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207-Weighting Management Quality
  Course 207:
  Weighting Management Quality
  Because people run companies, any investment opinion about a company is an
  opinion about the likely outcome of the combined efforts of the people who
  work for and manage it.
  
  Keeping this in mind when you evaluate companies as investment opportunities
  can provide valuable perspective on some of the qualitative factors you should
  focus on. This lesson will cover some of the most important questions to ask
  and the sources you can use to evaluate the people who run public companies.
  
  
  Why Management Matters
  In his groundbreaking work Common Stocks and Uncommon Profits, Philip Fisher
  argues that because company managers are much closer to a company's assets
  than stockholders, they wield considerable day-to-day influence over the
  arrangement and disposition of the company's affairs. (For more on Fisher, see
  Lesson 505.) According to Fisher, "Without breaking any laws, the number of
  ways in which those in control can benefit themselves and their families at
  the expense of the ordinary stockholders is almost infinite."
  
  Fisher suggests that investors should accumulate as much background
  information on companies and their managers as possible by talking to people
  in the industry. He refers to the process as gathering "scuttlebutt." Visiting
  management in person, and interviewing line managers, competitors, customers,
  and suppliers are most stock analysts' preferred means for gathering such
  information, and the impressions they garner during these visits can have a
  strong, yet subtle impact on their view of the company's prospects. This type
  of research is typically not realistic for nonprofessional investors with
  limited time, but there are still things you can do to get a sense of the
  quality of a company's management.
  
  Ultimately, it boils down to trust: As an investor, can you trust this
  management team to develop and execute the right business plan and perform
  their duties in your best interest?
  
  Investors can easily familiarize themselves with the backgrounds and
  qualifications of the managers of the companies they invest in by checking
  their biographies on company Web sites or in the annual proxy statements sent
  to shareholders (and filed with the SEC as Schedule DEF 14a). Part of
  answering the question, "Can I trust this team?" certainly hinges on basic
  information like, "Is the team qualified?" But often enough in corporate
  America, managers have grown up with a company, and their resumes won't say
  much about what they've done recently, and they won't tell you much about
  whether to trust these individuals with your money.
  
  We believe that in the grand scheme, people respond to the incentives they are
  given or set for themselves. In some ways, this represents the kernel of the
  American Dream: Regardless of your background, if you prove yourself and work
  hard, you can do anything. The promise of financial reward accompanies most
  versions of the American Dream we've heard of. This is the angle from which we
  here at Morningstar approach the question about trusting management. We assume
  the team is qualified (whether by pedigree, education, or hard knocks), but we
  question the motivation and reward system that the team (including the board
  of directors) has put in place and by which they measure their own
performance.

  
  Management Structure
  Technically, the management team of a public company works for and reports to
  the board of directors, who represent the company's owners: its shareholders.
  In the U.S., companies typically hold annual elections at which shareholders
  vote (or assign their vote to someone else, called a proxy) to elect directors
  to the board. In theory, then, shareholders can wield great influence over the
  management and direction of the companies whose shares they own. In practice,
  as corporate and investing cultures have evolved, the relationship between
  shareholders and company managers has become ritualized and more distant.
  
  So how should investors close the gap? We believe that by identifying and
  investing in companies that have demonstrated their commitment to treat
  shareholders well, individual investors can reassert their influence on the
  day-to-day choices and priorities that companies set.
  
  What do we mean by "demonstrated commitment to shareholders?" Perhaps an
  analogy will help. Imagine you have decided to start a lemonade stand with
  your neighbor. When you meet at the appointed time to go over your plans, your
  neighbor brings a pound of sugar for the lemonade. Such a gesture demonstrates
  your neighbor's commitment to doing business with you.
  
  Similarly, when you view a home for sale, you expect it to be orderly, and
  that the owner will make arrangements for you to see it. In this small way,
  the seller has demonstrated his or her commitment to doing the things that are
  necessary to sell you the home. If it's a hassle to view the home, or it's
  disorderly when you view it, that should prompt questions about how the later
  stages of negotiation and closing will be handled.
  
  
  Buying a Business
  Now imagine that you are considering buying part of a business, potentially to
  keep and to profit from for a long time. What signs should you look for that
  the company's directors and managers are interested in doing business with
you?
  
  Investors should look for companies that offer clear communication about the
  business, have established a clear separation between business and personal
  relationships, and have set clear goals for measuring progress in conducting
  the business. In practice, these goals often involve raising barriers or
  instituting policies meant to inhibit human nature. By snooping around the
  edges and examining the outward signs of how a company's management team
  behaves and rewards itself, we can surmise how committed they are to honoring
  their role as stewards of investor capital.
  
