Luckily, Spring Break is the upcoming week, so I'll have a lot of time to finish the checklist and make my conclusion on Best Buy, then work on some projects.
Management
The next part of the series is management, some investors call this the most important of the analysis, it is the are where I have the least experience and have tripped up the most in the past.
I don't have any way of talking to management from any company, save the one for which my dad works, so my analysis will be only things that one can find on any computer.
I believe there are three distinct things to look for when evaluating management:
- Integrity
- Competence
- Good Communication with Shareholders
Integrity
Integrity is of the utmost necessity for good management. If a shareholder can't tell if the management of his company is telling the truth, there is no need to have anything to do with that company.
I use a number of different measures to gauge management's integrity, gleaned from different sources that will be mentioned later.
Pay
This is a big one in the news, but I don't find it as big a deal as people like to make it. Yeah, CEOs make a truckload of money and the Average Joe doesn't, but I doubt the Average Joe paid in the same amount for education or worked the same amount of hours to get to the position where an Average CEO is. I also doubt the Average Joe has to run a multi-billion dollar business, with the public watching his every move.
That said I have nothing against the Average Joe, and do believe management can be overpaid.
If I get to this point in my analysis its obvious management is not completely incompetent, and I believe they should make at least what the CEO of a competitor makes, maybe a little more because they run a good company, but if its a huge premium there's something wrong.
Also, a company should not need to issue a ton of options to motivate employees, a little is fine, but excess amounts just breed bad ethical decision making. I'll also monitor options granted (it should stay under 2.5% of income, at the most) as a percent of income and share growth.
Restructuring
This includes all one-time charges, restructuring charges, limitless write-downs, etc.
If a company has a one-time charge every year, it is no longer a 'one-time' charge (I think that's from Thornton O'Glove).
Related-Party Stuff
Companies have to report any related-party transactions. Some of these are fine, and don't need to be worried about.
But, if the company is loaning excess amounts of money to the chairman's son for his business you should probably steer clear, because management obviously doesn't care about the shareholders' best interest.
Board of Directors
Look at who is sitting on the board of directors, if there are more than ten members or if many of them are politicians, members of the founding family or others with no business background you should probably pass.
Also, if the Charmian of the board is also the CEO it is unlikely the board will ask him any challenging questions.
Pension Fund Stuff
Michelle Leder calls this the best way to easily find if a company reports trustworthy numbers.
There are too things to look for regarding pension funds are they overfunded or underfunded and the expected return rate.
In the pension fund footnote the company reports their pension fund obligations and assets. If the assets are more than the obligations, they have an overfunded account, if the assets are less it is underfunded.
Both can be troublesome, if the fund is overfunded it could be inflating earnings, so look hard at earnings to find if it is. If it is underfunded it creates a drag on net income (look at General Motors, who has had possibly the worst pension fund management in history).
Companies also report the rate at which they expect their pension fund to grow. If this rate is too high (Robert Olstein says 6% should be the highest rate, because it includes fixed income and stocks) it shows the company has too aggressive accounting and adds to the net income amount, without adding cash.
Revenue
This part of the analysis is two-pronged: recognition and receivables.
How companies recognize revenue says a lot about how they do business. If they sell a product they may record revenue when the contract is signed to sell the product, when it would be better to record it when the cash is received after they ship the product. Checking how a company reports its
Also, if revenue is growing fast, but when you check accounts receivables they are growing just as fast there might be future trouble if the company is unable to collect the money it is owed.
Earnings
This is a quick one, if a company never falters in its earnings and always meets the target it is probably fudging earnings (Genrral Electric did this a lot in the past).
Look at the past ten years of earnings, if there is never a drop in growth or if they always meet the target (you can find this on Yahoo Finance) be suspicious and look into how much of their earnings each year are actually cash.
Which is also part of this analysis, it is beneficial for an investor to compare the free cash flow (or owner's earning, or other cash flow measure) with the actual net income, if it varies (in either direction) by a lot the company is reporting income that it hasn't earned in actual cash.
