Fortunately, managers and executives that commit misappropriations on the scale of Dennis Kozlowski are the exception rather than the rule. But just because there's no outright fraud or illegal act doesn't mean a company's management team is being a proper, responsible steward of shareholder funds.

For instance, excessive pay packages aren't necessarily illegal, even for companies that are losing money or missing their profitability targets. The same is true of stock-option grants to managers or company-financed corporate jet use. In most cases, such expensive perks do very little to enhance shareholder value.

Take options expensing scandals as an example. For years, companies did not have to legally report the options they issued to managers as an expense on their income statement. However, these options were a form of compensation. If the company's stock did well, managers would exercise the options, thus increasing the company's outstanding share count. That, of course, is the opposite of a share buyback and has the effect of diluting the firm's existing shares.

And of course, poor accounting and poor financial transparency can be devastating for shareholders. Companies that only disclose the bare minimum during quarterly earnings releases tend to see more surprises and volatility in their stock; due to the lack of information, investors and analysts find it difficult to accurately evaluate their corporate prospects.

The use of aggressive, misleading accounting tricks to boost returns can lead to disastrous stock performance. Enron went bankrupt after revealing more than a billion dollars in losses held in off-balance-sheet financing vehicles. However, some savvy investors were not at all surprised by Enron's corporate meltdown. In the years leading up to that announcement, many analysts had complained about the poor quality and lack of transparency in the company's releases. And more recently, shares of both Fannie Mae (NYSE: FNM) and American International (NYSE: AIG) dropped after those two companies announced accounting irregularities on a smaller scale.

(1.)  Shareholder-Friendly Policies Lead to Outstanding Results

Fortunately, the concept of corporate stewardship cuts both ways -- companies with a history of aligning their interests with those of shareholders routinely outperform their peers. In addition, firms with highly transparent accounting policies and solid, complete disclosure are less likely to generate negative surprises for shareholders. And finally, companies that perform shareholder-friendly policies like stock buybacks and dividend distributions can directly enhance shareholder value.

Here are a few of the features we look for when evaluating a company's shareholder friendliness . . .

Insider Ownership -- One of the easiest ways to know if management's interests are aligned with common shareholders is to look for management teams that are also major shareholders. For most companies, we look for insiders to own at least 5% of the company's stock. For larger companies, we look for senior management to have equity stakes that are significant relative to their annual salaries. When analyzing insider ownership, we pay particular attention to holdings owned by the CEO, CFO and COO. Typically, if an officer owns stock worth at least double or triple his/her annual compensation, then this is a positive sign.

Share Buybacks -- Companies that continually buy back stock are directly boosting the shareholders' stake in the firm. The effect is not on total earnings, but is reflected in a company's earnings per share (EPS) -- total earnings divided by total shares outstanding. As a firm repurchases its shares, its existing shareholders own a larger and larger slice of the firm's earnings pie, thereby boosting EPS. This is one of the most shareholder-friendly policies a company can pursue.

Be sure to pay attention not only to a company's announced buyback plans, but also to the actual trend in the share count over time. When companies are buying back shares, the share count should consistently drop. Companies with buyback plans that have a stable or rising share count may simply be buying back stock to neutralize the effect of shares issued as compensation for employees.

Low Debt -- Debt holders have first claim on a company's assets in the event of bankruptcy -- bondholders must be paid before shareholders get a dime. Therefore, managers of companies with an excessive amount of outstanding debt may be more focused on paying bondholders and meeting interest payments than on generating value for shareholders.

Perhaps even more importantly, companies with excessive debt loads carry a higher risk of folding when times get tough. The investment landscape is littered with bankrupt companies that took on piles of debt to fund aggressive expansion, only to flounder at the first sign of an economic slowdown. Typically, we prefer companies with debt-to-equity ratios (total debt divided by shareholder's equity) of less than 40%. Management teams that take on excessive debt are playing a high-risk game with your investment dollars.

