Because people run companies, any investment opinion about a company is an opinion about the likely outcome of the combined efforts of the people who work for and manage it.

Keeping this in mind when you evaluate companies as investment opportunities can provide valuable perspective on some of the qualitative factors you should focus on. This lesson will cover some of the most important questions to ask and the sources you can use to evaluate the people who run public companies.

Why Management Matters

In his groundbreaking work Common Stocks and Uncommon Profits, Philip Fisher argues that because company managers are much closer to a company's assets than stockholders, they wield considerable day-to-day influence over the arrangement and disposition of the company's affairs. (For more on Fisher, see Lesson 505.) According to Fisher, "Without breaking any laws, the number of ways in which those in control can benefit themselves and their families at the expense of the ordinary stockholders is almost infinite."

Fisher suggests that investors should accumulate as much background information on companies and their managers as possible by talking to people in the industry. He refers to the process as gathering "scuttlebutt." Visiting management in person, and interviewing line managers, competitors, customers, and suppliers are most stock analysts' preferred means for gathering such information, and the impressions they garner during these visits can have a strong, yet subtle impact on their view of the company's prospects. This type of research is typically not realistic for nonprofessional investors with limited time, but there are still things you can do to get a sense of the quality of a company's management.

Ultimately, it boils down to trust: As an investor, can you trust this management team to develop and execute the right business plan and perform their duties in your best interest?

Investors can easily familiarize themselves with the backgrounds and qualifications of the managers of the companies they invest in by checking their biographies on company Web sites or in the annual proxy statements sent to shareholders (and filed with the SEC as Schedule DEF 14a). Part of answering the question, "Can I trust this team?" certainly hinges on basic information like, "Is the team qualified?" But often enough in corporate America, managers have grown up with a company, and their resumes won't say much about what they've done recently, and they won't tell you much about whether to trust these individuals with your money.

We believe that in the grand scheme, people respond to the incentives they are given or set for themselves. In some ways, this represents the kernel of the American Dream: Regardless of your background, if you prove yourself and work hard, you can do anything. The promise of financial reward accompanies most versions of the American Dream we've heard of. This is the angle from which we here at Morningstar approach the question about trusting management. We assume the team is qualified (whether by pedigree, education, or hard knocks), but we question the motivation and reward system that the team (including the board of directors) has put in place and by which they measure their own performance.

Management Structure

Technically, the management team of a public company works for and reports to the board of directors, who represent the company's owners: its shareholders. In the U.S., companies typically hold annual elections at which shareholders vote (or assign their vote to someone else, called a proxy) to elect directors to the board. In theory, then, shareholders can wield great influence over the management and direction of the companies whose shares they own. In practice, as corporate and investing cultures have evolved, the relationship between shareholders and company managers has become ritualized and more distant.

So how should investors close the gap? We believe that by identifying and investing in companies that have demonstrated their commitment to treat shareholders well, individual investors can reassert their influence on the day-to-day choices and priorities that companies set.

What do we mean by "demonstrated commitment to shareholders?" Perhaps an analogy will help. Imagine you have decided to start a lemonade stand with your neighbor. When you meet at the appointed time to go over your plans, your neighbor brings a pound of sugar for the lemonade. Such a gesture demonstrates your neighbor's commitment to doing business with you.

Similarly, when you view a home for sale, you expect it to be orderly, and that the owner will make arrangements for you to see it. In this small way, the seller has demonstrated his or her commitment to doing the things that are necessary to sell you the home. If it's a hassle to view the home, or it's disorderly when you view it, that should prompt questions about how the later stages of negotiation and closing will be handled.

Buying a Business

Now imagine that you are considering buying part of a business, potentially to keep and to profit from for a long time. What signs should you look for that the company's directors and managers are interested in doing business with you?

Investors should look for companies that offer clear communication about the business, have established a clear separation between business and personal relationships, and have set clear goals for measuring progress in conducting the business. In practice, these goals often involve raising barriers or instituting policies meant to inhibit human nature. By snooping around the edges and examining the outward signs of how a company's management team behaves and rewards itself, we can surmise how committed they are to honoring their role as stewards of investor capital.

While it would be impractical for every private shareholder to visit management and dig around for scuttlebutt, this doesn't mean that individual investors should simply give up on investigating the people who run their businesses. On the contrary, through a handful of public sources, investors can begin to crack the nut around one of the most subjective elements of stock research: management.

We will refer to the host of topics surrounding management as "stewardship." Fisher describes the qualities he looks for in managers as trusteeship. Others refer to these issues as corporate governance, fiduciary responsibilities, and other names. We call it stewardship because we look for managers who see themselves as stewards of investors' capital and who have signaled their self-image to us in verifiable ways. We find the alternative--managers who see the company they run as their personal piggy-bank--repugnant.

20 Questions

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.

Transparency
1. Does the company overuse "one-time" charges or write-offs? In public announcements, does it consistently disregard GAAP earnings and point to pro forma numbers (i.e., figures "excluding charges...")?

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?

Shareholder Friendliness
7.  Does the company have a separate voting class of shares that an insider controls?

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
13. Has the board agreed to a compensation structure that rewards management merely for being employed, rather than for making value-enhancing decisions?

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.

Morningstar Stewardship Grades

Morningstar has already done a lot of management investigation for you! For the 2,000 companies that we cover, Premiumsubscribers to Morningstar.com have access to analyst-driven Stewardship Grades based on the topics discussed in this lesson. Like in school, the grades are "A" through "F," with "C" being the most common grade.

Morningstar stock analysts base the Stewardship Grades on public filings, previous management actions, conversations with company officials, and their own expertise. We assign the grades on an absolute scale--not on a curve or on an industry-peer basis. Therefore, if a company engages in practices that Morningstar analysts think do not reflect good stewardship of investors' capital, it will receive a poor grade regardless of how other firms may have scored.

The Bottom Line

Though competitive positioning remains extremely important to a company's long-term fortunes, quality of management matters, too. After all, even the most attractive ship can be run ashore by an incompetent skipper, or be pillaged by a pirate. The whole reason it is worthwhile to go through these exercises is to make sure you are investing your money with people you can trust.