Corporate Governance Metrics: How to Determine Management Quality

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When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact- Warren Buffett. Clearly, corporate governance is an important  but how does one find a company with good management? SocGen is out with a new report on the topic. We highlight the key points from the report below.

Corporate Governance: SocGen

Corporate Governance

David Winters On an Example of Good Corporate Governance

Criteria used to select our basket

Our CEO Value screening tool (launched in April 2006) is built using a bottom-up approach. We apply it to the Stoxx 600 index, to obtain a list of European companies expected to deliver a “positive” message to investors over the next two years and thereby likely to outperform its benchmark, with a clear large cap bias.

To be included in our list, stocks have to meet the following criteria:

  • Underperformance of >15% relative to peers over the past four years;
  • CEO in office for more than three years (or less than 1 year), we consider this to be the time needed to implement a strategy effectively;
  • A “solid” financial structure (as measured by the company’s credit rating, liquidity, gearing ratio AND a qualitative stock analysis);
  • “Sound” corporate governance standards (measured by a combination of quantitative AND qualitative corporate governance data ranging from “level of board independence”, to “remuneration”… to “controversies”.

Our strategy is not without risk

The idea is to select companies that will implement change and move from being underperformers to outperformers. We identify two possible risks in our approach: 1) no change happens; or 2) changes take place, in management for instance, but the company’s situation continues to deteriorate.

Poor performance and dismissal go hand in hand…

Based on their most recent survey (“Time for New CEOs” – April 2013), Booz & Co. who have monitored CEO turnover for more than 10 years, saw a growing correlation between poor short-term shareholder returns and CEO turnover. Furthermore, companies are working thoughtfully to ensure they hire/promote the “right” leader they need, after a steep fall in turnovers during the recent economic turmoil.

Barry Rosenstein Attacks Canadian Corporate Governance [VIDEO]

…But not all changes are “for the better”

In our report “CEO Value & Corporate Governance: pressure on management leading to improved stock performance” (June 2007), we provided the results of a statistical case study on the subject. We did not run any other filter at that stage, and the results of our study illustrated the risks inherent to such an investment strategy. We found that:

  • On average, a recovery story ensued after the arrival of a new CEO, with the stock catching up with the performance of its sector.
  • One year later, the stocks confirmed their recovery, outperforming their peers by 0.9% on average (against an average underperformance of 6.4% per year over the prior three years).
  • However, almost half the stocks in the pool still underperformed their peers one year after the new CEO’s arrival.

Sound corporate governance is our compass

The good performance of our CEO Value basket of stocks using the additional filter based on good corporate governance principles shows, in our view, that sound corporate governance is a way to mitigate the risk of this kind of investment strategy.

Long investment horizon…

Increasing pressure on management from all stakeholders (including political and regulatory pressure) can lead to a clear improvement in share performance but this tends to happen over the longer term, as financial recovery is the ultimate goal. We believe CEO-driven stock selection should be made during two ideal periods: 1) when stakeholder pressure is building; and 2) following the announcement of a CEO’s departure, when share prices typically dip or mark a pause.

What is “sound corporate governance”?

Corporate governance evaluation – how it works We have identified four “core” corporate governance principles (which could be combined with “satellite” related information such as “controversies”) that we believe are of particular importance to our investment strategy in a challenging economic environment.

1) Independence of the board from the CEO’s vision

The major criterion in our view is the independence of the board of directors from the CEO’s vision and the board’s ability to question and challenge (and even dismiss) the CEO if deemed necessary. We believe board independence can be tracked using the following indicators:

  • Separation of the chairman and CEO functions: this not only makes it easier to question the CEO’s strategy but also limits concern over the balance of powers and lowers the magnitude of the risk linked to the departure of a single person holding both positions. A CEO who is also the chairman is more secure in his position than a CEO who is not the chairman. In 2009, of all departing CEOs who never held the title of chairman, half were forced to leave. This compares with 34% for those who also held the chairman position at the end of their tenure, and 26% for those who held it since the beginning of their tenure (source: Booz & Co.).
  • Independence of the supervisory directors: in addition to the different links that directors can have with the company and which therefore may raise the question of their independence, it is commonly admitted that tenures of more than 12 years are not consistent with their qualification as independent; we have therefore added this criterion to our screening.
  • A high proportion of non-executive directors: executive directors may be overly dependent on the CEO to perform a critical role.
  • The CEO does not play a role in the nomination process: the CEO is not a member of the Nomination Committee and does not play a role in choosing NEDs (non-executive directors) or supervisory directors. Indeed, board members who are selected by the CEO and enjoy substantial pay and prestige because of their position are unlikely to “rock the boat” during trying times.

