|Course 207: Weighing Management Quality|
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.
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?
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
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 Magna International MGA. For one, this diversified auto-parts maker has a dual-class share structure, which essentially limits shareholder influence. The other significant negative regarding governance is the extremely large consulting contracts paid to its founder Frank Stronach. In exchange for consulting work relating to Magna's European matters, he has received $140 million in fees from 2004 to 2007 alone. Magna has also purchased golf courses and other real estate from Stronach-controlled companies, which we feel are not necessary to run an auto parts firm. Morningstar's analysts have compiled lots of egregious examples of related-party transactions just like these.
Next: The Bottom Line >>
|Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.|
If you have questions or comments please contact Morningstar.