  While it would be impractical for every private shareholder to visit
  management and dig around for scuttlebutt, this doesn't mean that individual
  investors should simply give up on investigating the people who run their
  businesses. On the contrary, through a handful of public sources, investors
  can begin to crack the nut around one of the most subjective elements of stock
  research: management.
  
  We will refer to the host of topics surrounding management as "stewardship."
  Fisher describes the qualities he looks for in managers as trusteeship. Others
  refer to these issues as corporate governance, fiduciary responsibilities, and
  other names. We call it stewardship because we look for managers who see
  themselves as stewards of investors' capital and who have signaled their
  self-image to us in verifiable ways. We find the alternative--managers who see
  the company they run as their personal piggy-bank--repugnant.
  
  
  The Proxy: A Management Information Goldmine
  The primary source for information about how a company's shareholders,
  directors, and management have arranged their affairs is its annual proxy
  filing, or Schedule DEF14a, which serves as a notice of, invitation to, and
  background reading for the annual shareholders' meeting. The proxy details the
  board's activities, managers' compensation, and any shareholder or management
  proposals that require a vote by shareholders. It also contains director and
  manager biographies, information about managers' and directors' compensation
  and ownership of shares, and often a description of any related-party
  transactions or other relationships that the company's top management team or
  directors may have that could present them with a conflict of interest.
  
  Next, we will discuss the sources we here at Morningstar check most often to
  find information that we use to evaluate management's stewardship. Of course,
  you should try to soak up as much information as you can from as many sources
  as you can.
  
  Within the proxy, we pay attention to the report of the compensation committee
  of the board. Although often bland, this report gives some insight into how
  pay is set in the executive suite. (The blander the report, the more likely we
  think that the CEO effectively sets his own pay, which is a problem.) We also
  recommend that investors read management's discussion (usually a rebuttal) of
  shareholder proposals attached to the proxy--these can shed light on
  management's priorities and consideration for shareholder interests, depending
  on the merits of the proposal.
  
  We also check other public sources for information relevant to evaluating
  management. We read management's discussion and analysis in the annual report
  (10-K) for many reasons, one of which is to ascertain the level of exposition
  company managers provide about how they see the business. The annual financial
  filing also discusses litigation and risk factors, as well as a record of
  options granted in recent years. In the quarterly report (10-Q) filed
  immediately after the annual shareholders' meeting, we look at the results of
  the shareholder vote. This allows us to evaluate how seriously the board takes
  shareholder proposals that pass by a majority, even though these are often not
  even binding.
  
  Increasingly, companies post all of the above information on their Web sites.
  On the company Web page, look for a link to "Investor Relations," and from
  there, look for a section dedicated to "Corporate Governance." By looking at
  all these sources and following the flow of information concerning how the
  company's profits are allocated to management, we can learn much more than by
  just poring through cookie-cutter articles of incorporation.
  
  Therefore, when we evaluate management, we split our areas of inquiry into
  three main topics:
  
  Transparency. Paramount among outward commitments, public dissemination of
  information about the business and its finances reflects strongly on
  management's respect for investors. Without adequate and reliable accounting
  practices and overall disclosure, investors would be entirely at the mercy of
  insiders.
  
  Shareholder Friendliness. To assess the power of shareholders relative to
  management and how the board and management treat other shareholders, we
  evaluate the firm's share-class structure and assignment of CEO and board
  chair roles, and take particular note of any takeover defenses or
  related-party transactions.
  
  Incentives, Ownership, and Overall Stewardship. In this area we ask whether
  management's and employees' incentives are aligned with shareholders'
  interests. In particular, we focus on whether management's compensation is "at
  risk" alongside the results of the firm, and whether it is structured to
  motivate long-term value creation. Investors should penalize those firms that
  change management goals midstream, issue too many options, overcompensate
  executives, or have low levels of equity ownership.
  
  
  20 Questions
  Here's the fun part. If you liked 20 questions as a parlor game, you may enjoy
  using the same 20 questions that Morningstar's stock analysts currently use to
  evaluate the three main areas of stewardship at the companies they cover. As
  you will see, some of these require a working knowledge of accounting and the
  company's track record. Nonetheless, familiarizing yourself with the subject
  matter of even a handful of these inquiries will bring you closer to
  evaluating management on your own behalf.
  
