SRI Notes

The Owner vs. The Boss

Who controls the corporation?  Most economists and investors would say "the shareholders."  Even proponents of stakeholder theory agree that shareholders should have a significant say in how a firm conducts itself.  In 2005 Jean-Paul Page wrote an excellent little book entitled Corporate Governance and Value Creation for the CFA Research Institute.  It's a think piece on the role of corporations in society, written from first principles ("corporate governance begins with power") and a deep awareness of the contending schools of thought in the field.  After much deliberation Page concludes that this should be the first commandment of corporate governance: 

The ultimate power in a company must rest with its shareholders.

It's not hard to come up with an illustration for why this must be so:

Let's say you own an apartment building, and have hired a management company to run it.  You're planning to sell the building in a year or so, so you decide to only do cosmetic maintenance.  You authorize minimal repairs, but instruct the manager to put off major issues, if possible, for the next owner to deal with.  Seeing this, the management company decides to hold back a portion of the rent payments you receive and 1) gives itself a raise and 2) begins managing the property as if they, not you, were the owner.

What would you do in this situation? 

It is not an academic or hypothetical example.  It is an almost exact description of what is happening in corporate America today.  Enthused by the prospects of a sale (to private equity, perhaps), and pressured by performance-driven compensation structures, shareholders are becoming more short term-oriented than ever.  As discussed many times here, time horizons have shortened to microscopic levels - the average turnover on the New York Stock Exchange is 100%, suggesting the average investor is looking out about one-year.  Since many shares never trade (think of all that low cost-basis stock in bank trust accounts), the de facto time horizon for a given trade is even shorter than that.  People don't own stocks anymore, they rent them.

And the managers hired to run the business are increasingly treating the owners like tenants.  Let me rephrase the story I just told you:

Let's say you manage an apartment building for an absentee landlord.  Inattentive, fickle, and unsophisticated, this person is trying to sell the building for a quick profit.  You've been authorized to do only cosmetic maintenance - putting off major issues for the next owner to deal with.  After thinking it over, you decide to hold back a portion of the rent payments you receive and 1) give yourself a raise (you need to get more money up front - who knows what the next owner will think of you?) and 2) begin managing the property from a longer-term perspective (the owner may not care if the building falls down the day after the sale, but you do).

In the latest Business Week, Clayton Christensen and Scott Anthony present the clearest defense I have seen of management's perspective ("Put Investors in Their Place").  "Why," they ask, should management "pander to people who now hold shares, on average, less than 10 months?  Should managers really regard such investors, whose investment horizons are shorter than the most nearsighted of managers, as stakeholders whose value they ought to maximize?"

Well, game on.  The battle for control of the corporation is now clearly out in the open.  Large pools of equity capital, sophisticated investment banks, and leading management consultants are offering alternatives to the longstanding model of public ownership of U.S. corporations.  If that model cannot be fixed, and soon, society will face a significant loss of corporate transparency and accountability, as companies are taken private.  Christensen and Anthony point out that companies in Asia, such as Tata (India) and Li & Fung (Hong Kong) are doing exceptionally well without the help of day traders and corporate governance activists. 

Christensen and Anthony argue that this will come with social benefits.  Their script for managers reads:  "Our responsibility is to maximize the long-term value of this company.  We will therefore act in the interest of those whose interests coincide with our long-term prospects, namely employees, customers, the communities in which our employees live, and the minority of investors who plan to hold our securities for several years."

It is a noble goal.  But the choice is not a simple one.  Should social investors be prepared to sign away Page's "ultimate power" to get the social benefits (which, after all, are just a promise)?  Or is it time to start looking for a new management company?

Who Gets the Spoils?

I cannot resist linking to this post from William Bernstein at Efficient Frontier.  Bernstein is a consistently insightful commentator on issues in modern investment, but here his analysis takes him into executive pay and governance issues as well.  For the first time in my career, leading thinkers in finance and management are saying the same thing:  the rewards system is confused.  We're chasing the wrong carrots, and getting the wrong results.

Update on Universal Owners

Thestreet.com's mutual fund columnist, Brett Arends, has an interesting (and strident) take today on the Home Depot controversy. 

"...[T]he people who should be right at the center of the scandal aren't the executives who are taking the loot or even the directors who gave it to them. It's the managers of some of America's biggest mutual funds, including Vanguard and Fidelity. Instead, so far, they're getting a pass."

That's the first time I've seen that said in the business media, although this criticism has been circulating in academia for some time.  In their excellent book, The Rise of Fiduciary Capitalism, Hawley and Williams warn of a society in which owners are separated from the companies they own by chains of agents (fund managers, directors, etc.), who ultimately do not do a good job of representing their interests.  That's what Arends sees going on at Home Depot:

"Bob Nardelli didn't really do anything wrong. He just asked for, and received, a massive amount of money. Wouldn't you?

"The problem lies with those on the other side of the trade -- the people hiring the executives. The people who are involved in the negotiations, namely the directors, aren't particularly motivated. They don't get paid very much, at least by heavy-hitter standards. And it isn't their money that's involved. No wonder they just outsource the calculations to "consultants" whose biggest interest is in keeping the executive class happy.

