Does This Stock Start Your Portfolio's Engine?

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With over 5,000 publicly traded stocks to choose from, researching a winner can feel more difficult than finding your soul mate. To help you pick from the thousands of potential matches for your portfolio, you should read an annual company filing that's usually overlooked by investors because of its lack of hard financials: the proxy statement. Let's take a look at Cummins' (NYS: CMI) recent proxy as an example.

The proxy statement, also known as the DEF 14A, gives you an up-close look at top management. Think of it as a first date with the board of directors. Specifically, look for:

  1. How is management compensated and incentivized?
  2. How much is management personally invested (insider ownership)?
  3. What experience does the CEO have?
  4. Who is on the board of directors?

These facts provide you with an impression of whether you should trust Cummins' management with your hard-earned cash. And because it is difficult to measure management with one simple screening ratio, this gives you an edge over the rest of the market.


1.How is management compensated and incentivized?
First, managers' salaries should be reasonable relative to revenue or profits. You don't want a relationship with a company that spends your money frivolously on pearls and golf outings.

Cummins' last CEO, Theodore Solso, retired at the end of 2011, after which Thomas Linebarger took over the role. In 2011, Solso socked away $17.9 million in total compensation, with $1.35 million in base pay. Cummins had 2011 sales of $18 billion, for a ratio of salary to revenue of 0.0075%, and total compensation to revenue of 0.099% (these are most likely a bit higher this year due to payouts from his retirement). This compares to Navistar International (NYS: NAV) CEO Daniel Ustian earning a 2011 base salary of $1.2 million, which is 0.008% of Navistar's 2011 revenue, and total compensation of $15.17 million, which is 0.10% of total revenue.  Cummins' executive compensation seems reasonable.

A majority of the compensation might be outside of the base salary, which is great if the other compensation aligns the CEO closer with stockholders, like through stock awards. Just beware that the company is not heavily diluting shares through these large stock awards.

Along with reasonable salaries, the bonus structure should be constructed to maximize shareholders' benefit for the long term. This means giving management goals with metrics that they can control and that are not easily manipulated, like revenue, cash flow, or return on equity. These metrics are better than something like earnings per share, which can be tweaked through creative accounting or stock buybacks.

In Cummins' case, management's bonuses depend on ROANA, or return on average net assets, which is calculated by dividing earnings before interest and tax, or EBIT, by average net assets. As EBIT could be manipulated by management, the ROANA calculation could be flawed. But the overall premise of incentivizing return on assets, which eventually rewards shareholders, should excite any long-term investor. And, there is no discretionary component to bonuses, meaning the compensation committee doesn't give out wads of cash beyond what has been spelled out.

2.How much is management personally invested?
Would you want a relationship with a company that didn't share your interests? Of course not. Referred to as insider ownership, this is one of Fool Co-founder Tom Gardner's favorite metrics. Found under the "Security Ownership of Certain Beneficial Owners and Management" or a similar heading, you can get a quick view of how much management has riding on the success of the company.

Check out Cummins and its competitors:

Company

Insider Ownership

Cummins<1%
Navistar2.8%
Caterpillar (NYS: CAT) 1.3%
Briggs & Stratton (NYS: BGG) 4.9%
Brunswick (NYS: BC) 4.4%

Source: Companies' most recent proxy filings.

Typically, insider ownership higher than 5% is good, but of course it's much more difficult to own 5% of a $70 billion giant like Caterpillar than a smaller player like $900 million Briggs & Stratton. In cases like this, you can compare an executive's holdings to his annual compensation. For new CEO Linebarger, he owns roughly $21.5 million in Cummins stock. This is passable, and while Cummins' requirement of the CEO owning five times their base salary seems beneficial, this means Linebarger would only be required to own roughly $6 million in stock.

For comparison, the CEO of Caterpillar holds roughly $13 million in Caterpillar stock, while his total compensation last year amounted to $10.5 million. The CEO of Briggs & Stratton holds about $3.2 million in his company's stock, while his total compensation came in at $4.5 million. And Brunswick's CEO has $8.5 million in Brunswick stock, with a total compensation of $7.6 million.

3.What experience does the CEO have?
This is the small-talk section of the proxy statement. For Cummins, Linebarger first worked at the company in 1994 and held various manager positions until becoming president and COO in 2008. He has technical expertise with master's degrees from Stanford in engineering and business, as well as industry experience through a few business cycles.

4.Who is on the board of directors?
Like a significant other's friends, the board of directors approves the company's major decisions, such as distributing dividends. At Cummins, there is a balance of financial and industry expertise including a former Secretary of Labor, former chief accountant of the SEC, a University of Notre Dame engineering professor, and a former astronaut (a true rocket scientist).

Overall, Cummins' proxy statement looks solid. Management seems fairly compensated with a proper bonus structure, the CEO is heavily invested beyond requirements, and both the CEO and board have vast and varied experience.

Now that you're prepared to enter the world of proxy statements to find that one special company, what better stock to use your new moves on than our top stock pick for 2012? Find out what that stock is in this free report!

At the time this article was published Fool contributor Dan Newman owns holds no position in any of the above companies. He requires any potential soul mate to file an annual proxy statement. Follow him @TMFHelloNewman.Motley Fool newsletter services have recommended buying shares of Cummins. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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