How To Evaluate A Company's Management

With the market riding pretty high and stock buying opportunities limited, I wanted to take some time to put together a series of articles going a little more in-depth on the GreenDot Stocks investing process.

As laid out in the Help page, we start by using the Green Screens to mechanically filter the entire investment universe of over 5,000 stocks down to just a handful of companies that have strong revenue growth and free cash returns on capital. That gets us started in the right direction.

After that, we want to take a closer look to find in those screens the truly great companies, that would make awesome investments at the right price. While this is part science, part art, in general the diligence process comes down to 4 check boxes. In this series, I'm going to go in-depth on each of these and tell you what to look for to either give a company a "pass" or "fail" on each.

The 4 "Check Boxes"

Those 4 "check boxes" are (articles are linked):

1) Recurring Revenue

2) Long-Term, Organic Revenue Growth

3) A Strong Economic Moat

4) Business-focused Management Teams (this article!)

When a company "passes" all 4, then we move to a stock price valuation - which is separate from business analysis. We can cover that a different day!

Management Matters - A Lot!

A company's top-level management - specifically (but not limited to) its chief executive officer (CEO) and chief financial officer (CFO) - is the "steering wheel" of the firm's future.

Great decisions by these individuals, like steering the firm into lucrative new markets, expertly navigating a recession to gain market share, successfully defining and implementing a company culture, and being good stewards of shareholder capital, can turn even mediocre businesses into great investments.

On the other hand, bone-headed decisions like massively overpaying for acquisitions, deceiving investors or regulators with misleading financial reports, or milking the company's finances for personal gain, can cause a lot of investment losses even when the business has many attractive qualities.

Ultimately, companies are a hierarchy of people, and like any organization, leadership at the top is a big contributor to success or failure.

So, making an evaluation of the management team is a critical step in judging a company's fitness for investment.

But what do we look for?

What To Look For When Evaluating Management

Here are the questions I ask when taking a look at the management team:

1) Has the team shown it is focused on the long-term health of the company?

2) Are the key financial trends (growth, balance sheet, free cash ROI) going in the right direction under current management?

3) Does the team have many years experience at the company, or is it a bunch of "hired hands"?

4) Does leadership have a meaningful economic stake in the firm's long-term success (e.g. do they own a lot of shares)?

In truth, I'm more looking for negative aspects in management track records. Contrary to popular belief, most executives really are looking to run a successful company that generates wealth for shareholders and has good relations with customers and employees. Some management disqualifiers include things like:

- A history of overpaying for massive acquisitions ("empire building"). This often leads to poor balance sheet and cash ROI figures.

- Past involvement in less-than-desirable events (accounting scandals, shady businesses, etc.)

- Insider transactions, for example taking personal loans from the company, or setting up side deals with other management-controlled entities.

- A history of massive layoffs, which are a sure indication of previous bad business decisions.

These are just a few things to look out for. If I don't see any of these, and if the 4 questions above can be answered in the positive, you generally are dealing with a trustworthy management team.

Why I like Founder-Led Companies So Much

Those who have read the stock write-ups on this site have no doubt noticed my admiration for founder-led business teams.

The main reason for this is that they simply perform better than other companies as investments (at large).

But it goes deeper than this. Founders see their business as "their baby" - a life's obsession that in many cases represents their legacy. This leads to decisions that are focused around the long-term health of the company, instead of meeting a quarterly sales or profit goal (as you often see with "hired gun" management teams).

A good example of this are the recent events at Paycom (PAYC). The company has developed a self-reporting payroll system called Beti. It has been very successful - clients are having to re-run their payrolls to fix errors much less frequently. However, the fewer payroll runs leads to lower quarterly revenue for Paycom. Analysts grilled management on the latest conference call for this. CEO and founder Chad Richison knows, however, that providing their clients with a lower-cost, better quality solution is going to help Paycom grow long-term in a market it only has about 5-6% share in.

That's what long-term, owner-oriented thinking looks like.

Founders are also much less likely to tolerate actions that tarnish the company's reputation. Would you want your legacy to be damaged by accounting shenanigans, or shady business deals? Of course not.

Finally - and this is a hard one to pin down - it is rare for any management but a founder-led one to be able to create a lasting, beneficial culture inside of its business. This is the compass for business success. Sam Walton always focused on being the lowest-cost retailer when he built Walmart. Steve Jobs strived for great user experience at Apple. Jeff Bezos was laser-focused on customer convenience at Amazon. With "north stars" like these, all employees were pushing in the same direction, engaged in a clear mission. Great things happen when that takes place.

Conclusion

Excellent management teams are a key ingredient in winning long-term stock investments. Most management teams do at least try to be good stewards of capital, but there are some key things to look out for in leadership philosophies that can send companies astray. Founder-led management tends to be the best, as they are more able to clearly set the company's "North Star" mission statement and keep all employees driving towards it. Founders are also more likely to obsess over their firm's long-term success as a matter of personal pride and legacy. We want to use this to our advantage as individual investors.

This concludes the GreenDot Stocks investing process series of articles! I hope it has helped illustrate how the site goes about analyzing stocks and recommending some as potential investments.