Assessing management is a vital skill if you want to find great companies.

By Owen Richards, author

Someone once told me that the thing he liked in company annual reports was the photographs of the board members and the management team. This enabled him "to check how dorky they look". I'm not sure whether this is particularly helpful in share selections for investment purposes, but in an oft-quoted statement by the US investor Warren Buffett, his preference is always to choose companies that he understands, have an able and honest management, and are being offered at a reasonable price.

It should be fairly simple to meet his first criterion and also to make a judgement on whether the price is reasonable. However, it is more difficult to assess management, although a starting point is to look at the quantitative aspects of their effectiveness from their financial reports. Probably the most common measurements of how well a company is being run is to determine its return on equity (ROE), return on assets (ROA) and earnings per share (EPS) growth.

These are simple ratios to calculate, and then relate them to the company's market capitalisation and the industry it is in. In all cases, it is important to establish the ratios first and then, as far as possible, compare them with companies in the same industry and which have a similar capitalisation.
Some suggested ratios for a healthy, well-run company are:
ROE of greater than 10 per cent and rising
ROA of greater than 15 per cent and rising
EPS growth of about 10 per cent over the past year and rising for the past 18 months.

Low-capitalisation companies, such as software companies and consultancy firms, which are well run, will probably have much higher ratios.

Figures may not lie, but …

We should now be familiar with the saying "figures don't lie, but liars can figure". Investors should always treat any numerical representation with some caution. Although ROE is probably the most popular quantitative measure of management effectiveness, this ratio (like any other) can be manipulated. Companies can artificially maintain a healthy ROE by increasing debt leverage and using share buybacks funded through accumulated cash, to mask a deteriorating performance.

No single metric is ever perfect and different approaches are always appropriate to get a more accurate representation of management performance.

It is a more complex task to make a qualitative assessment of management - that it meets Buffett's "able and honest" test - but essentially it is critical that management's interests are aligned with those of its investors. There is, at present, substantial general interest in the resignation from a famous US investment bank by a senior executive after 12 years with the company. What is different in this case is that his letter of resignation was effectively printed in the New York Times.

The executive describes the culture of the company as "toxic and destructive" and lays the blame for this on the current CEO and president, who he says have "lost hold of the firm's culture on their watch". He cites their major failing as essentially focusing only on "...how can we make the most possible money?" Some commentators have expressed surprise and said that this is what an investment bank is supposed to do.

And, of course, this is true. But as the executive points out, this cannot be at the expense of their clients whom, as well as being referred to internally as "muppets", are allegedly being sold expensive products that are not appropriate to their needs. Nor is this fair to the shareholders, who must see the company's value deteriorate over time as the client base inevitably declines.

Things to look for

There is no doubt that a company's board acting through the company's management (collectively, "management") will largely determine the shared attitudes and beliefs of the company and how well this aligns with the interests of all its stakeholders and especially its shareholders. Although there is no fixed template, there are some characteristics that investors can look to for guidance on how well they can assess their interests will be best served.

Good management should have substantial ownership in the company, often referred to as having "skin in the game", through shareholdings or options. This indicates the belief that there is no better alternative for their money, and should provide some security for investors in knowing that management is unlikely to perform foolishly in the long term with their own wealth at stake.

Keep an eye on major share purchases or sales by board members. If a number are bailing out of the company within a reasonably close timeframe, look for reasons why; but always be mindful that individuals have to buy houses, educate children and diversify their own holdings.

Look for management that acts as a steward of your interests. The worth of management is not necessarily related to a strong performance within a short time, and a good share price does not necessarily indicate a high-quality company. You want people who can invest in projects and activities that create value for the shareholders in the longer term. Still, where the chairman or CEO of a company is also the major shareholder, there is always a possibility that deals may be done that are more in their personal interest than the company's.

Excellent management surely increases investors' value, but excellence must be paid for. You don't want management that unreasonably increases their bonuses at the expense of the shareholders, or pays their top people outrageous salaries. Diverse industries offer diverse amounts, but you should look for companies that reward its officials with compensations that roughly match similar industries.

Wanted: reasons, not excuses

Honesty takes a number of forms. What you want in a CEO is someone who is not afraid to admit they have made mistakes. If something like an earnings disappointment occurs, you deserve an honest explanation as to why and what is planned to overcome it. Too many companies provide only excuses for poor performance and blame external factors, such as the government or the economy. It can also be useful to check the tenure of management. Look for rock-solid management that has been with the company for years.

You should read the section on management's discussions and analysis in the past couple of annual reports and make an assessment of how thoroughly they follow through on their planning and promises. You may find that many of the plans of management were never implemented.

You want a management that is consistent in words and actions. Look at the company's mission statement and its effectiveness. Good mission statements create efficient managements and usually good returns for shareholders. If all you read is corporate jargon and buzz words, management is not being honest with you.

In many ways, if you are interested in a company where the directors are people of known probity and the company is generally acknowledged as well run, your requirement for assessment may be minimal. If business scandal has touched any one of them, however, exercise caution. It is rare for a leopard to change its spots.

Viewing the financial statements every six months is essential, although they do not always tell the whole story. In the final analysis, companies are staffed and run by people, and it is a wise investor who checks as best as possible the people who set out these financial statements.

About the author

Owen Richards has been a trader for some years and is a contributor to local and overseas trading magazines. He has written this story on behalf of the Australian Investors Association, an independent, non-profit organisation aimed at helping its members become more successful long-term investors.

From ASX

Don't miss ASX's new Corporate Profile series, which provides a short video interview to help companies inform investors. Many of these profiles are for small and medium-size resource companies. Each three-minute video usually features a chief executive who explains their background and experience, and gives an overview of their company's business and growth plans. This helps investors put a "face" to companies and learn more about those running the company on a day-to-day basis, in a simple, user-friendly format.


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