Thursday, February 21, 2008

Rating a Company's Management

Good stock selection, defined as finding and investing in currently underpriced companies, is Job #1 for the covered calls investor. A previous post described this advisor's top-down approach to stock selection -- Link. The basic process is to identify those companies rated as 'Buy' by both stock selection advisory services used -- this will provide a list of about 300 companies. The list is trimmed further by eliminating those companies with low options liquidity, high historic volatility, or imminent earnings releases. This process will result in about 125 investment candidates. Then some additional fundamental screening criteria are applied to reduce the list of potential investment candidates to about 60 companies, at which point each company is analyzed in detail. This advisor uses an Analysis Sheet for each company to present critical metrics in ten primary categories for each company analyzed. These categories are: ROI, Downside Protection, Safety, Profitability, Stock Ratings, Value, Growth, Momentum, Options Liquidity, and Management. This article presents an overview of the method used by this advisor to rate one of these ten analysis categories, namely a company's Management.

Of these ten categories, evaluating a company's management effectiveness is definitely the single most difficult one to assess. Most of the other categories have highly quantifiable metrics that can be obtained from a company's historical financial statements. But evaluating a company's current management is a daunting task in that it requires us to make subjective judgments about the individuals leading the company, primarily the CEO and CFO. Despite this difficulty, it is an important exercise to undertake because of the critical influence of top management to the future success of the company. The difference between excellent, mediocre, and weak management teams on overall company performance is normally substantial, so doing our homework in this area is not easy, but it is essential.

The Management Grade sheet for Disney shows the specific evaluation factors and the grades given by this advisor. The CEO/CFO information at the top of the form is normally available from the company's own website. The Corporate Governance Quotient(CGQ) is the best available independent measure of a corporation's overall management stewardship and is available via Yahoo Finance. The remaining evaluations are conducted by listening to the company's latest quarterly conference call -- this is normally available on the company's own website for several days (or even weeks) after the earnings release date.

A detailed explanation of why each of the attributes included on the Management Grade form were chosen is not provided at this time. For now, it is sufficient to say that grades are assigned on the A,B,C,D,F grading system. Any company not receiving an Overall Grade of A or B is eliminated from further consideration as a potential investment.

Again, this homework is not easy. It is definitely time consuming. But because of the critical importance of senior management to the future success of any company, taking the time to conduct a management evaluation is an essential part of our overall stock selection process.

Regards and Godspeed,

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