Three ways to find a stock you can trust

The public anger over executive pay has been boiling over for months now. But it really came to a headlast week with the furore over RBS boss Stephen Hester.

The truth isthat Hester's bonus came at a bad time for the politicians. Just a few weeks before, David Cameron said that he wanted to tackle excessive executive pay head on. And business secretary Vince Cable is been regularly bemoaning the culture of reward for failure'.

So there must have been a flurry of high-level behind-the-scenes phone calls before the RBS boss agreed to dump his bonus.

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But there is a disturbing story here that is being ignored. Because while the public fixate over bank bonuses, executive pay at other blue chip companies has been soaring. The last year has seen a huge lift in top-level pay at FTSE 100 companies. And that is terrible news for investors. Because it means their interests are increasingly out of whack with the boards of these companies.

What you need to know is: can I trust the people that run my major investments?

That's the question I'm going to answer today. I'll point to three methods I use to spot management that I can believe in.

But first

How bad have things got?

Last year, FTSE 100 CEO's saw their overall pay increase by about 32%, while the workforce at large got a paltry 2% wage increase.

Much of that pay increase was down to the fact that the stock market did well, and therefore stock incentive' plans reaped big rewards for the fat cats.

But this is ridiculous, and sets exactly the wrong sorts of targets for executives. First, they pocketed big bonuses just because the market went up. Do they give back their rewards when the markets go down? No chance.

But more importantly, many of these ill-considered share incentive schemes can end up landing our businesses in trouble.

Often, incentive plans give management options to buy company stock at a pre-determined price. So if the stock goes up, their options are worth more. A lot more! Holding an option is not the same thing as holding shares. Options are short-term instruments offering highly leveraged returns. One of the things that makes options valuable is volatility.

Yes, that's right. It's often in the interests of management to get the share price fluctuating wildly up and down... exactly whatwe shareholders don't want!

Ideally, management would get the share price down when setting up the incentive plan, and then they want it to fly so they can bail out of their options at a fat profit.

Nowhere was this sort of posturing worse than in the banks. Why did many of the banks take on so much risk? I strongly suspect it was down to badly cooked up incentive plans. Remuneration plans, as Cameron says, that were rubber stamped on a merry-go-round of executives helping each other out. So long as the price rises, they can win big time as they cash in options. If the stock later plummets so what? They'll just get more options at a lower price and do it all over again.

Sometimes it feels likewe private investors are powerless. And to a degree it's true. But we can vote with our feet.

Buy companies where management is already incentivised

First, look to young companies. The shares of many young companies are often tightly held by management. Many investors hate this they say it makes them too powerful and allows them to pursue their own agenda.

But I look at it the other way round. To my mind their own agenda will be to make sure their shares will be worth more over the long run.

One of the criticisms against high-flying SuperGroup is that management are pursuing a high-growth strategy with wild abandon. And I would take that criticism seriously if management were mainly incentivised by share options. It would make me worry that short term targets were taking precedence over long term shareholder value.

But this is a young company. Management own most of the stock. Maybe they're pursuing a high growth, high risk strategy, but at least they're doing it for all the right reasons. And outside shareholders can come along for the ride if they want to.

But even when the stock isn't tightly held by management, a powerful outside shareholder can help.

Go for it Stelios!

This week, the spat between Easyjet's founder and the board really took off. Though Stelios Haji-Ioannou no longer works for Easyjet, he still holds over 37% of the shares. He hit out against the board: "The gravy train of £180m free shares issued over the last decade must come to an end now!"

He continues "These guys are welcome to resign anytime. As shareholders we could easily replace them with talented executives who'll cost half as much in bonuses".

Yeah... go for it Stelios!

Outside shareholders can really shake things up. Powerful hedge funds and strategic investors can force company management to look at things from the shareholders' point of view. It's always worthwhile checking out the share register and finding out if there's a powerful shareholder willing to keep management in check.

Find management that you really trust

Finally, what you've got to ask yourself is "Do I trust these guys?" Look at the stock incentive plans in place does it look like management's taking you for a ride? If the managers do earn shares, do they tend to hold on to them?

Go to the AGM. Listen to the way that management responds to their shareholders. Are they arrogant? Are they sitting in an ivory tower looking down at the plebs? If so, it's probably best to steer clear.

Do you get the feeling the guys at the top are in it for the long haul? What's staff turnover like -especially at the top?

These aren't fool-proof investment criteria. But I think it's important that you build a rapport with management. If you can really understand what's going on with a stock and its management, you can often save yourself some nasty surprises.

I've written before about pub operator Shepherd Neame. It's a family firm, both managed and largely owned by the family. I've attended several AGMs, and the feeling of longevity (the firm goes back many generations and centuries) and long-term commitment to shareholders is obvious.

Though the company's in a tough sector, it's doing very nicely. The shares have had a tough ride, but it's a business that I personally feel comfortable with.

That's why I don't worry too much about the short-term price movement.

Leave the sabre-rattling and moaning to the guys that do it best: the politicians. For us small investors, it's best just to avoid the businesses that are set up to enrich management. We don't want to change the world. We just want our fair share.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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