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Excellent management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground. Your goal is to find management teams that think like shareholders—executives that treat the business as if they owned a piece of it, rather than as hired hands. Unfortunately, managers like this are more rare than you might think.

People buy stocks all the time without checking out the folks in the exec­utive suite, and the excuse I hear most often is that it's tough to assess management "without meeting them face-to-face. Hogwash. There are many, many ways to get a feel for the folks running a company that have nothing to do with looking the CEO in the eye. No one can run a public company without leaving a trail of pretty strong objective evidence behind. My advice is to divide the management-assessment process into three parts: compensation, character, and operations.

Compensation is the easiest of the three areas to assess because the bulk of the information is contained in a single document, usually called the proxy statement. This is the form that companies mail shareholders around the time of the annual meeting, and it details how much executives are paid and what perks they get. (You can find this form online at www.sec.gov or www.freeedgar.com. Look for form DEF14A.)

Here's what to look for in a company's compensation plan. First and most important, how much does management pay itself? (This is detailed in the aptly named "summary compensation table.") Generally, I prefer big bonuses to big base salaries and restricted stock grants to generous option packages. Bonuses mean that a good portion of the pay is at least theoretically at risk, and restricted stock means the executive loses money if the share price declines. That's just the tip of the iceberg, though.

First, look at the raw level of cash compensation to see if it's reasonable. There's not necessarily a strict limit here, though I personally think an $8 mil­lion cash bonus is silly no matter how well the company has done. (For reference, the average CEO of a large U.S. firm currently earns about JOO times as much as the average employee. Twenty years ago, this multiple was just 40.)

In any case, use your own judgment—if the amount that executives earn makes you cringe, it's probably too much. Also look at competing firms to see what their CEOs are paid, so you can see how the boss that you're investigating stacks up. In general, the larger the firm and the better its financial performance, the more an executive should be paid. But some executives think they have a license to print money just because they manage a huge company, no matter how poor a job they're doing, which is why you need to determine whether their pay is tied to the firm's operational performance. (Case in point: After retiring as chairman and co—CEO of Verizon, Charles Lee became a "consultant" to the firm at the exorbitant rate of $250,000 per month. To me, that's a cringe-worthy retirement package.)

Pay for Performance

What's even more important is whether executives' pay is truly tied to the company's performance. At many companies, so-called "performance targets" are set by a subcommittee of the board of directors, which can often rewrite the rules of the game if the CEO appears to be losing. In 2OOI, for example, Coca-Cola's board reduced CEO Douglas Daft's goal of IJ percent earnings growth over five years to n percent. Moving the goalposts like this can be justified in one sense—after all, if the performance target isn't achievable, it's hardly going to motivate the CEO—but you can also fault the board for not setting more realistic goals in the first place. In any case, I think it's a negative sign when the targets are changed but the potential reward stays the same, because it indicates that the board is un "willing to stand up to the CEO and punish him or her by slashing the bonus when performance slumps.

At least Coke's shareholders knew what the target was, though. According to the 2OOI proxy, Walt Disney's compensation gurus decided that bonuses:

may be based on one or more of the following business criteria, or on any combination thereof, on a consolidated basis: net income (or adjusted net income), return on equity (or adjusted return on equity), return on assets (or adjusted return on assets), earnings per share (diluted) (or adjusted earnings per share [diluted]).

In other words, Disney's CEO was going to get paid no matter what. To add insult to injury, the gang at Disney wrote that "[we believe] that the specific target constitutes confidential business information the disclosure of which could adversely affect the Company." More likely, it "would have adversely affected Disney management because the board wouldn't have been able to move the goalposts in the middle of the game. This kind of nondisclosure on the compensation front is a bad sign when you're looking for good managers.

Another sign of poor compensation procedures is paying managers for actions that make the company bigger, but not better. In 2OOI, for example, Disney wrote the following in its proxy statement:

As permitted by the plan, special bonuses were paid outside the plan to three executives . . . Peter Murphy, Thomas Staggs and Louis Meisinger—for ex­traordinary services to the Company unrelated to the plan's performance targets, including, in the case of Messrs. Murphy and Staggs, services related to the Company's acquisition of Fox Family Worldwide, Inc.

