Identifying management teams with excellent leadership traits is a key part of being a successful stock investor. Good leadership can make or break an investment, especially in highly competitive industries like retail. Here are 5 leadership traits to look for when evaluating management and the board of directors.
Sustained Revenue Growth and Profit Margins
What could be a better measure of management than business results? A management team that has been in place for a lengthy period of time (5 years or more) and has delivered results is likely to be solid. All of the standard financial metrics apply here. Has revenue been growing at a steady pace? Have margins been steady or increasing? Has free cash flow been growing? If you can say "yes" to these questions, chances are that the management team has exceptional business acumen.
Focus on Return on Invested Capital
Boiled down to the essence, the purpose of management is to efficiently allocate the capital available to the firm. This can mean different things depending on a company's stage in the business cycle. For firms with lots of organic growth potential, capital is best allocated by re-investing it in the business. On the other hand, businesses that dominate their sector and have realized most of their growth potential can best use capital by paying out dividends and buying back shares (instead of overpaying for acquisitions that don't fit the core competencies of the firm). The best way to measure return on capitalis by using the "traditional" equation, including goodwill and intangible assets, which penalize over-payments for past acquisitions. If this figure has been at or above 20% over the tenure of current management, you can be sure that return on capital is a primary focus. On the other hand, be wary if current management has shown a penchant for spending big bucks on businesses that don't fit well with current operations.
Reasonable and Shareholder Friendly Compensation Guidelines
Many investors focus more on amounts when looking at compensation, but it's more instructive to actually read the compensation guidelines instead. What kind of targets does management have to meet to earn their bonuses? Good targets focus on such things as meeting a return on capital benchmark, growing operating earnings, and growing free cash flow. Questionable targets are often vague or focus on such things as earnings per share growth, which is easily fudged. A revenue growth focus is particularly onerous... it encourages managers to grow sales at any cost, even if that means overpaying for acquisition or stuffing retail channels towards the end of the reporting period. You can always find compensation policies spelled out in a company's proxy statement (form DEF14A on the SEC website).
I should also mention composition as well. Options and restricted stock are better than cash, as this helps to align management's goals with our own (an increase in the stock price). Which leads us to...
A Personal Stake in the Business
A CEO with a lot of personal wealth in the company he or she runs is certainly more likely to run it honestly and run it to increase its long-term value. Look for dollar figures here instead of percentage of ownership - large, 100 year old firms are very unlikely to have anyone that holds a significant portion of the shares. However, if your CEO owns $100 million in stock, and makes $1 million a year in compensation, you can be sure his/her interests are aligned with yours. This one is particularly important with smaller firms. The best small caps are controlled by founders who still run the business and have most of their family's wealth attached to its performance.
A Truly Independent Board of Directors
This is probably the most difficult to find. The Board is important - they are entrusted with evaluating the CEO, determining his/her compensation, and ensuring that he or she is operating with shareholder interests in mind. Good compensation guidelines are one sign of an effective Board. Some other signs: the CEO and Chairman roles are separated, there are no bonus payments after a down year, no or very minor "perks" for management, and non-staggered yearly elections (all board members are up for election every year).
Quick Examples of Good and Not-So-Good Leadership Traits
Good Leadership: Coach (COH)
Although recently undergoing a transition, Coach has been a good example of great leadership. Under former CEO Lew Frankfort's 18 year tenure, Coach grew revenues at an 18% compound annual clip, maintained operating margins above 30%, averaged a mind-boggling return on invested capital figure of about 45%, instituted a dividend in 2009 and has raised it (often substantially) every year, and has reduced share count every year since 2005. Frankfort owns over $280 million dollars of personal wealth in Coach stock. The one strike would be that Frankfort also sat as chairman, but compensation guidelines have always been reasonable here and Coach is one of the few companies with a non-staggered board.
Investors can only hope that new CEO Victor Luis has as successful a tenure!
Questionable Leadership: Quest Diagnostics (DGX)
Through two leadership transitions in the past 10 years, Quest has not generated a whole lot of confidence in management. Revenues have actually fallen since 2008, despite the substantial growth in overall healthcare spending in that period. Operating margins have declined from 18% down to under 14%. While management has bought back shares and recently hiked the dividend, past acquisitions have not been very successful and return on capital is weak at just 9%. Compare these results against main competitor Lab Corp (LH): 28% sales growth since 2008, 17% operating margin, 11% return on capital.
Furthermore, the company has a history of excessive compensation, little insider ownership, and a board with 3 staggered tiers, each elected for 3 year terms. While Quest's management team is far from the worst in business (we'd have to go outside of MFI for that), it is a good example of red flags to look for, and a partial explanation for the company's mediocre business performance.