High Return-on-Equity (ROE) -- Return-on-equity is one of Warren Buffett's favorite financial ratios. ROE is calculated by dividing net income by shareholder equity. Since shareholder equity is a measure of shareholders' total investment in the firm, ROE is essentially a measure of how much value a company generates for shareholders. Shareholder-friendly firms tend to have higher ROE levels.

As a rule of thumb, we prefer to invest in companies with ROEs of 20% or higher. We also examine ROE ratios for several years and focus on companies with consistently high ratios.

(2.)  Warning Signs to Watch For

When searching for shareholder-friendly firms, keep a watchful eye out for the following potential red flags . . .

Excessive Management Compensation -- The salaries of all company directors and senior managers are disclosed in financial statements. There is no hard and fast rule for what constitutes excessive compensation -- evaluating salary packages is somewhat subjective.

Be sure to examine the size of senior managers' salaries relative to the size of the company. Obviously, managers at a firm with $100 million in annual revenues should be earning less than managers at a multi-billion dollar behemoth. Moreover, evaluate compensation relative to performance. Some managers will take significant salary cuts when financial performance is poor. Compensation can even be tied to certain performance metrics. The details of managerial compensation packages are typically disclosed in annual reports and company filings.

Options Issuance -- Earlier in today's report, we highlighted the potential dilutive effects of options. Issuing options to managers is not as common as it was in the late 1990s. New accounting rules regarding the expensing of options have made it less attractive to issue excessive options packages to employees and top company officers.

Nonetheless, some options or share compensation is not necessarily a bad thing, as stock ownership aligns management's interests with shareholders. Just as with overall compensation, there's no hard and fast rule here. Options issuance should be examined relative to a company's size and financial performance. The same is true of shares a company issues directly to managers.

Exceptional Accounting Charges -- Exceptional charges are supposed to be one-time expense to account for unusual events such as legal settlements, inventory write-offs, or insurance deductibles. The idea of a one-time charge is that the expense does not reflect the company's normal course of business and should therefore be excluded from its normal operating results. By contrast, if charges are recurring events, then they should be accounted for as normal expenses.

But some companies take advantage of this accounting rule by regularly announcing "one-time" charges. By doing this, management can obfuscate expenses and make the business appear more profitable than it really is. While this trick can work for a little while, eventually a company's true fundamentals will become apparent. This sets up shareholders for some major negative surprises. As a general rule, you should avoid companies that post frequent one-time charges or sizeable accounting charges that aren't fully explained in financial statements.

Frequent Surprises -- No company meets or exceeds Wall Street expectations every quarter. But some companies seem to constantly report earnings that are below expectations quarter after quarter. Usually, this results in large downside moves in the stock after each earnings report.

A few missteps can be forgiven, but if a company is serially disappointing Wall Street, then this can be a sign that management is misleading analysts. Alternatively, management may simply not be providing transparent information to investors so that they can form accurate expectations. Either way, continued disappointments may be a sign that a company is not as straightforward with the public as it should be.

Unusual Share Structure -- Be cautious of companies that have multiple share classes, or shares that convey exceptional voting rights. Insiders often use these techniques to maintain control even if they only hold a minority position in the stock.

Alternatively, such shares may be evidence of what's known as a takeover defense -- a way for management to block hostile takeover attempts from other companies or private investors. Often, hostile takeovers lead to strong share price gains for existing shareholders. As such, takeover defenses generally do not create shareholder value. Instead, they merely provide added job security for top managers.

With these points in mind, we recently scoured the investment landscape in search of shareholder-friendly companies. In the text that follows, we'll bring you a closer look at some of our favorite shareholder-friendly firms . . .

END OF FREE CONTENT

The remainder of this report is available exclusively to our Market Advisor subscribers. In it, we offer an in-depth look at six companies exhibiting shareholder-friendly traits. Each one should provide solid returns going forward, as they all show they are looking out for number one -- the shareholder. 

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