9+3 Criteria in Evaluating Company's Management before buying a Stock

You may see the best of Earnings, cash flow, growth and business potential. This may just be your dream stock that you always wanted to buy. But it can all come to a zero, if the numbers were cooked up or the company's management was not reliable enough. But then, how do you judge the quality of a company's management?

There is no single template for evaluating a company's management. Most investors realize that it's important for a company to have a good management team. It's clear that investors can't always be sure of a company by only scanning through the financial statements. Fall outs such as Kingfisher and Satyam have demonstrated the importance of emphasizing the qualitative aspects of a company.  The problem is that evaluating management is not as straight forward as calculating an EPS ratio. Unlike technical results of the company, so many aspects about a company's management are intangible. 

There is no magic formula for evaluating management, but there definitely are factors to which you should pay attention. Taking care of these factors reduces your risk of selecting a stock with questionable quality of management. In this article, we'll discuss some of these factors to assess the quality of a company's management.

1/ Length of Tenure

One good indicator of good quality management is how long the CEO and top management has been serving with the company. There are many great examples across the globe of such companies which are management by top executives for decades at a stretch. A 10+ year profile is desirable - the more the better. Longer tenure gives us an indication that the management has been able to retain their position in spite of cyclic and technical changes in the industry.

Warren Buffet has also talked about Berkshire Hathaway's superb record of management retention. One of Buffet's investment criteria is to look for solid, stable management that stick with their companies for the long term.

2/ Insider Buying and Stock Buybacks

If insiders are buying shares in their own companies, it's usually because they know something that normal investors do not. Insiders buying stock regularly show investors that managers are willing to put their money where their mouths are. The key here is to pay attention to how long the management holds these shares. 

Flipping shares to make a quick buck is one thing; investing for the long term is another. So, if you see insiders buying and holding stocks, then it is a sign of good quality management of the company.

The same can be said for share buybacks. If you ask the management of a company about buybacks, it will likely tell you that a buyback is the logical use of a company's resources. After all, the goal of a firm's management is to maximize return for shareholders. A buyback increases shareholder value if the company is truly undervalued.

3/ Management Compensation

Compensation that the management takes home is a fair indicator of their quality. However, do consider that management in different industries take in different amounts. For example, CEOs in the banking industry take in much more than the CEO of a retail or food service company. As a general rule, you want to make sure that CEOs in the same industries have similar compensation. You have to be suspicious if a manager makes an obscene amount of money while the company suffers. If a manager really cares about the shareholders in the long term, would this manager be paying him/herself exorbitant amounts of money during tough times? You know the answer.

Salary/remuneration data of promoter/management/directors is provided by the company in its Annual Reports. This data may not be easily available in the public financial sources like Screener, Moneycontrol etc. Therefore, it is essential for investors to read the annual reports to assess the management on this parameter. 

The usual salary range for promoter directors/management is about 2-4% of net profit after tax (PAT). The salary generally contains 2% commission on PAT and a fixed monthly component along with other perquisites. If you see continuously increasing salaries despite decreasing profits it is definitely a cause for concern.

4/ Do your online Research in public domain

It is essential to search for the name of the company with certain keywords like “Fraud, Issues, SEBI, Dispute, Court etc.” One such search attempt should give an investor about any critical information that might be present in the public domain.We should do similar checks about independent directors as well. Many times we see that independent directors constitute ex-bureaucrats, industry professionals etc. We should form our opinion about whether the business requires ex-bureaucrats on the board. Though ex-bureaucrats bring a lot of administrative & management experience to the table, however, such positions might have been offered as a reward for favour done while on job or as a liaising officer for government approvals & contracts. Such arrangements can be indicative of crony capitalism. However, an investor needs to make her own call about such matters. Once the investor is convinced that there is nothing to question the character & integrity of promoters & directors, she should move ahead with further analysis.

5/ Related party transactions

This section is one of the essential parts of the annual report that every investor should analyse in detail for every company management that one plans to study.  This section discloses a summary of all the transaction/balances at year end for the dealings that the company made with promoters and their personal entities, joint ventures etc. during the year.

Related party transaction section is a goldmine of the information for assessment of any management. By studying each transaction in this section, an investor can conclude whether the promoters are benefiting from the company at the cost of minority shareholders.

