According to equity analyst Todd Wenning, by considering the management's record and looking at the context of its decisions, an investor can gain insight into whether a company is a good investment choice.
Here he mentions the 10 areas an equity analyst at Morningstar looks at when evaluating stewardship:
1) Have most investments and acquisitions been in line with the company’s core competencies, or does management like to make diversifying acquisitions?
All else equal, we prefer companies to stick with what they know best and strengthen their core businesses rather than engage in conglomerate building. Good stewards of shareholder capital might also have a record of selling non-core businesses at good to fair prices.
2) Have investments and acquisitions been moat-widening?
In other words, have returns on invested capital or profit margins improved as a result of management's decisions? A strong sign of good stewardship is that management's capital-allocation decisions improved the company's competitive position and consequently increased shareholder value.
3) Does the company have a record of taking large impairment charges?
Poor stewards of shareholder capital frequently need to write down the value of previous acquisitions and probably need to improve their M&A decision-making processes. Exemplary stewards consistently pay good to fair prices for their acquisitions.
4) Is management's investment focus on building long-term shareholder value, or has it engaged in a growth-for-growth's-sake strategy?
Investment decisions that provide both short- and long-term benefits are ideal, but exemplary stewards of shareholder capital should be willing to sacrifice short-term results to create long-term shareholder value. Poor stewards, on the other hand, have a myopic focus on short-term results and have less concern for long-term consequences.
5) Does the firm have a history of cost overruns or expensive operational missteps?
Our methodology doesn't punish companies for a string of bad luck. Instead, we're more interested in how management's actions and decision-making process may have played a role in value-destructive events. Poor stewards of shareholder capital will have a habit of not correcting their mistakes, whereas exemplary stewards consistently avoid repetitive and costly mistakes and quickly fix those that they do make.
6) Does the firm have the appropriate dividend and buyback policy?
The common traits of a good dividend policy are consistency, affordability and transparency. All else equal, firms in cyclical and capital-intensive businesses and those with significant value-enhancing investment opportunities should pay out a smaller percentage of earnings compared with firms in defensive industries or those with fewer reinvestment opportunities. As any successful investor would do, exemplary stewards look to opportunistically repurchase shares when the stock is trading at a material discount to fair value. We don't like to see executives using buybacks simply as a means of increasing earnings per share or offsetting dilution related to employee stock options with little regard for the price paid.
7) Does the firm have an appropriate amount of debt given the cyclicality and capital intensity of its business?
We look unfavourably on firms with leverage ratios that are inappropriate for their lines of business. Firms that operate in highly cyclical, capital-intensive industries shouldn't carry a large debt load, as this will serve to exaggerate the inherent volatility in the business. Similarly, firms in mature industries that carry no debt and have few reinvestment needs may not be maximising shareholder value, as issuing debt could lower the firm's cost of capital.
8) Does the ownership structure serve as a benefit or detriment to minority shareholders?
Dual voting structures with unequal voting rights, large family or insider ownership, and large government ownership positions can have a meaningful impact on executive capital-allocation decisions. The big question to ask is, "Are the major shareholders' interests aligned with those of minority shareholders?" and if they are not, "Has the arrangement led to value-destructive decisions?"
9) Has the board of directors established an appropriate incentive structure that rewards value creation?
Exemplary stewards will establish annual and long-term bonus metrics that align management's financial interests with those of long-term shareholders and are appropriate for the line of business. Poor stewards, on the other hand, may not disclose metrics for evaluating performance, have "moving goalposts" when rewarding management, or base incentives on metrics that reward growth without regard to value creation.
10) Do you think management is forthcoming about strategic missteps and challenges?
Exemplary stewards will be communicative with shareholders in both good and bad periods, while poor stewards will look to sweep bad news under the rug or make it more difficult for shareholders to evaluate capital-allocation decisions by rearranging reporting segments or adjusting accounting assumptions.
Answering these 10 questions should help you understand how well management is allocating capital, whether or not management's interests are aligned with your own, and whether management treats shareholders as partners or simply capital providers. In other words, you'll be able to decide whether or not you want to invest in the company for the long term.
This article earlier appeared on Morningstar's UK website
