Analyzing the Management

Every now and then we hear how a dying company was turned around from a losing business to become a profitable business. Unfortunately, we also hear how great companies and great stocks become worthless overnight. The success or failure of the company to a great extent depends on the top people running the company, also known as the top management.

Before a company hires an employee, the company will analyze the potential employees through interviews. But how do you, as an average investor analyze the top executives? You rarely get a chance to meet them, let alone interview them.

Fortunately, you could analyze the management in other ways such as assessing their compensation, character and execution.

Compensation

Get a copy of the proxy statement from www.sec.gov or www.freeedgar.com. Here is a sample of Google Inc's proxy statement. Look for the “Summary Compensation Table”. Here you will see how executives are paid and what perks they get.

1. Generally, big bonuses are preferable to big base salaries. If a significant portion of the management's compensation is via bonus, then they are at risk of losing this bonus if the company performs poorly. This should motivate the management to align themselves with the company's objective which is to maximize profit and stockholders.
   
   
2. Restricted stock grants are preferable to stock options. This is because with restricted stock grants the wealth of the executives is directly tied to the market price of the shares.
   
   If the executives were given an option to buy the shares at $10 and if the market price falls to $9, the option no longer has any value. It doesn’t matter to the executives if the price is $8, $7 or even less. However, if the executives were issued restricted stock grants at $10, and when the price falls to $9, his wealth also reduces to $9. And if it falls further, his wealth shrinks further. Therefore, there is a strong motivation for the management to keep the share price up with restricted stock grants.
   
   
3. Compare the compensation plan with other companies within the same industry or same size. Generally, the larger the company and the better its financial performance, the more the executives should be paid. However, if your gut feel is telling you the compensation is too high, then it probably is.
   
   
4. Bonuses should be tied to the company’s performance. And if the company’s performance fails to meet targets, then the executives’ bonuses should be reduced accordingly. If midway through the year, the management decided to revise to a lower target but the bonuses remain the same, then the management is taking the stockholders for a ride. The reason management lowered the target is because they knew the company's performance will fall short and by lowering the targets they will be entitled to the full bonuses when the company's poor performance meets the lower target.
   
   Do be cautious when considering investing in companies if the management lowers their targets but keeping their bonuses the same. This is a sign of disrespect to the stockholders.
   
   
5. Are the executives standing along side the stockholders? It is preferable for executives to hold stocks in the company. This should motivate the executives to run the company as if it was their own.
   
   

Character

As a business owner, you want people with integrity to run your business. If your business is run by shady characters, then you will always wonder if the management is doing their best, hiding information or ‘stealing’ from the company.

1. In the 10-K filing, look for a section called “Related Party Transactions”. This is where you find all business dealings between the company and the companies owned by the executives, his families and/or relatives. There is no need to worry if business dealings were transacted at arms length. However, these could be signs of deeper problems. In any case, you should shy away if the company is paying substantial amounts of money to companies run by the executives’ families or relatives.
   
   
2. Is the management honest about its mistakes? CEOs who bury their mistakes may hide other things as well.
   
   
3. Is there a high turnover in the top management? This could be assessed by looking at proxy statement for several years. Long tenure is a great sign the executives are motivated and confident in the future prospects of the company. On the other hand, high turnover could mean bleak company potential, internal politics and power struggle. If there is high turnover for key finance personnel such as the CFO, this could be due to the management trying to interfere with the accounting treatments to boost the company's performance.
   
   

Execution

At the end of the day, how much profit a company makes depends on how the business is run. A management team that is fairly compensated and honest will mean nothing if the team is incompetent.

1. Analyze the profit trend during the tenure of the current management team. The profit trend will tell you whether the team is heading towards the right direction or not. Are the ROAs and ROEs increasing? At the very least, if profit margin is increasing, the team is doing something right.
   
   
2. The economy moves in cycles. Good times are followed by bad times and vice versa. A good management will position the company in such a way that it is flexible enough to take on opportunities during good times and endure the bad times.
   
   Does the management take steps to keep the company in a flexible position? A company that takes on too much debt may find it difficult to meet the fixed commitments. Does the company take opportunities to retire debt when the opportunity arises? Does the company avoid taking on too much fixed costs? For example, a company could negotiate for retail outlet rental to be charged a low base rental plus a certain percentage of profit from the outlet instead of being charged a high fixed rental.
   
   
3. Does the management follow-up on identified new business opportunities? Does management tackle identified weaknesses? You could find out by reviewing the annual reports in the last 5 to 7 years.
   
   

The importance of the quality of the management team is second only to the company's economic moat when considering to invest in a company. It pays to put in the effort to research the company and the management.

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