Tips for Judging a Company's Management

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  or Enron ? 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 ). 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 , 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  stock price recently jumped the day CEO Michael Barrington stepped down.

Trust
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

• Does management engage in "aggressive" accounting?
• Does the company report "cash" earnings and talk about those more than net earnings? 
• Does the company save bad news for last in press releases? 
• Does the company make excessive use of off-balance sheet items? 
• Has the company, with either past or present management, had a formal SEC investigation during the past three years? 
• Has the company, under current management, taken repeated "one-time" charges?

2. Strategic vision 

• Does management chase fads, instead of leveraging the company's core business? (Fad-chasing happened a lot during the Internet boom of the late 1990s.) 
• Does management have a poorly defined long-term strategy and repeatedly change direction? (i.e.,  Motorola (MOT) or  Ericsson )

3. Shareholder friendliness

• Is management excessively compensated? 
• Has the company repriced or reissued options at any point within the past three years? (Beware of any company that does this; it's a direct slap in the face to shareholders.) 
• Does the company allow only Wall Street analysts to ask questions on its conference calls? Does management ban individual investors and Morningstar analysts from these calls? (As incredible as it sounds, some firms only allow analysts who have a positive opinion on their stock to ask questions on conference calls.)

You might wonder if there are any management teams out there that meet all these criteria. Rest assured, there are. Below are three of the most prominent.

 JetBlue Airlines JBLU
Founder and CEO David Neeleman has a good record with two other startup carriers; other top execs held high-level positions at  Continental ,  Southwest (LUV), and Neeleman’s first airline, Morris Air. I recently had a chance to hear Neeleman speak at a conference in Chicago, and his comments impressed me. He places employees at the top of his priority list, ahead of customers. His logic: In service businesses, if the employees are excited about working, customer satisfaction will naturally follow. JetBlue is the only major non-unionized airline. Neeleman, who makes just $305,000 a year and takes no stock options, says that the day his employees try to unionize will be the day he realizes he has stopped treating them right.

 Linear Technology 
Founder and CEO Bob Swanson is an industry veteran with deep roots in the analog chip sector. Linear’s incredibly consistent financial history speaks to how well the company is managed. It’s one of the few chip companies that pays a dividend, and it hardly ever makes acquisitions, preferring to grow internally. The company has a rational incentive plan; executive pay rises and falls in tandem with Linear’s earnings. For example, Swanson’s pay package fell 59% in 2002, a year in which Linear’s net income fell 28%. And executives received no stock option grants last year.

 White Mountains Insurance (WTM)
The executive team at White Mountains is one of the best. Industry legend Jack Byrne, 69, is chairman and owns 14% of the company. His record of creating value through savvy deals stretches back to the 1970s. Byrne, who handed over the CEO reins to Ray Barrette on January 1 of this year, took a salary of just $107,000 in 2002. New CEO Ray Barrette has 28 years of industry experience. Nearly all top executives are industry veterans hailing either from GEICO or Fireman’s Fund. No options were granted to executives in 2002 despite an outstanding performance by the company. Two notable investors, Warren Buffett’s  Berkshire Hathaway (BRK.B) and Franklin Mutual Advisors, own a combined 32% of White Mountains.

One of the best qualities of White Mountains’ management team is its disciplined approach to underwriting. The company writes insurance policies to make a profit; growth is just a byproduct. Most insurance companies switch that logic around.

Here are some more companies with excellent management teams. Premium Members can click on the links below to read our Analyst Reports on these companies, including details on management.

 Berkshire Hathaway (BRK.B)
 Southwest Airlines (LUV)
 Nucor Steel (NUE)
 Paychex (PAYX)
 Automatic Data Processing (ADP)
 Expeditors International (EXPD)
 Moody’s (MCO)
 PepsiCo (PEP)
 Sysco (SYY)
 3M (MMM)
 Colgate-Palmolive (CL)
 Wal-Mart (WMT)
 Avon Products 
 Wells Fargo (WFC)
 Progressive (PGR)
 Markel Corporation (MKL)

A version of this article appeared in the May 2003 issue of Morningstar StockInvestor.