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In addition to managers who are paid reasonably and are honest, you also want folks who can run the business well.

Performance

The first stop is simply the financial performance of the company during the tenure of the current management team. Look for high and increasing ROEs and ROAs—but don't forget to check whether increasing ROE was driven by higher leverage, as opposed to improved profitability or asset efficiency.

Are there any big jumps in revenue? If so, the firm probably did an acquisition, and you should check to see whether management paid a reasonable price and whether the acquired firm wound up adding to shareholder value. Most acquisitions do not pay off, so digging into past merger and ac­quisition (M&A) activity is definitely worth your while.

Finally, look at the share count over a long period of time. If the number of shares outstanding has increased substantially because of aggressive options programs or frequent equity issuance, the firm is essentially giving away part of your stake without asking you. That's not a great recipe for long-term share performance.

Follow-Through

When management identifies a problem and promises a solution, does it actually implement the plan, or does it hope you forget about it? The same goes for any "new strategic initiatives" that are announced: Does the firm go ahead with a new plan once it's announced, or does every year see the firm announcing a grand new strategy that's never realized? One way to vet this is to look at past annual reports and see what new initiatives were discussed three to seven years ago. It's fine if they "weren't all successful, but "where are they now? Has management kept shareholders up to date on them, or do the initiatives just disappear from the radar screen? In the latter case, management is probably spending more time hiring consultants with grandiose plans than actually figuring out what's broken.

Candor

Does the firm provide enough information to properly analyze the business, or does it clam up about certain issues? Generally, management teams will talk ad nauseam about parts of the business that are hitting on all cylinders, but questions about a problem area are sometimes met with evasion or a straight, "We don't disclose that."

For example, Merck changed the "way it reported its drug sales figures in 2OOI, but it wouldn't provide comparable data for past periods—which made it difficult to get a clear picture of what "was going on. Lucent "was another offender in this department because it grouped together high-growth and low- growth product lines when it broke out segment data. It's entirely proper for firms not to report certain things, but selective reticence about problem areas is never a good sign.

Self-Confidence

I generally applaud firms that do something markedly different from their peers or from conventional opinion. It's tough to take a pass on a hot consulting fad when all of your golfing buddies are singing its praises or to buy a beaten-down competitor "when your industry is in the tank—but these are both moves that can pay off in spades. Maintaining research and development spending during an industry downturn is another good example of self-confidence that shows management is more concerned with beating competitors over the long haul than beating its quarterly earnings guidance.

Flexibility

Has management made decisions that will give the firm flexibility in the future? These include simple decisions such as not taking on too much debt and controlling fixed expenses (even in good years), as well as more strategic decisions such as issuing equity when the stock is high. Attaching call options to debt, retiring high-rate debt when the opportunity presents itself, and buying back stock only when the price is low are also good examples of capital allocation decisions that evidence a solid operational hand on the tiller.

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