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Stock Strategist

Tips for Judging a Company's Management

There are two issues to consider: trust, and value creation.

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Corporate governance issues have taken center stage in recent years. As in all bear markets, corporate misdeeds that were once hidden begin to bubble to the surface; a receding tide reveals who’s wearing a swimsuit and who isn’t.

When you buy shares of a company, you’re making a conscious decision to go into business with the management. Few people would start a business with a partner they don’t trust, yet many are willing to buy shares of companies managed by executives they know little about. There’s no question the Dennis Kozlowskis and Andrew Fastows of the world should be forced to face up to their actions, but how many investors carefully considered corporate governance issues before making the decision to buy  Tyco (TYC) or Enron (ENRNQ)? If investors fail to undergo even a cursory evaluation of management before buying, or ignore glaring red flags, it’s hard to see why they shouldn’t accept some of the blame for the money they’ve lost.

Below, I’ve listed many of the corporate governance issues Morningstar analysts now consider when analyzing a stock these days. When we look at a company’s governance policies, we’re trying to get a handle on two issues.

Value Creation
First, does this management team create or destroy value? Managers who destroy value usually display an "empire building" syndrome. Typically, they do a lot of overpriced acquisitions (think  Cisco (CSCO) or  AOL (AOL)). They invest in low-return projects that require lots of capital (think  Microsoft (MSFT) and its cable investments, or the airlines’ capacity expansions in the late 1990s). They repurchase lots of shares when their stock price is high but discontinue repurchases when their stock price is low (think  McDonald’s (MCD)). Or, my pet peeve--they issue tons of stock options and then buy back shares on the open market to offset the dilution (think  Adobe (ADBE),  Dell (DELL), or, again, Microsoft).

The best way to figure this one out is to look at a company’s financial statements since the current CEO took over. Have returns on capital been trending downward? Have general and administrative costs risen dramatically as a percentage of sales? Has the company made an acquisition in an unrelated industry, and then divested the same company a few years later? (Tyco did this with CIT Financial.) Has the company bought back shares at high prices while concurrently issuing boatloads of options to employees? Over a five- or 10-year period, has each dollar of retained earnings produced less than $1 of market value for the company? If the answer to any of these questions is "yes," you’re probably looking at a management team that’s destroying value by making low-return investments.

A company with a wide economic moat can usually survive under one of these management teams (although its share price may stagnate). But the company’s survival is in spite of, not because of, the management team (though no CEO would agree with that statement when it’s time for his or her annual compensation review).

Narrow-moat or no-moat companies don’t have such a luxury; often, they can be irreparably harmed by a value-destroying CEO. In fact, when such a CEO resigns or is fired, the company’s stock price may even rise. For example,  Americredit’s (ACF) stock price recently jumped the day CEO Michael Barrington stepped down.

The second issue, no less important, is one of trust. Can the people running the company be trusted? There are a number of questions we ask ourselves to help us get a feel for this. This is a fuzzy issue; a "yes" answer to any of these questions doesn’t prove management isn’t trustworthy--it’s just a piece of evidence.

1. Accounting and financial transparency

Mark Sellers does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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