How do you work out if companies are well run when stockpicking for your Isa?

A well-run company is likely to perform better and avoid errors and scandal, but judging management competence can be a tough task for individual investors.

You can sift the evidence in financial statements and announcements, and glean what you can from whatever is in the public domain, and this will be useful research.

But although company bosses have to be transparent and follow rules on certain financial and regulatory matters, they are always understandably keen to put a favourable gloss on their actions and business strategy.

Investing in successful management: A well-run company is likely to perform better and avoid errors and scandal

The rise of ‘responsible’ investing, or what is referred to as ESG – meeting certain environmental, social and governance standards – has made investors more focused on how companies are managed, or ‘governed’.

On the bosses’ side, while some believe driving staff mercilessly gets the best out of them, others now put greater stock in creating a happy environment – even to the extent of actively screening out toxic staff from the workplace

Ultimately, investors have to learn as much as they can, and make the best call possible about how a management team is doing under the circumstances.

We asked financial experts what detective work investors should do and the clues they might follow to find out about a company’s management practices.

What should you look out for when assessing a company?

1. Track record: A sound financial situation and record is the most basic test of management competence, and perhaps the best and simplest place to start.

Richard Hunter, head of markets at Interactive Investor, says: ‘While certainly not an exhaustive list, potential investors should look out for measures such as successive years of earnings and profits growth, the company’s financial health (net cash or net debt position), the valuation compared to peers (the price/earnings ratio) and, depending on the individual’s need for income, whether a dividend is being paid and the company policy on dividends is progressive.

We explain how to research stocks here and how to make sense of a balance sheet here. 

Richard Hunter: ‘Management failings often become apparent after the fact and, in some cases, too late for investors to react’

2. Future prospects:  Forecasting is hard, but you can look at the current circumstances of a company and extrapolate to a certain extent what is likely to happen if it continues on its current path.

Hunter suggests the following list of questions you should consider when weighing up whether to invest.

‘Does the company have a unique selling point in terms of the goods or services it provides?

‘Is there a high barrier to entry for new competitors (or a ‘moat’, as Warren Buffett would say) which therefore strengthens its position?

‘Is its current success transitory (such as high fashion, which can change quickly) or is it entrenched (such as household goods and energy, both of which have strongly defensive qualities)?

3. Strategy: You can form opinions about the judgement of the management team based on what they say about where the company is heading and how they plan to get there.

‘A clearly defined and long term strategy helps investors to understand the main focus of the business, and also focuses minds within the company too.’ says Laith Khalaf, financial analyst at AJ Bell.

‘Long term decision-making means managers aren’t cutting corners to boost profits now, at the expense of the longer run interest of the business.’

Khalaf cites the following mission statement from fantasy figurine maker Games Workshop as a good example of management setting out its intentions in absolutely clear terms. 

‘We have a simple strategy at Games Workshop. We make the best fantasy miniatures in the world, to engage and inspire our customers, and to sell our products globally at a profit. Our decisions are focused on long-term success, not short term gains.’

Management practices: Some bosses actively create a happy working environment – and even screen out toxic staff

4. Leadership: You need to keep an eye on maverick bosses, warns Khalaf.

‘There can be a fine line between marked out as a visionary or a maverick,’ he says. 

‘Tesla chief executive Elon Musk is walking that tightrope right now, with dubious dabbling in cryptocurrencies and regular tweeting taking attention away from Tesla’s core automotive business.

‘[Frasers Group’s] Mike Ashley is another chief executive who has occasionally been judged to have stepped over into the maverick camp.’

5. Family ownership: ‘Companies where founding families are still heavily invested tend to have personal ownership of the products they are selling to customers, which tends to foster higher levels of accountability,’ says Khalaf.

‘AG Barr is a good example, where the Barr family still owns a good chunk of shares and has representation on the board, after founding the company in 1875.’

However, Peter McLoughlin, head of research at Rowan Dartington, suggests one of the checks investors make on boards is that there are no relatives on it, because it is better if directors are independent.

Laith Khalaf: ‘There can be a fine line between marked out as a visionary or a maverick’

6. The board: Arguably the easiest way for ordinary investors to gain insight into the management of a company is by researching the composition of its board, according to McLoughlin.

It is important that the chief executive and chairman are separate, he says. Check that a former chief executive has not become the chairman, or that they have not combined the roles and taken on both jobs.

Also, McLoughlin says you should put the names of the chief executive, the chairman and the non-executive directors – particular the lead non-exec – into a search engine and read their CVs.

You want to be sure non-executive directors are fully independent, and have not worked together with the other board members in the past, he explains.

‘You do want dissent to some of the decisions being made.’

McLoughlin adds that the board should be not so big it is likely to be unwieldy, with about eight to 10 people being about right.

Meanwhile, you should check whether the management owns shares in the company themselves because if they do it’s a sign they believe in its future.

7. Setting pay Find out how the management sets pay targets, advises McLoughlin.

How much they reward themselves can be a negative sign, and you should check the difference between what the chief executive gets and what the workforce is paid, he explains.

McLoughlin says there have been cases of ‘obscene’ levels of pay at the top, which reveal a divergence of interest between the management and the firm’s shareholders and employees.

8. Diversity: It is positive when women and people from ethnic minorities are represented on a board, according to McLoughlin.

‘It’s great to increase diversity on a board over time,’ he says. ‘The board has to make sure it’s the right people.’

Peter McLoughlin: ‘You do want dissent to some of the decisions being made’

He notes that if there is a small group of women who are on a lot of boards, that raises the issue again of people knowing each other, and their independence.

McLoughlin believes it is important to increase diversity from the bottom up, to nurture talent among people who could be promoted in the future, as well as improving diversity at the top on the board, and if a company is doing both these things simultaneously that is a good sign.

9. Corporate buzzwords: ‘There’s a certain inevitability that businesses of a certain size will all look to the same sources for inspiration, and unfortunately this is often consultancies rather than employees or customers,’ says Khalaf.

‘It’s not a good sign when these buzzwords overwhelm communications to shareholders.

‘It suggests that management have little flair for plain speaking, or worse, they are just repeating cornfed gobbledygook because that’s what everyone else is doing.’

Meanwhile, the same might be said for marketing jargon. When senior management appears to have fallen under the spell of this department, it is an indication it has been given too much sway within a business, and possibly too big a budget.

Or, bosses might have recently overpaid for outside marketing consultants and be trying to justify their huge bill.

What can go wrong? Management disasters from the past

Spotting the cracks can be hard, but some are more obvious than others and have become notorious with hindsight.

The most famous cases relate to bosses whose behaviour was at odds with the company’s goals, explains Hunter.

He cites Gerald Ratner calling a product sold by his jewellery chain ‘total crap’ in the 1990s, or warning signs at Royal Bank of Scotland under former boss Fred Goodwin before the 2008 financial crisis.

On the latter, he says: ‘Not only was the company involved in an ill-advised £50billion takeover of ABN Amro, but he also orchestrated the building of a major new complex in Edinburgh in an effort to showcase the company’s lofty ambitions.’  

Fred’s folly? RBS’s Gogarburn complex outside Edinburgh

Hunter goes on: ‘Unfortunately for investors, one of the reasons for equities being regarded as higher risk investments is that management failings often become apparent after the fact and, in some cases, too late for investors to react.

‘This in turn is a reason for the tired, but tried and tested suggestion of not keeping all of your eggs in one basket.

‘A diversified portfolio is designed to offset weakness from any one company in terms of trading or management misdeeds, by having a number of other companies which together can pick up most of the slack caused by the underperformance of just one company’s shares.’