In this article on how to evaluate a company's management team, I will cover the various competencies and measures you should pay attention to and research when attempting to evaluate the management of any publicly traded company.
Over the long-term, a bad management team will almost always result in a falling stock price and dividend cuts, if previously issued. Moreover, a company's management team can greatly influence a company's success, even with companies that have the most simple business models.
Therefore, it’s extremely important that long-term investors look at the quality of a management team and attempt to make sense of their competencies through qualitative and quantitative measures, as discussed in this article.
In short, over the long-term, there's a direct correlation between a company's management team and the performance of the company. So, if a management team works together effectively and develops great products and/or services, the company will almost always grow as a result. The following sections will therefore attempt to help you make sense of evaluating a company's management, regardless of the company or industry that it's in.
The primary role of management in a publicly traded company is to create value for shareholders, which should be reflected in the form of an appreciating stock price. Of course, management also cares about their own personal gains through compensation, as later discussed.
Although a rising stock price is generally a good sign of competent management, this is not always the case. In particular, short-term stock price appreciation is a lot less indicative of a strong management team than long-term stock price appreciation.
For example, the "dotcom bubble" led to high valuations of Internet-related companies in the late 1990's, which then burst in 2001 and through 2002 when many Internet firms reported a lack of profits. Therefore, this drastic increase in short-term stock price was not indicative of a strong management team whatsoever.
One example of bad management with a company that had good long-term stock appreciation is with Enron, an energy-trading and utilities company.
In short, Enron leveraged fraudulent accounting practices to inflate the company's revenues and hide debt in its subsidiaries, which led to higher stock prices. However, once this fraud was exposed, Enron's shares went from around $90 to $0.25, and the company filed for a $63 billion bankruptcy.
So, just because a company has long-term stock appreciation, this does not automatically mean management is competent in its current state. Even if management has brought strong stock market performance in the past, this is not a guarantee for strong stock market performance in the future!
Moreover, if management fails to adopt new technologies, or if new management is brought on board, or if management struggles to find more growth opportunities for the business, these could all lead the stock price to stagnate or fall overtime.
So, although you should look at a company's overall long-term stock price when evaluating a company's management, never assume that this is completely indicative of a competent or strong management team.
When discussing a company's stock price and management, another important thing to research is just how much in compensation management is making. Management compensation is the total amount of salaries, bonuses, shares, stock options, and other benefits earned in a specific period (usually a fiscal year).
Although upper-level management typically pulls in high six-to-seven figures, it's difficult to determine how much in compensation is "too high."
You can find the U.S. executive compensation data on the SEC (Security and Exchange Commission) website. First, search for a company name or stock symbol. Then, search or scroll down to locate the most recent "DEF 14A" filing. This is where all the publicly available data on management's compensation is found.
After locating the DEF 14A filing, the first thing you can do is to look at the compensation of these upper-level management individuals and attempt to distinguish any obvious outliers. This may be more obvious in times when a company is struggling, where CEO's may be making millions, even on the verge of bankruptcy.
You can also compare the compensation of one executive in one position in an industry, to another executive in the same position and in the same industry. For example, you could compare the compensation of the COO of PepsiCo (PEP) and Coca Cola (KO), but it would not make sense to compare the compensation of these COO's to the COO of Boeing (BA), as they are in completely different industries.
This compensation figure may also be inflated from stock options, which act as an incentive for managers to increase shareholder value. These stock options are also not free, and the money may come from dilution of existing shareholder's stock, which means a decrease in how much of a company a holder owns.
As Investopedia mentions, the problem with stock options is that executives sometimes drive up the share price artificially, so that they could make a quick buck in the short-term, which does not benefit long-term investors whatsoever. Investors would then realize that the books had been cooked, and the share prices would fall, with management profiting from the fall in stock price.
So, you should look to see whether management is using stock options to make millions, or whether they are actually attempting to increase the value of the company over the long-run. This information can sometimes be found in the "notes to the financial statements" found on 10-K annual reports.
