How to Trade Bad Management

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Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers. To subscribe to RealMoney, click here.

As a sell-side analyst in recent years, I followed L-1 Identity Solutions (ID), which is involved in a range of ID programs from driver's licenses to facial recognition software. Trouble is, management simply couldn't resist the urge to promise too much. They were one of a number of management teams that had built a reputation for "overpromising and underdelivering."

So what do you do if you like the business but can't believe management? Sit and wait. In time, you can acquire stock in such a company at a greatly reduced price, usually when most others have thrown in the towel.

My colleague Steve Gear wrote a comprehensive review of the company's virtues a few weeks ago. I don't quibble with Gear's analysis and agree with him that the stock holds great appeal now that it trades below $4. I'm just glad he didn't recommend the stock when it was at $10 last year, $20 in 2007 or $30 back in 2004.

In the span of the last five years, L-1's CEO Robert LaPenta serially offered quarterly guidance that was simply unobtainable if you bothered to do the math. For many of us, it came as no surprise when he would suggest the next quarter that "we missed our targets last time for reasons beyond our control, but we'll blow away our targets this time."

And therein rests the most important step an investor can take: refraining from buying an appealing stock. Instead, listen to management's goals on the conference call and then listen again the next quarter to see if they delivered what they promised.

If they "underpromise and overdeliver" for several quarters in a row, then it's time to buy the stock. Conversely, constantly missed targets signal that you should avoid the stock or even short it.