Assessing Management Quality
Management quality is one of the most important factors you need to
consider when evaluating a company’s outlook, and hence, whether you’ll
make money owning the stock.
How do you do that? We can’t call a firm’s top executives and tell them
that we want to hang out with them for a few days while we evaluate
whether or not they’re up to the job. But we don’t have to.
Non-Recurring Red Flags
Many market pros consider clean and straightforward accounting a
hallmark of good management. For them, repeated nonrecurring charges are
“red flags” signaling questionable accounting practices.
There’s nothing wrong with classifying expenses as nonrecurring when
used appropriately, for instance, to exclude the effects of one-time
events such as acquisitions, income tax refunds, or legal expenses.
But when companies report quarterly results, they often emphasize
earnings from continuing operations. When calculating that number, they
don’t subtract non-recurring charges from reported earnings. The problem
comes in when company execs inappropriately and repeatedly classify
expenses as non-recurring to boost reported earnings from continuing
Unfortunately, many market reporters and stock analysts don’t question
managements’ definition of non-recurring expenses.
Easy to Check
It’s easy to spot nonrecurring charges because they are usually listed
on separate lines on each company’s income statement. But the raw
numbers don’t mean much by themselves. What’s significant for a
micro-cap wouldn’t move the needle for a large company. So, it’s best to
express the non-recurring expenses as a percentage of total sales, which
is also shown on the income statement.
Do that by dividing the nonrecurring expenses by revenues (sales) and
computing the result as a percentage. For instance, the ratio would be
10 percent if a company recorded revenues of $1,000 and listed $100 in
nonrecurring charges (100/1000).
Getting the Info
You can find the needed information on many financial sites. I’ll
use Yahoo Finance to demonstrate the process.
From the Yahoo Finance homepage (finance.yahoo.com),
enter the company name or ticker symbol, and then select Income
Statement listed under Financials. On the Income Statement, be sure to
select Annual Data (not the quarterly data default).
For example, start with medial device maker Boston Scientific (BSX).
income statements for the last three fiscal years, in this case,
ending in December 2007, 2008 and 2009. I calculated the percentage of
non-recurring vs. revenues for those years as 14%,
34%, and 28%,
For comparison, look up the annual income statements for construction
Caterpillar (CAT). You won’t need your calculator for this one.
Caterpillar did not record any non-recurring charges in each of its last
three fiscal years.
You’d find the same results for
Microsoft’s last three fiscal years (June 2008, 2009 and 2010),
Systems did record non-recurring charges in its fiscal years ending
in July 2007, 2008, and 2009, but in each year, the charges amounted to
less than 1% of revenues.
Look for Patterns
Judging management quality is a subjective exercise. Most firms will
from time to time incur costs that are truly nonrecurring. The trick is
to differentiate those from the firms that persistently come up with
nonrecurring expenses to boost reported earnings from continuing
Looking for patterns is more significant than any single year’s number.
You can do that by simply eyeballing the results or averaging the past
three-year’s ratios. A single year above 15%,
or three -year average ratios above 6% are red
flags signaling the need for further research on your part.
Consider this strategy of analyzing non-recurring charges as another
tool for your stock analysis toolbox. Clean accounting doesn’t guarantee
that a company’s stock is headed higher.