Another thing in relation to management compensation is to see whether management is purchasing stock of their company. If you see management purchasing stock, this is usually a great indicator of the stock's potential.
However, to evaluate management, what really matters is how long management holds these shares. So, if you notice that management has a history of purchasing shares and flipping them in the short-term, this is typically not a good sign of competent management.
Insider transactions must be reported within two business days, and there are quite a few ways to keep track of these transactions. Below are just three ways:
You should also be aware of any company stock buybacks, which act to maximize return for shareholders through reducing the number of outstanding shares on the market. This typically occurs when management believes its share price is too low, or when management wants to improve its financial ratios.
Stock buybacks tend to increase share prices, due to the reduction in outstanding shares, especially with companies that are considered undervalued. Therefore, although legal, if you see any short-term insider buying and selling within a company's stock buyback period, this may be a sign of an untrustworthy management team.
Besides looking at the amount of compensation upper-level management receives, along with insider buying and stock buybacks, it's important to look at the management team on an individual basis to see whether you can trust them. You can find this information by going to a company's website or through the DEF 14A filing as well.
Here are the key management positions I would focus on before looking into any other management positions (which are also important):
Start by looking at these key management positions for any company, and then evaluate other positions in upper-level management after these individuals have passed your check.
Here are a few questions I would ask myself when evaluating a management team:
By finding the answers to these questions, among the ones related to management compensation, you'll be able to determine whether you're investing in a management team that will be able to make the most out of your investment.
When investing in a stock for the long-term, you need a management team that is very communicative, which means communicating any problems to investors upfront when it occurs, and not years down the line when the problem may be affecting the business model and stock price.
In many businesses, management does not reveal these problems until it's too late, so it becomes difficult for investors to make a rational decision when this news is finally available to the public.
Therefore, this section covers the various means by which management relays their thoughts on the company to investors, and what you should pay attention to to ensure you're investing in a company with competent management.
Shareholder letters are not required under SEC rules, but many companies include a letter from the CEO in the 10-K annual reports, typically near the beginning of the report.
If the company you're looking to invest in for the long-term doesn't have any shareholder letters, I would recommend not investing in the company, as this may be a sign of a management team (typically the CEO) that isn't trustworthy or transparent enough to its shareholders.
So, you should begin by reading all the shareholder letters for the past ten years or more. By doing so, you can learn a lot of things about the business, such as how well the CEO discusses the company and its stock price, any problems and/or challenges within the business, other managerial insights, and more.
If a CEO discusses a problem or challenge the company is facing, then you should look through later 10-K annual reports to see whether the CEO addresses these problems or challenges.
For example, if the CEO talks about high levels of debt within the company and how management will lower these debt levels, then you should expect to see an update from the CEO regarding this problem in the next 10-K annual report. If not, then this may be a sign of an incompetent CEO.
In short, a management team with integrity will deal with problems and share their solutions, instead of hiding it or not sharing the full details. What better place to start evaluating a management team than with the CEO of a company?
The management discussion and analysis (MD&A) is a section in the 10-K annual reports where management discusses the company's performance since the previous period, its current financial standing, and management's future projections and goals, among other things.
This is an important section to read, as it provides investors a good idea of a company through the eyes of the company's management team, including various topics that you would never be aware of from just the financial statements.
So, you should read through the most recent and previous MD&A's to see whether management actually accomplished the goals they set in the previous year(s). If not, you should look into why, and if you cannot find a good reason, this may be a sign of an incompetent management team.
Another thing I would look at are the more recent press release archives and company investor presentation(s). You can also listen to the earnings call of a company, or skim through the transcript if you want to learn more about the financial results of a company for a particular period, among other things.
I would recommend listening to earnings calls, as analysts typically ask difficult questions to the CEO's of companies. This forces CEO's to discuss any problems happening in the business, and potentially what management's solutions may be. So, this is where you can learn more about the integrity and character of a CEO, and whether you think his/her answers are good enough for you.
