Evaluating Company Management: A Core Stock Picking Skill

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No matter how good its product or its industry, the success of a company will be highly dependent on its management team. Evaluating company management is a critical step in selecting quality investments.

Evaluating a company's management is easy to talk about and hard to do. Quality of management is a very subjective thing. Two different investors might come to opposite conclusions studying the same people.

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• 1. Factors to Consider When Evaluating Company Management
  • 1.1. Honesty
  • 1.2. Management Skill
  • 1.3. Management Incentives
• 2. Conclusion

So what are the objective criteria you can use to evaluate the management of a company?

Before even evaluating the competence of a management team, you must judge whether they are honest. There is nothing more dangerous than smart, but dishonest managers. Dumb and dishonest would be bad, but easy to spot. Brilliant scoundrels are much more likely to take your money.

For a perfect example, just look at the Enron scandal . Brilliant but dishonest and greedy managers falsified the accounts to hide risk until the company from a much-loved stock to bankruptcy almost overnight.

Here are some of the signs of untrustworthy management:

• Previous indictment. This might sound obvious but is often overlooked. If someone has a criminal past, this might indicate a very weak or flexible moral compass. This is a particular concern if the crime went mostly unpunished, like a fine when jail time would have been more appropriate.
• A history of lies and deceitful statements . Did the company repeatedly make lofty promises and ultimately deliver poor results? Then why should you believe them this time? Another red flag is poor communication. If management refuses to respond frankly to questions or acts defensively, this should be worrying.
• Personality cult around the CEO. Some CEO are natural-born leaders, radiating charisma and able to convince anybody they are exceptional. It might be true. But it might also be all show, with little to back it up. Look no further than the Theranos debacle, and its celebrity CEO Elizabeth Holmes , for proof of how dangerous it can be for investors. Excessive dependence on a single individual is always a risk, and if that individual is dishonest or unstable the risk is magnified.
• High turnover. When the management team keeps changing, this might indicate serious hidden problems. If a new CEO quit a few months after he got access to confidential information, that might show he doesn't want to compromise his reputation and get entangled in a mess. High turnover in the CFO position is a particular concern.
• A focus on unprofitable growth . This can be both due to dishonesty or incompetence. In any case, some managers like pursuing growth or mergers and acquisitions to get bigger for the sake of it. It is usually because it will give them a bigger salary, a private jet, more prestige, etc. They may be less concerned about the impact of their moves on the company or its shareholders.
• Creative metrics. Successful companies will display proudly growing revenue, net income, cash flow, etc… Shady companies will focus on much less solid metrics. For example TAM (Total Addressable Market), non-GAAP accounting, EBITDA, users count, time spent per user, etc… Honest managers care about making money, not making poor financial results look good.

'I think that, every time you see the word EBITDA, you should substitute the word 'bullshit' earnings.' - Charlie Munger

The next step in evaluating company management is deciding whether they are good at their jobs.

The first part is qualifications and experience. Diplomas do not always prove skills. But if management is coming from a completely different industry, with unrelated qualifications, they'd better have a good reason. This is especially crucial in very technical industries, like tech, biotech, mining, finance , etc.

Experience is also valuable. Someone with 20+ years in an industry will have seen full market cycles, disruption by new technology, and other cyclic influences. They are more likely to successfully anticipate and navigate future problems.

Another way to judge management skills is to look at previous achievements . If they are in their position for a while, how did the company perform? If they arrived recently, how did they perform in their previous role? This is the most objective metric, as growth, profitability, and dividends are what will matter in the long run.

It's useful to check the transcripts of earnings calls. Are managers discussing the company's performance openly and honestly? Are they answering questions directly, or being evasive?

One last element to check is management's diversity . By that, I do not mean only ethnic or gender diversity as is it often understood. But also diversity in age, experience, background, personality, nationality, etc…

European or Asian leaders might have a different business culture than Americans. A 60-year-old will see the world differently from a 30-year-old. A former banker will have a different opinion on strategy than a geologist.

More diverse management will bring more ideas, more knowledge, and more adaptability to the table.

Let's say you've decided that management is both honest and competent. You still need to know whether their interests are aligned with the minority shareholders' interests.

As with previous achievements, actions speak louder than words. Are senior executives buying the stock of the company? If they think it is undervalued, they are likely to be right. After all, they know a lot more than most investors. They know the operational details, the not-yet-disclosed deals and R&D successes, etc.

Insider buying is a very strong indication of management putting its money where its mouth is. Ideally, managers should have a large part of their net worth in share of the company they direct.

Insider selling can be a little trickier. It doesn't always indicate a lack of confidence. Managers may sell to diversify their portfolio, buy a house or prepare for retirement . Nevertheless, insider selling should be studied with care, as a potential early warning sign.

You can find information about insider buying on multiple stock analysis platforms. The details should also be accessible in the company's annual report or associated documents and annexes.

The other way to judge if management has the shareholder's interest at heart is to look at their compensation . Are their salaries mostly fixed, or depend on the company achieving relevant metrics? Is their compensation mostly in cash or stock option? Are bonuses linked to short-term stock price or long-term success?

In general, good management should see their own financial success linked directly to the company's long-term prospects. Fixed salaries or short-term incentives might push management to take decisions that are good for them, but not for the company or its shareholders.

Even excellent management might struggle to save a poor company, but poor management can sink even a strong company. Because evaluating company management can feel subjective, many investors look at it superficially or skip it entirely.

This would be a mistake. You may not be able to learn everything about management, but you can learn a good deal.

Looking at compensation and management's ownership of company stock will tell you if they have your best interest at heart. After all, it would not be realistic to expect even honest directors to forgo their own interests in favor of those of minority shareholders.

If interests are aligned, you will know that management has an incentive to make their money and your money grow over time.

Ideally, investors would choose companies that tick all 3 boxes: honest, competent management, and that has its own interests aligned with the minority shareholders. There are plenty of companies that fit the bill. There is no reason to risk investing in what might be a good company but is either poorly led or led in such a way that investors might never be rewarded for their ownership of the stock.

Article by Jonathan Schramm, FinMasters

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