2) Board and shareholding structures

We also identify a second set of criteria, relating to the board and shareholding structures:

  • Medium- or small-sized boards: large boards are considered less effective than small boards as there tends to be an increase in agency problems when boards become too big. The stewardship role of the board therefore becomes more symbolic and the board neglects its monitoring and control duties.
  • Presence of large shareholders: firms tend to listen to the market more when some of their shares are held by active shareholders.

Mike Mayo Predicts ‘Rebirth of Shareholder Rights’ [VIDEO]

3) Compensation schemes linked to shareholder returns

Remuneration is one of the most sensitive corporate governance issues in the current economic environment, attracting public, investor and political attention. Share ownership is said to align directors’ interests with that of shareholders. There has been growing pressure to increase the link between executive pay and shareholder returns; many regulations voted throughout Europe link severance packages to company performance. The FSA recently issued a statement on executive pay, highlighting the widespread concern that inappropriate remuneration schemes to the detriment of the interests of shareholders and other stakeholders may have contributed to the market crisis.

4) Succession planning

Succession plans: one reason that boards may act slowly when it comes to replacing a CEO could be a lack of suitably qualified candidates. Succession planning structures and schemes allow companies to build a pool of candidates.

From “theory to practice”: we analyse corporate governance at two levels

We cannot make all of the above criteria mandatory in our stock selection as our pool of possible stocks would be reduced to close to zero. Instead, we use two levels of corporate governance analysis as an additional filter.

First, we collect corporate governance data under “core” categories to determine which companies match basic corporate governance best-practice standards: 1) Shareholders; 2) CEO; 3) Independence; 4) Committees; 5) Remuneration; and then we screen for the following “satellite” categories: 6) Diversity; 7) Controversies; 8) Other policies; and 9) CSR.

Second, we gauge the views of our equity analysts on corporate governance standards in their sector at the identified companies they followed.

Using both levels of analysis; we exclude groups that have a poor corporate governance evaluation, i.e. below-sector practices and/or a poor governance perception as provided by analysts.

CRM Analysis: F on Shareholder Disclosures, Insider Sales

Bottom line, this is not a “best-in-class” approach

We find it useful to be more specific on this matter: our screening methodology is not based on a classic “best-in-class” approach, which would potentially pick the best-rated companies on corporate governance in a sector. As we apply multiple filters – in particular selecting companies that have underperformed their peers over the last four years – our pool of possible stocks is not representative of a best-in-class basket.

“CEO Value” updated list of 25 stocks

Our CEO Value strategy consists of establishing a list of stocks for which corporate governance principles could be a driver for improved financial performance. Our CEO Value stock selection has outperformed its benchmark since its launch. In this report, we rebalance our selection, replacing 15 stocks which either recovered OR faced negative change in terms of corporate governance.

Our basket’s features

  • Each stock in our selection list is equally weighted;
  • When rebalancing the list, we equally weight each stock again;
  • Our portfolio selection criteria make no allowance for any balance across sectors or countries; the selection process is based purely on individual stock underperformance and corporate governance criteria;
  • Our CEO Value list was first created on 10 April 2006 and has since been rebalanced on seven occasions (13 June 2007, 29 February 2008, 2 November 2008, 19 August 2009, 3 May 2011, 10 May 2012 and finally 27 May 2013).
  • New “CEO Value” basket as of 27 May 2013:

Corporate Governance

Stock selection rationale

This stock selection is based on the potential catalysts for an upswing in performance over the next few years, as identified by our screening model.

Corporate Governance

Origins and Value of The Essays of Warren Buffett: Lessons for Corporate America

Company “corporate governance” assessment

A detailed analysis of the corporate governance criteria used in our analysis for our “CEO Value basket” is presented as follows.

  • A summary of “Global performance in Corporate Governance” across four categories: 1) Shareholders; 2) Directors; 3) Controversies and 4) Codes, Policies, CSR, AND two groups: “Room for improvement” and “Good standards”
  • The related raw data.
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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.

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