“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands…”

Warren Buffett – 2010 Berkshire Hathaway Shareholder Letter

Over the past several months, I’ve literally looked at thousands of different companies in the microcap space. The stocks that made my watch list were ‘cheap’ by one metric or another.

Often it’s the balance sheet that catches my eye – a stock trading at a large discount to book value. Or sometimes the company trades at a low multiple to its long-term earnings power – a low EV/EBIT ratio as one example.

But in microcaps – more than any other asset class – one indicator sticks out above the majority:

Quality of management is key.

The logic makes sense – in a tiny company, strong management has a huge influence on strategy and corporate decision-making. A good CEO remembers that their duty is to the shareholders, and even institutes practices to reward long-term holders (see ADVC).

A great CEO is able to turnaround a struggling company.

As a general rule, I invest in companies where insider ownership is very high. If insiders have a financial stake in the stock, then the idea is that they are financially motivated to make smart, value-creating decisions.

Control Shareholders

Investing in this space also requires an evaluation of ‘control shareholders,’ usually a family or founder that controls more than 50% of shares outstanding.

In such circumstances, it is much harder for activists to push for change, and therefore value investors – attracted to a low P/B or excess cash balances – are left with fewer options if management starts acting irresponsibly.

In these control situations, an unexpected acquisition – my favorite type of value unlocking situation – is less likely, but it is usually counteracted by a stable share count and potential to be taken private at a premium.

Usually, the greatest danger is if management is satisfied with the status quo and does nothing while the stock price lingers and excess cash sits on the balance sheet (or even worse, is blown on a dumb acquisition).

Management Compensation

High insider ownership is one part of the scenario, but I also firmly believe in another maxim:

People respond to incentives so compensation must be properly aligned.

I check the insider ownership position in the proxy statement, but also spend time understanding the performance targets and bonus structure for company management.

I’ve been around enough bonus and commission plans to know that people will exploit the bonus structure to its fullest extent, so care must be taken to ensure that management and shareholders’ interests are properly aligned.

Recent Examples

The importance of these two concepts is not confined to microcaps however.

Just ask Microsoft’s shareholders after the company’s recent acquisition of Skype – “Microsoft Buys Skype: I Feel Poorer”

As Warren Buffett said, management must not move the bulls-eye in tough times and also be willing to forego a bonus if results are not up to par.

In critiquing the bad compensation practices at Kraft, My Investing Notebook summed up the ideal scenario.

If only more companies followed this advice:

“Setting compensation is not that difficult. Pay people well for things they control, don’t reward them for things they don’t. Think on a per-share basis. Avoid tying compensation to share performance. Avoid stock options. Pay very well for operating performance and return on incremental invested capital.”