6/ Management's reaction to Share Price Movements

Running a business as well as investment in equities demands long term vision. A promoter/manager is expected to create wealth for the shareholders and take decisions that are beneficial for the business over the long term and not be primarily concerned about short term implications. Similarly, a long term value investor should consider holding her investments over many years and not get worried about periods of share price declines in the interim period. However, many times we see that the promoters/managers are constantly worried about the share price of the company, which is heavily influenced by daily level changes in the operating environment. Such kind of management is hardly willing to take the strong decisions that might be needed for long term benefit of the business and in turn for shareholders. Therefore, an investor should always analyse past decisions of the promoters/managers to assess whether their decisions have been motivated by long term vision or the short term share price fluctuations.

7/ Management's Philosophy on Dividends

One of the key features of stock investment that attract investors is the dividend payment by companies. Stock investors hold regularly dividend paying companies in high regards and believe that the managements that consistently pay dividends are shareholder friendly. However, before an investor firms up such a belief about any management, it is crucial to assess that the company is paying these dividends out of the free cash available.

Free cash flow (FCF) can be calculated by deducting capital expenditure (Capex) done by the company from its cash flow from operations (CFO):

FCF = CFO – Capex

It is highly likely that if a company does not have free cash flow available after meeting capex requirements from its operating cash flows, then it is meeting the requirements of funds to pay dividends to shareholders by raising debt from lenders. And investors would agree that if a company keeps on paying dividend consistently by raising debt, then sooner or later the debt will reach such levels that lenders would find it difficult to keep giving loans to it and the dividend payments would not remain sustainable.

8/ Promoter's Stake

An important parameter is the find the management’s stake in the equity holding of the company. There are enough empirical evidences to prove that the management which has no stake in the equity of a company tends to be reckless and often irresponsible. That is the reason intelligent investors shy away from companies where the promoters stake is low. It is not unusual for promoters to sell off their entire stake, and still sit on the board of the company, directing the affairs of the business as owners. This is potentially dangerous situation. Unless they have the skin in the game, they are not to be trusted. The recent case of Singh brothers running Religare and Fortis long after selling off their stake is an example of ‘no skin in the game’

9/ Pledging of Shares

While pledging of promoter shares to raise funds is quite a common phenomenon, but a regular increase in pledged shares or pledging going beyond 50% are definitely riskier situations - which should be avoided. Read this for more details --> Pledging of Shares by Promoters and its impact on Stock Valuation

Tracking the above 9 factors can help you reduce your risk. However, a couple of misleading factors are also discussed below, which can be useful too.

1/ Stock Price Isn't Always a Reflection of Good Management

Some investors argue that qualitative factors are pointless because the true value of management will sooner or later be reflected in the bottom line and the stock price. There is some truth to this over the long run, but a strong performance in the short run doesn't guarantee good management. The best example is the downfall of dotcoms. For a period of time, everybody was talking about how the new entrepreneurs were going to change the rules of business. The stock price was deemed as a sure indication of success. The market, however, mostly behaves irrationally in the short term. Strong stock performance alone doesn't mean you can assume the management is of high quality. As the book Autobiography of A Stock says, the Market price of a Stock is a factor of a collective perception and has hardly any relevance to the quality of management.

2/ Stock Options don's drive long term performance

You can't talk about compensation without mentioning stock options. A few years back, many praised options as the solution to ensuring that management increases shareholder value. The theory sounds good but doesn't work as well in reality. It's true that options tie compensation to performance, but not necessarily for the benefit of long-term investors. Many executives simply did whatever it took to drive up the share price so they could vest their options to make a quick buck. Investors then realized the books had been cooked, so share prices plummeted back down while management made out with millions. Also, stock options aren't free, so the money has to come from somewhere, usually the dilution of existing shareholder's stock.

3/ Don’t rely on awards

Awards also doesn’t necessarily mean a lot and can be very misleading. Satyam Computers received an award for corporate governance just before the fraud was made public.

While their is no hard and fast check points to get 100% assurance on management quality, going through these 9+3 points can help you reduce your risk of getting stuck with a script that is being driven by poor quality management. 

Regards

Manoj Arora
Official Website