"Meanwhile, the people who are motivated to get the best price, namely the shareholders, aren't really involved. Which is why attention should turn to those who are supposed to represent them. Mutual fund managers have a fiduciary responsibility to their investors. "

It's an interesting article.  Did you know Fidelity voted against half of the stock option compensation plans that came up for a vote last year?  I sure didn't.

Hawley and Williams' site has much more on the universal owner concept.

More on Owners, Managers, and Socially Responsible Investors

The Financial Times got a great quote Wednesday (link via MSNBC) from executive headhunter John Challenger:  "The pressure is not going to relent on CEOs in 2007.  The days of the imperial chief executive are over."

One reason is the growing influence of private equity.  Reporter Francesco Guerrera got another great quote from Steve Ellis of Bain & Co.:  "One of the messages for 2007 is:  whether you like it or not, your company is for sale."

It seems that society's view of the CEO is becoming increasingly bi-polar.  We assume CEOs are extraordinarily gifted, as evidenced by their robust pay packages.  But we are simultaneously become less tolerant of underperformance, as evidenced by the Ellis quote and Mr. Nardelli's recent exit from Home Depot.  One could wonder if this fire and ice approach will deliver the best results.  It brings to mind something Warren Buffett wrote in another context in his 1990 Letter to Shareholders:

"Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice."

Like excessive debt, the current policy toward CEOs raises the stakes without doing much to improve prospective performance.  If one of our biggest problems is short-termism (past commentaries here), putting the CEO in a position where the only options are immediate positive results or termination seems to me ill-advised. 

But what is the alternative?  In his excellent update of Benjamin Graham's The Intelligent Investor, Jason Zweig observes that in early editions of the book Graham wrote extensively about management quality.  But he reduced the section over time, ultimately limiting it to a few paragraphs on dividend policy.

Perhaps no other part of The Intelligent Investor was more drastically changed by Graham than this...  Why did Graham cut away more than three quarters of his original argument?  After decades of exhortation, he evidently had given up hope that investors would ever take any interest in monitoring the behavior of corporate managers.

...Graham wants you to realize something basic but incredibly profound:  When you buy a stock, you become an owner of the company.  Its managers, all the way up to CEO work for you.  Its board of directors must answer to you.  Its cash belongs to you.  Its businesses are your property.  If you don't like how your company is managed, you have a right to demand that the managers be fired, the directors be changed, or the property sold.  "Stockholders," declares Graham, "should wake up."

So perhaps they are.  For those who believe, as Graham did (and as Robert Monks does today) that shareholders should rule the company, there is plenty to rebel against (see, for example, my September post on stakeholder theory).

But investor attention is, um...intermittent.  Scandals make headlines, but it's hard to show that governance improves.  Graef Crystal observes that even after the scandals and reform of the first half of this decade, there's still not much rhyme or reason to how top executives are paid.  That won't change until shareholders give the matter sustained rational attention. 

But how likely is that?  Home Depot co-founder Bernie Marcus doesn't seem to think it's about to happen.  In the AP story he is quoted as saying:  "It’s like the old story, if the stock goes up 10 points, who’s going to care?" 

By the way, there is an interesting new paper on CEO tenure and firm performance here.  I particularly like their distinction between 'owner' and 'manager' CEOs. 

Governance: Show Me the Money

The dialogue about the performance of socially responsible investments is full of mixed messages and mixed motivations.  Recent developments and data on corporate governance are likely to bring on a fresh wave of intellectual dissonance.

Corporate governance has been kind of a stepchild for social investors.  Although attention has been paid, and the most egregious violators are usually excluded from SRI portfolios, I would argue it has not been a central criterion for inclusion or exclusion - activist social investors have been more interested in things like South Africa, climate change, and Darfur, while less-activist ones have often delegated corporate governance due diligence to their money managers.  Still, everyone says governance is important.

It doesn't help that we don't have a good consensus definition of corporate governance.  ISS, Morningstar, and others provide rating services, but there are major differences in both definitions and ratings of individual companies.  CalPERS has its own take, which is different again - it has managed to both add value and annoy Warren Buffett, another mixed message for returns-focused investors.

But governance has special significance because it's one of the social or quasi-social variables where there's been academic support for the idea of a performance benefit.  It makes sense conceptually, and there's data.  The best data so far cam from Gompers et al, which showed that companies with corporate governance they didn't like underperformed materially in the 1990s.  For the most part, the Gompers governance metrics focused on takeover defenses - the more anti-takeover defenses, the lower your rating.  This raised the question of what we were measuring because large acquirors (the firms most likely to have strong anti-takeover defenses) underperformed materially in the 1990s.  But in the 2000s acquirors have done well, as takeover premiums became smaller and investors rejected big deals resembling the ugly stories of the 90s.

