Two Tests for Corporate Execs

All too often, investors start and end their evaluation of a stock’s prospects with its earnings. Although there’s no getting around the significance of the bottom line, companies can manipulate their net income to obscure a flagging operation. As such, it’s important to go beyond quarterly earnings and actually assess the underlying business.

To that end, investors must examine the quality of a company’s management team, and attempt to determine how they’re adding value to the business they run. But unlike Wall Street analysts and fund managers, the average investor doesn’t have the luxury of meeting with corporate executives in person.

Nevertheless, there are two powerful data points that can help investors identify a strong management team: high inside ownership and return on invested capital (ROIC). For this column, we’ll run through why these data points are worthy of consideration, and then see if they lead us to a potential stock pick. 

Check Corporate Execs’ Alignment

Inside ownership is one of the main ways investors can determine whether management’s interest is aligned with shareholders. These days, many top executives receive the bulk of their compensation in the form of stock options and grants. But because the shares they receive in this manner are essentially an alternate form of income, they often sell them shortly after they’re awarded. That means it’s worth noting when corporate insiders, which include both executives and directors, actually retain substantial holdings of their company’s shares.

Insiders regularly report these holdings as well as any related buying or selling activity to the Securities and Exchange Commission (SEC). So investors can monitor these data and learn not only the extent to which insiders invest in their own company’s shares, but also their sentiment regarding the company’s near-term performance.

Additionally, investors can read a company’s annual report to learn whether these stock awards are tied to metrics that incentivize management to act in the company’s long-term interests. Companies whose executives are compensated based on profits alone risk the sort of shenanigans that can artificially boost earnings. Instead, more concrete metrics such as sales growth and ROIC ensure that management thinks strategically instead of quarter by quarter.

Management Quality Is Job One

Indeed, investors should also use ROIC to gauge management’s success at one of its primary charges: the skillful allocation of capital toward projects that produce organic growth. To calculate ROIC, take the company’s net operating profit after taxes (NOPAT) and divide the result by a firm’s total capital, which includes long-term debt and preferred and common stock.

The more common version of ROIC uses net income in lieu of NOPAT, but the latter figure isolates the profits of the core business by removing numbers that can cloud actual performance, such as one-time items and non-cash adjustments. Although companies don’t typically report NOPAT, investors can calculate it themselves by multiplying a firm’s earnings before interest and taxes (EBIT) by its effective tax rate.

With these two metrics in mind, I constructed a stock screen to narrow the universe of stocks down to a manageable list with promising names. Even with exacting criteria, a stock screen can still pull stocks of dubious value, so it’s important to then subject the resulting list to additional scrutiny.

Arriving at a Consensus

One name, in particular, caught my attention: Copart (NSDQ: CPRT). Major insurance companies enlist the firm to auction totaled vehicles to salvage yards, used-car dealers, and even third world countries, where the vehicles may still be considered drivable. Copart is still largely a domestic operation, though it’s starting to expand overseas, with global sales facilitated by its online auction system.

Copart stood out because in my previous column, which detailed the consensus holdings among nine top-performing mid-cap mutual funds, Copart was one of the 10 names held by four or more funds.

In that article, I was looking for stocks that might still qualify as current buys based on the funds’ recent trading activity in one of these consensus picks. One of the four funds boosted their holdings in Copart by 6 percent during the third quarter, the other two stood pat, while the fourth modestly decreased its position by 4 percent.

However, it should be noted that this latter fund pared dozens of holdings during the quarter, so its recent activity may be due to rebalancing. And Copart’s average allocation among these four funds is 2.3 percent of assets, which is not insubstantial when considering the funds hold between 38 and 150 names.

Even so, the aforementioned trading activity wasn’t quite sufficient to meet the criteria for a current buy. Indeed, Copart is trading just 1.7 percent below its 52-week high, so that may explain why these funds are essentially maintaining the status quo. Still, Copart boasts some extremely attractive characteristics that make it a solid addition to investors’ watch lists.

Attractive Fundamentals

The company has high inside ownership, with management holding nearly 11 percent of shares outstanding.

And its ROIC has averaged 16.5 percent over the past five years. Even better, its ROIC has exceeded its weighted average cost of capital (WACC) by a greater than two-to-one ratio.

Revenue growth has averaged 10.5 percent over the past five years, while earnings per share have grown 13.8 percent annually over that same period.

Questions to the PM

Last Thursday, I had the opportunity to chat again with Rich Eisinger, portfolio manager of Madison Mosaic Mid-Cap (GTSGX), which is one of the top-performing mid-cap mutual funds mentioned in my prior column. His fund had a nearly 4 percent allocation to Copart as of the end of October.

As such, I asked him to detail what he finds compelling about the business. He said that Copart operates in an industry that is essentially a duopoly between it and KAR Auction Services (NYSE: KAR), but that Copart is the superior firm.

In addition to what I noted earlier about the company, Eisinger added that the company generates strong cash flows, and that its management team is patient and invests in the business for the long term. For instance, while other companies repurchase shares when they trade at a premium, Copart’s management only buys back shares aggressively when they trade at attractive prices. Beyond that, Eisinger expects Copart to generate 10 percent to 15 percent earnings growth for the foreseeable future.

So be like Copart’s management and use the next market selloff as an opportunity to add shares of the stock to your portfolio.

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