Rewarding management for consummating an acquisition is an absolutely terrible idea—paying big bonuses just for getting a deal done simply encourages executives to go out and do more dubious deals. A better idea, though not one I've ever seen implemented, would be to wait a couple of years and pay a bonus only if an acquisition has provided an adequate—and predetermined—return on the investment.

The bottom line is this: Executives' pay should rise and fall based on the performance of the company. So, after reviewing a company's historical fi- nancials, read the past few years' proxies to see whether this has truly been the case or whether some lackeys on the board of directors have cooked up justi­fications for big bonuses even in bad times. Firms with good corporate governance standards won't hesitate to pay managers less in bad times and more in good times, and that's the kind of pattern you want to see as a shareholder.

Other Red Flags

Aside from the big-picture question of whether executives' pay truly is linked to company performance, keep an eye out for the following issues when you're assessing executive compensation.

Were Executives Given "Loans" that Were Subsequently Forgiven? This was a common—and disgusting—practice before the Sarbanes-OxleyAct banned it in 2OO2. Companies would give loans to senior managers at below-market rates of interest and then often quietly forgive the loans a few years later. In my book, a loan that's not repaid is a bonus, and companies that tried to fudge executive pay in this fashion weren't treating shareholders "with respect. If the executive needed a loan, he should have asked his bank, not his employer. Don't tolerate this kind of behavior from companies you're investigating—even though it's not legal any longer, companies that did this sort of thing in past should be viewed with skepticism. After all, would they have stopped unless they "were forced to? (Loans of this sort are usually disclosed in the "other compensation" column of the executive compensation table in the footnotes.)

Do Executives Get Perks Paid for by the Company that They Should Really Be Paying for Themselves? It's a sure sign of corporate excess when execs get country club memberships and other frippery paid for by shareholders. After all, when you're paying someone several hundred thousand dollars per year, making shareholders foot the bill for their greens fees seems rather silly. More im­portantly, such behavior at the top sets a poor example for everyone else in the firm. Managers who enjoy ridiculous perks are acting like latter-day royalty rather than prudent custodians of shareholders' money. Conversely, thrifty CEOs are a plus: Managers who do things such as paying for their own parking and eschewing pricey perks set a good tone for the rest of the organization.

Does Management Hog Most of the Stock Options Granted in a Given Year, or Do Rank-and-FHe Employees Share in the Wealth? Generally, firms with more equitable distribution schemes perform better over the long run. Most firms break out the percentage of options granted to executives relative to the total granted in the proxy statement.

Does Management Use Stock Options Excessively? Even if they're distributed beyond the executive suite, giving out too many options dilutes existing shareholders' equity. If a company gives out more than 1 or 2 percent of the outstanding shares each year, they're giving away too much of the firm's equity every year. Conversely, it's a great sign if the firm issues restricted stock instead of options. Restricted stock has to be counted as an expense on the income statement (options don't, as of this writing), and restricted stock also forces the recipient to participate on the downside if the stock falls.

If a Founder or Large Owner Is Still Involved in the Company, Does He or She Also Get a Big Stock Option Grant Each Year? This makes me queasy. After all, it's hard to argue that, for example, CEO Larry Ellison of Oracle needs additional options to motivate him when he already owns 25 percent of the firm.

Do Executives Have Some Skin in the Game? That is, do they have substantial holdings of company stock, or do they tend to sell shares right after they exer­cise options? As a shareholder, I want management to have meaningful equity in the company. After all, selling shares in the name of "diversification" means not being exposed if the company goes downhill. Generally, I'm happier own­ing companies where executives own stock right alongside me because large unexercised option positions are cold comfort. You can find this information in the footnotes of the proxy. Companies indicate executives' percentage ownership including options prominently in a table labeled "security ownership of certain beneficial owners," but they declare only how many actual shares are owned in the footnotes. In Peoplesoft's 2003 proxy, for example, CEO Craig Conway was listed as owning 3.8 million shares, or 1,2 percent of the company. But if you looked at the footnote, you'd have seen that he owned only 626,000 shares, 625,000 of which weren't even vested yet.

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