Ownership
This is a very arguable criterion. A lot of people base their investment decisions on inside ownership, other claim it does not matter.
I believe a healthy amount of insider ownership aligns management's interest with that of the shareholders.
I also believe, that when management owns part of a huge company it is hard to own a big percent of the shares. So I look at the absolute amount of a company management owns. If the CEO owns $100 million worth of stock, but he runs a multi-billion dollar company, it won't show up as huge inside ownership, but he obviously has the shareholder's interest on his mind.
I also don't care much for insider buying or selling, no one knows the reasoning behind insider buys and sells, and in my mind it is a waste of time to try to figure them out.
Auditing
The last part of the integrity analysis is to check the auditing firm, if they are a no-name firm that doesn't seem likely to ask hard questions, one should view the financial statement with a grain of salt.
Competence
Expenses
I have a page in my spreadsheet that does a percent analysis for the income statement. It breaks down what percent of Revenue each expense accounts for.
If a company has lower margins than competition identifying the expense causing this is crucial to turn-around, if management seems ignorant of this, pass on the company.
Debt
It says in the Bible, "The rich rules over the poor, And the borrower becomes the lender's slave (Proverbs 22:7)."
Regardless, of one's religious beliefs it is obvious that one in debt will act differently than one funded strictly with cash.
The same goes for companies, if a company is focusing all its interest on how it will pay off its debt, it has no time left to figure out how to grow.
Look to see how debt a company has, and also find what percent it is paying on that debt in interest, if the interest payments alone account for a huge percent of income it is time to pass.
Returns
I repeat this over and over, but it is necessary, when analyzing each facet of a company. The amount of income a company can produce using its equity (or assets) is the best gauge for determining the validity of the company.
If management is unable to allocate its capital efficiently there is nothing else it can do correctly to make up for this and the you should pass on the company.
Also, coinciding with the last criteria I like to look at Return on Capital (income over equity plus long-term debt) and Return on Assets (income over assets) to find how much of a company's return on equity is produced using leverage: if a company is proficient at earning cash on its assets it should have no reason to borrow money, and should be internally funded.
Retained Earnings Contrasted to Market Cap
This is from Buffett's letters.
Basically, for every dollar in retained earnings (net income minus dividends) a company's market value should increase at least one dollar.
The hard thing is computing this, Quicken does it in its Buffett section, but only for company's with ten-years of stock price history.
It is true that a company needs a long history for this to be applicable, but I believe that could be five years, I'm developing a page for my spreadsheet that computes this.
That concludes the competence part, which is not very long, but management's competence should be obvious if it has a moat and good returns.
Shareholder Communication
This part is the one the I think is the least necessary. It's important for CEOs to be honest and let shareholders know what is going on.
But, I can also understand if management doesn't necessarily care about what Wall St. think so they report the bare minimum. For this reason I won't put as much weight on this part as the former two.
Earnings Reports
A lot can be found from a company's press release announcing their earnings.
First, you should look at the headline, if it is announcing the company's brilliant quarter and its strong growth be cautious, but if it just says, "X Company reports Q4 earnings," be happy.
Next, is pro forma income check into how a company determines pro forma income, if it is excluding expense that need to be included in the running of the business or adding non-cash measures ignore the pro-forma earnings and be suspicious of everything else management says.
Also, if management reports their huge growth check to which numbers they are referring. If they are using pro-forma income as their growth measure and their net income didn't grow, or fell, they are most likely dishonest.
Finally, EBITDA is a popular measuring stick. I'm all for adding in non-cash expenses, but interest and taxes must be accounted for and if you add back D&A you need to subtract capital expenditures, or this will never be accounted for.
What they say and What they do
It is a very informative exercise to read over a bunch of years of annual reports and conference call transcripts and record all of management's promises and predictions to find what actually happened.
This post was unusually long and is a lot to digest, so I'll go over Best Buy in another post.
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