How to Spot the Worst-Managed Companies

Management is critical to a company's success. And it's often a good place to start your evaluation of whether one company would make a better investment than another -- especially within the same sector or industry.

Here's a primer on how I identify the poorly run players in a specific business, plus my three picks for the worst-managed U.S. companies of the year.

My Criteria

While not all the companies on my list suffer from every one of the following problems, they meet at least one or more of these negative characteristics which make them lousy investments, and potentially excellent short sales.

My main checklist:

1. Poor financial condition. Heavy debt loads, large amounts of goodwill and poor cash flow are common among poorly run companies. As a result, their balance sheets are in poor shape. The inability to shore up balance sheets could spell further danger in the future. Take a look at Charter Communications (CHTR Quote). This company has nearly $20 billion in long term debt with virtually no cash on hand.

2. "Second Banana Syndrome." Some of the companies on my list are not what would you refer to as "best of breed." Most of them are in an industry or sector that has at least one more dominant competitor. For example, Circuit City (CC Quote) is a distant second place electronic retailer to Best Buy (BBY Quote). In the smart phone technology category, Palm (PALM Quote) has fallen to second or third place behind Research In Motion (RIMM Quote) and Apple (AAPL Quote).

3. Ineffective management. Successful companies will have management teams which not only innovate, but can also manage during times of stress. In fact, innovation does not simply mean the introduction of a single "cool" product, such as (the now struggling) Sharper Image (SHRP Quote) did with the Ionic Breeze Air Purifier. Effective innovation and management is about being able to transform a company into a provider of a well-balanced and diversified line of products.

Look at the success of retailer Dick's Sporting Goods (DKS Quote). While it may be the top retailer of golfing products and apparel, the company also sells a wide range of sporting goods and apparel. As a result, I believe Dick's Sporting Goods will be able to survive an economic downturn. Other retailers will not be so lucky. In retail (and in many other businesses), when it comes to navigating a difficult economic environment like the one we're in now, inventory management will be a critical key to success.

4. Strategic mistakes. This can take many forms. One of the most damaging are large acquisitions which turn out to be costly mistakes. Take Washington Mutual for example. The company acquired Providian, a subprime-type credit card issuer for $6.5 billion in 2006. ( 2008: "JPMorgan Chase Takes Over WaMu")

Six Flags (SIX Quote) has invested heavily in capital expenditures ("capex") in both its theme parks to build up related holdings such as restaurants and hotels. These strategies have not resulted in increased park attendance and cash flow which management had anticipated from the increased capex.