And simultaneously, a study by Empirical Research Partners ('Does Corporate Governance Matter?')finds that companies with high scores on the 'Gompers index' of corporate governance have significantly underperformed low-rated companies since 2000.  Empirical is a strong sell-side quant shop, and I have no reason to doubt their results.  Author Michael Goldstein (formerly a strategist for Sanford Bernstein) writes:

"There was, over the entire 15-year period, some payoff to good governance in holding periods beyond a year, but it wasn't impressive...  We also considered whether the governance score could help us distinguish winners from losers among the best- and worst-ranked stocks in our core model and its earnings quality module.  We found thre was an advantage conveyed by paying attention to governance when avoiding losers but only in the 1990s and not thereafter."

This is unpleasant news for governance advocates who have ridden the Gompers data a long way.  Goldstein goes on to argue that governance shouldn't matter much for stock prices since it's easily observable and tends to change slowly.  I disagree there - I don't know that we've perfected the art of measuring it, but one of the few points on which Ben Graham and Amy Domini would both agree that investing with a management you can't trust is a fool's game.

When Stakeholder Theory Meets Financial Theory

Studying corporate social responsibility and social investing is hard because it's so interdisciplinary.  People in Management, Finance, and Economics start from such different places that it's hard to get them to agree even on basic premises.

For example, is the company run solely for the benefit of shareholders, as finance students are taught?  Or should shareholders be viewed as just one of a constellation of competing interests, as stakeholder theory assumes?

But financial theory is increasingly starting to look a lot like stakeholder theory.  Miller & Modigliani's famous theorem opened the doors to a broader view of capital - a view in which shareholders are not 'owners' but suppliers of a commodity known as equity capital.  Like all suppliers they have to be paid...but getting paid is not the same as having every activity of the enterprise dedicated to your enrichment.

Some practitioners seem to believe this now.  Arnott and Bernstein's work in the early part of this decade was deeply influential and, as I read it, advocates radical skepticism.  It implies that most returns have historically come from dividends, and shareholders should therefore be primarily focused on dividends when looking forward. 

Now theoretically this is ok - in theory, all earnings are ultimately paid out as dividends.  But in practice it doesn't seem to work out that way.  For the past four quarters S&P 500 companies paid out only about 30% of their earnings in dividends (23.43 in dividends per S&P share vs. 82.10 in EPS, according to Baseline/FirstCall). 

So where are the rest of those earnings going?  They're supposed to be reinvested for the benefit of shareholders, through profitable investment in plant and equipment, acquisitions, or share repurchase.  But Arnott & Bernstein believe these retained funds will generate low incremental returns for shareholders:

"[R]etained earnings are often not reinvested at a return that rivals externally available investments; earnings and dividend growth are faster when payout ratios are high than when they are low, perhaps because corporate managers are then forced to be more selective about reinvestment alternatives."

So what stakeholder theorists predict, Arnott and Bernstein confirm.  Shareholders do not rule the roost:  they are a supplier to be compensated, but they do not, in aggregate, claim the full distributable earnings of the firm.

So should social investors cheer or boo?  We certainly use the language of stakeholder theory a lot - when we want a company to behave better we cite the interests of non-financial stakeholders such as employees and the community.  And we don't like it when someone invokes shareholders'  interests to argue against social proposals.

But we should be careful what we wish for.  Do we really want shareholders to to have less influence?  This is what Hawley and Williams are talking about - over the past generation ownership of large corporations has changed dramatically, and there are often chains of intermediaries between the investor and corporate management - they view the resulting loss of influence as a significant problem.  Robert Monks would, I'm sure, agree.

So I think the work of Arnott and Bernstein confirms the intuition of stakeholder theorists in a really interesting way.  But it leaves us with two big questions:

1)  E - D= ?

2)  Is that good?

Crystallizing the Executive Pay Debate

This brief piece by Bud Crystal is a must-read.

Daniel Fermon and the CEO

I've expressed skepticism in the past that the sell side could add much to the social investment world, but there is a lot going on now, some of it very interesting.

Daniel Fermon, Senior Europe Strategist at Société Générale, is doing work that incorporates  traditional financial research, social/governance research (from Société Générale's SRI researchers, Sarbjit Nahal and Valéry Lucas-Leclin), and his own innovative views on the role of the CEO in investment returns.  There is a brief but interesting interview with him here.

In coming years I believe markets will gradually grow more efficient with respect to traditional investment variables such as valuation and momentum, making it tougher for traditional investment strategies to add value.  As that happens, researchers will have to dig deeper into predictors of sustainable value creation, such as management quality and governance.  Fermon's work shows how this type of analysis can be done.

Crystal's CFO Pay List

Graef Cystal, Bloomberg's executive compensation columnist, has put up his list of the most underpaid and overpaid CFOs.

Beware The Superstar CEO

Jim Collins has detailed the dangers of superstar CEO in his excellent management book Good to Great.

Now a new study by Ulrike Malmendier of Stanford and Geoffrey Tate of Wharton provides a ton of color and interesting detail around this phenomenon.  They find that superstar CEOs tend to have subpar performance (more than would be expected from mere mean-reversion), and that the worst situations are those where governance is weak.  These guys are serious - their regressions include a variable for whether the CEO was writing a book at the time!

Someone should cross-reference this with the social/sustainability ratings.  I've beaten this to death already, but I'll bet that superstar CEOs underperform on social as well as financial metrics.