Picking stocks is challenging, in part because you have to consider so many factors in your evaluation. One of the most important non-analytical factors is the quality of management and how that impacts company performance.
How do you evaluate management effectiveness?
There is the easy way and the harder way and your choice is a matter of personal preference.
The easy way this is subscribe to a premium account with MorningStar.com and let their analysts do all the legwork for you. If you look at a lot of different stocks, the monthly premium is a bargain.
The harder way is to do-it-yourself. This involves looking through annual reports, 10K filings, other SEC filings, then using tools like Google to search out any press references to particular managers.
You can also use some analytical tools, which I described below, that will let you compare companies to industry peers. This is not a foolproof method, but it does provide some numbers to look at.
So, what are you looking for when you're snooping through the various SEC filings and Google search results that you may find?
Obviously, any civil or criminal or regulatory action against the management is a cause for concern.
You should also look at whether management compensation is tied to the long-term health of the company, which is also shareholder friendly, or whether they are drawing a paycheck and bonuses just to show up in the morning.
Look also through the filings to see if management has engaged in any activities or transactions that are not in the best interest of shareholders, for example excessive loans to management or transactions with companies owned or controlled by managers or family members of management.
In general, you are looking for activities that serve the best interest of management rather than shareholders.
The bottom line question is would you trust your money to this management team confident that they had your interest at heart and were working on a compensation plan that rewarded such efforts.
Looking at the numbers
One way to evaluate a stock is to look at how effective the company's management is in utilizing the resources available to them.
This measure of management effectiveness provides you with an idea of how well the company is being run relative to others in its sector and the market as a whole. Consistently low numbers are a red flag.
Unlike many comparisons, you can use these tools to compare companies in different industries. The tools are:
Fortunately, you don't have to compute these ratios yourself. Many websites provide this information. On of my favorites is Reuters.com. Just enter the symbol of the stock you are interested in and click on "ratios." The information is found toward the bottom under "Management Effectiveness."
Return on AssetsReturn on assets tells you how well a company's management uses its assets to make a profit.
You calculate the ROA by taking the net income and dividing it by the total assets.
The ROA comparison works better over time so you can see a trend in how well management uses assets to the advantage of the company.
The higher the ratio, the better and the continued high level over time is even better because it indicates management makes a habit of managing with efficiency.
Poorly managed companies, will consistently fall before industry averages in this area, while better run companies stay out in front of the averages.
Return on InvestmentReturn on investment measures not only the company's contribution, but also the purposeful use of leverage or debt to extend company's reach.
You calculate ROI by dividing net profits by (long-term debt plus other long-term liabilities plus equity).
Managers choose to combine the company's equity with outside debt to extend programs quickly and efficiently.
Skillful use of debt can change a $50 million project into a $75 million project. If everyone has done their homework correctly, the company can see additional profit from a larger project than they could have afforded without the debt.
Return on EquityReturn on equity is music to stockholders ears if the numbers are good, because it measures how well management did in earning money for them.
Unlike return on assets and return on investment, this measure goes directly to the stockholders and their stake in the company.
Unfortunately, ROE is somewhat flawed. You calculate ROE by taking net income and dividing by shareholders equity. Missing from this equation is debt and that distorts the picture somewhat.
Although ROE is somewhat helpful in looking at companies, it doesn't provide the guidance the ROA does.