It's Time to Build a List of Trustworthy Stocks

A Sample Framework

I think that the standards that we want to hold these stocks to will evolve with the list, but here's a rough starting point.

Executive compensation: Excessive executive compensation, especially massive bonuses for mediocre performance, large personal loans and big grants of options, are signs that the board of directors may be asleep. And it may signal that company executives have incentive to manage for short-term goals that line their pockets rather than working to increase long-term shareholder value.

Accounting: Financial reporting should be as free as possible of one-time charges that make it difficult to get a handle on company performance (and watch out for companies that take one-time charges every quarter). It should give a picture of company performance without the effect of trends outside the company's control such as currency exchange and interest rate changes. Lastly, it should give investors a way to judge the difference, if any, between growth produced by acquisitions and organic growth that comes from the development of existing businesses.

Conflicts of interest: They're everywhere, so we're looking for companies that work to control the potential for such conflicts and the potential damage they might cause. Danger signs include entrenched accounting firms that have done the books year in and year out and also do massive amounts of consulting work with the company; and a lack of strong outside directors on the company's accounting, compensation and corporate government committees. To that, we add directors with outside business interests that sell or buy from the company, and ownership structures that put the interests of a class of owners at variance with the interests of public shareholders.

Growth strategies: Growth by acquisition can produce a constant barrage of one-time charges and write-offs that make it impossible to judge company performance. Companies structured as roll-ups where a single competitor acts to consolidate smaller businesses in a fragmented industry are notorious for producing overly optimistic pictures of revenue and earnings growth.

Corporate structure: A company with a plethora of subsidiaries and off balance sheet entities presents a challenge to investors trying to figure out where the cash is coming from and where it's going. Transfers of cash between related entities or less-than-arms-length business relationships between related entities present opportunities to hide or distort cash flows. (This, after all, is the point of the exercise in the first place.)

Potential return to investors: The shares of the company in question should show the potential for outperforming the general market over the long term.