The company investor presentation, in specific, is designed to convince investors to invest in their company. After viewing this presentation, you should decide whether you agree with management and their recommendation to purchase the stock at its current stock prices.
For press releases, you should focus on those in the last five years, and only those that you deem of relevance to the investment you're making. For example, any management changes, operation changes, changes to the products/services they produce, or any financial results, would all be press releases that I would read through.
You can view these resources by searching "investor relations" or "press releases" and then the company name into your desired search engine. For example, here is Coca Cola's Investor Relations page for the most recent quarter (as of writing), where the presentation and earnings call are located, and here's their Press Center page.
Something else you want to be looking at is company policy. These company policies are typically found on their websites or on their 10-K annual reports.
These policies are not actually written on paper and signed, so they are not always guaranteed. A company can actually turn back on their word at any moment, as there is no obligation or law for these companies to follow the policies they themselves made.
The way to prove if a company is following the policy they put in place, is to simply see whether they are actually following the policy they set!
For example, if a company pays dividends, you could look at a company's history and look to see whether they are actually paying a percentage of their profits as dividends. If they're constantly doing it and they haven't missed a single year, then you can probably put more trust in their management and expect them to continue to follow their policy in the future.
Another thing that ties into policy are the goals management has set for the company, if any.
In particular, you should look to see whether the company has a mission statement, and then determine how concise this mission statement is. You may not want to invest in a company with a mission statement full of corporate jargon and buzzwords, which managers supposedly follow.
Although determining a management's competency is largely a qualitative process, there are still a few ratios you should calculate or find to provide you with a better overall understanding of a company's management.
In general, you should be looking at two things here, capital allocation and debt management.
Capital allocation refers to the decisions management makes in order to grow their investments as much as possible. Management has many choices on where to invest company money, including acquisitions, inventory, research and development, stock buybacks, and more.
Regardless of the investment, management is hoping to get back more than their initial investment. So, if we're able to assess how good management is at capital allocation, then we'll be able to generate a profit in the long-term.
Debt management is all about companies taking on a level of debt that does not put the company at risk of default. Debt is simply an easy way for managers to make investments within the business, especially when management believes they can leverage this debt to make even more money within the business.
However, when this debt becomes unmanageable, this can lead to sharp decreases in the stock price, if not bankruptcy. Therefore, we want to be investing in businesses that are not taking on too much debt, which is a sign of competent management.
Below is a table with five useful ratios (among others) I would find that will help you make sense of a company's return on capital allocations and debt management abilities.
|Return on Equity (ROE)||ROE = Net Income / Shareholders' Equity||Measures how effectively management is using its equity to generate profits.|
|Return on Invested Capital (ROIC)||ROIC = NOPAT / Invested Capital||Shows how efficiently a company is using is capital, and whether or not it will be able to generate substantial returns from this capital.|
|Current Ratio||Current Assets / Current Liabilities||Measures how well a company can meet its short-term debt obligations with its current assets.|
|Debt-to-Equity Ratio||Liabilities / Shareholders' Equity||Evaluates how much of a company's capital structure is leveraged with debt or equity financing.|
|Operating Margin||Operating Margin = Operating Income (EBIT) / Revenue||Indicates how well a company's management controls non-operating costs.|
After you find these ratios, the best practice is to compare it to other similar companies or the industry average, and then see where it stands. Afterwards, you would use your previous qualitative company management analysis to determine whether you'd want to invest in this company.
Although not straightforward, attempting to evaluate a company's management will provide you with a better understanding of how the company has grown, what it's currently doing to grow, and what the growth outlook is for the future. Much of this also cannot be determine by just looking through numbers on a financial statement.
In summary, the decisions management makes on a day-to-day basis will directly impact how much cash a business produces over the long-term. In other words, all of the decisions management makes, small or large, will impact the business and how profitable or successful the business will be overtime. This is why it's crucial to invest in companies with strong management.