquisitions, not returns to shareholders. Moreover, as HRPT wrote in its most recent 10-K, "Our fee arrangement with RMR could encourage RMR to advocate property acquisitions and discourage property sales by us."
And through a huge REIT bull market, HRPT has dramatically underperformed other office REITs such as Vornado (NYSE:VNO) and Boston Properties (NYSE:BXP).
6. Has management ripped off shareholders? Of all the red flags, this one is the most serious. If management has historically abused shareholders, then they're likely to do so in the future. And there are degrees of abuse. On the mild side, you have companies like Nike (NYSE:NKE) that give executives low-interest loans, then generously forgive them. In the middle, you have the former management of Tyco (NYSE:TYC) or current management of Aaron Rents (NYSE:RNT) using corporate assets to fund extravagant lifestyles. At the extreme, you have management pillaging the business by selling themselves parts of the company at generous terms.
In most cases, a single red flag may not be enough to eliminate the company as a candidate for investment. After all, I think the majority of public companies have at least one of these issues. So it's important to decide for yourself which issues are scary enough to steer clear of.
The Foolish bottom line
The issue is particularly important for value investors. We try to pick up companies that are trading at low prices because they're out of favor with the Wall Street crowd. But often, companies are unpopular because they're known to have less-than-stellar management. So it's critical for value investors to be able to identify bad leadership to avoid companies that are cheap because they just aren't all that valuable.
If you want to see how we do it, you can check out our Inside Value newsletter here for free. Not every company we pick is squeaky clean, but we discuss cases where we think management could be an issue, so that you'll have our best information when evaluating a potential buy.
Fool contributor Richard Gibbons considers it tragic that the majority of public companies have one of these issues. He does not have a position in any security discussed in this article. Tyco is an Inside Value recommendation. HRPT is an Income Investor recommendation.