  Transparency
  1. Does the company overuse "one-time" charges or write-offs? In public
  announcements, does it consistently disregard GAAP earnings and point to pro
  forma numbers (i.e., figures "excluding charges...")?
  2. Does the firm have aggressive accounting? For example, has there been a
  major change to accounting practices, such as revenue recognition, during the
  past three years that may have been intended to hide something?
  3. Has the company recently restated earnings for any reason other than
  compliance with an accounting rule change? Has the company had an unexplained
  delay in making regulatory filings or reporting quarterly results?
  4. Does the company grant options without expensing them?
  5. Does the company choose not to provide any balance sheet with its quarterly
  earnings release?
  6. Bonus: Does the company's disclosure go above and beyond what its
  competitors provide?
  Shareholder Friendliness
  7. Does the company have a separate voting class of shares that an insider
  controls?
  8. Does the company have takeover defenses in place that, if exercised, would
  significantly dilute existing shareholders or favor the interests of
  management over shareholders in a takeover situation?
  9. Has a majority vote of shareholders on a proposal been thwarted by any of
  the following: (a) management inaction; (b) management interference in the
  ballot process; or (c) the existence of a supermajority provision?
  10. Are the chairman of the board and the CEO the same person?
  11. Has the board or management engaged in significant related-party
  transactions that cast doubt on its ability to act in shareholders' best
  interests?
  12. Bonus: Is there cumulative voting (i.e., are shareholder votes equal to
  shares owned times number of directors)?
  Incentives, Ownership, and Stewardship
  13. Has the board agreed to a compensation structure that rewards management
  merely for being employed, rather than for making value-enhancing decisions?
  14. Over the past three years, has the firm given away more than 3% of shares
  annually as options?
  15. In bad times, has the board granted "one-time" "retention bonuses,"
  redefined management goals midstream, repriced options, or bestowed other
  "extraordinary" perks?
  16. Is the CEO's equity stake in the company (including options) too small to
  align his or her interests with shareholders'?
  17. Do directors receive a substantial portion of their compensation in cash,
  rather than stock?
  18. Do the goals set out for top management by the board's compensation
  committee encourage short-term actions rather than long-term value creation?
  Is the board's disclosure of such goals insufficient, too generic, or too
  fuzzy to allow you to answer the preceding question?
  19. Given the company's financial performance, the board's and management's
  past actions, and the above factors, is management inappropriately motivated
  and/or rewarded?
  20. Bonus: Does the board and management have a substantial track record of
  doing right by shareholders?
  We do not weigh all of these questions equally, and sometimes the details
  necessitate the exercise of judgment. Of all these questions, we place the
  greatest emphasis on Question 11 because related-party transactions can be
  especially harmful to shareholders and are a decent indicator of bigger
  governance problems. Frequent and egregious lapses are a leading indicator
  that a given company's inner sanctum has too easily rationalized putting its
  self-interest over shareholders' interests. Caveat emptor.
  To illustrate an egregious related-party transaction, consider Sinclair
  Broadcasting SBGI. This television broadcasting company reported in its proxy
  that it made a large investment in a car dealership in which its CEO and
  chairman already held a significant stake. We don't see how this deal served
  Sinclair shareholders. Moreover, the fact that it had to be reported did not
  hamper the management team from completing the deal, which we also see as a
  warning sign. A glance at the company's stock chart reveals that investors
  have caught on to what value management has and has not created for
  shareholders over the years. Morningstar's analysts have compiled lots of
  egregious examples of related-party transactions just like this.
  
  
  Morningstar Stewardship Grades
  Morningstar has already done a lot of management investigation for you! For
  the 1,500-plus companies that we cover, Premium subscribers to Morningstar.com
  have access to analyst-driven Stewardship Grades based on the topics discussed
  in this lesson. Like in school, the grades are "A" through "F," with "C" being
  the most common grade.
  
  Morningstar stock analysts base the Stewardship Grades on public filings,
  previous management actions, conversations with company officials, and their
  own expertise. We assign the grades on an absolute scale--not on a curve or on
  an industry-peer basis. Therefore, if a company engages in practices that
  Morningstar analysts think do not reflect good stewardship of investors'
  capital, it will receive a poor grade regardless of how other firms may have
  scored.
  
  
  The Bottom Line
  Though competitive positioning remains extremely important to a company's
  long-term fortunes, quality of management matters, too. After all, even the
  most attractive ship can be run ashore by an incompetent skipper, or be
  pillaged by a pirate. The whole reason it is worthwhile to go through these
  exercises is to make sure you are investing your money with people you can
  trust.