Security Analysis: Four Ways to Evaluate the Quality of Management

While evaluating a company from the perspective of value investing, an important aspect is the quality of the company’s management. Almost everyone has a strong view about it but there is really no objective way of doing so. We do not have any objective, reliable tests to measure the competence of the management. Let’s say that a company is very successful and making millions of dollars per year. By looking at these numbers, can we really say with confidence that the management is competent? There are many factors that could have contributed to the success and growth of the company. It’s not to say that the management didn’t play a role; but the management’s contribution is difficult to assess.

When considering the impact of management competence on the value of a security, we also need to be aware that its impact would already have been incorporated in the stock price. Only when there is something new, such as a change in management, that the market doesn’t know about or is yet to incorporate, do we need to worry about the management. Nonetheless, there are a few factors/signs that we can study to understand how the management is doing to increase shareholders’ value. These factors primarily relate to the conduct of the management. We can read the previous annual reports and read what they have said and then read the follow-up reports to see whether they actually did what they said in the previous years. It is important that the management accepts its failure to keep the promises rather than try to hide it. Such information can be found in the Management Discussion section and also spread throughout the annual report.

Is the CEO paid too much?

If the company is paying $400 million to its CEO, then it must have a really good reason to do so. Unless the CEO has done something really extraordinary such as expanded the business by 500 times, or created an innovative solution to a nasty problem, there is hardly any reason to be paid such obscene salary for running the business. Such behaviour shows that the management is more interested in its own interests rather than the shareholders’ interest.

Does the company reissue/exchange stock options?

If you notice that the company has repriced or exchanged stock options for insiders, then you must avoid buying that company’s stock. In such a scenario, the company cancels the existing stock options, mostly because it’s now worthless, and reissues stock options to the employees and management at a better price. This means that these options are protected from the downward price movement. Buying the stocks of such a company is self-destruction.

Are company executives buying/selling shares often?

The management of the company has been granted stock options so that they can use it for their benefit. There are many justifiable reasons why a senior executive or a director (read insider) may want to sell its stocks, such as to buy a bigger house, or some other emergency. However, what if the executive is engaging in buying and selling shares often? Can you consider him a partner in running the business when he/she engaging in buying/selling shares?

What about the accounting practices?

We have seen many scams emerging from misappropriation of funds or shady accounting practices followed by the company for showing a better financial picture of the business. Check for extraordinary items and how they are accounted for. Are there any nonrecurring items that keep recurring every year? Does the company keep talking about “Pro forma” earnings rather than “Net Income”?

All these are signs that the management is not giving priority to the shareholders’ long-term interests and working for its own benefit for focusing on short-term gains.