Yesterday I went to a fabulous presentation on board governance hosted by Katten Muchin in Chicago. The speaker was Baruch Lev from NYU. He covered a wide range of issues that I was interested in. Mr. Lev received his PhD from the University of Chicago. Like a good professor, he taught me something. I thought I would relay his information for the benefit of the broader community.
There are several good reasons for investor discontent. We have had the worst stock market decade since the Great Depression. America has witnessed a parade of corporate implosions and accounting scandals. We have seen stock option manipulation, and cases of executive compensation excesses. New technology has brought us a flash crash and dark pools of liquidity.
The reaction of investors has varied. What’s alarming is that they have begin to desert the equities market in droves. This hampers market transparency and is detrimental to building wealth in a society. Sentiment has allowed lawmakers to pass costly and restrictive laws like Sarbanes-Oxley and Dodd-Frank. Additionally, the SEC has amended securities regulation to allow Say On Pay, proxy contests and “vote no” on directors. Hedge funds have been able to use these new regulations to intervene in board composition, corporate strategy and manager’s pay. CEO’s are shackled.
Even though the sands of investor sentiment are shifting, internally life inside companies is business as usual. That can be a dangerous, and strategic mistake.
Lev went on to show some of his research. He looked at S&P 500 company specific total CEO compensation versus the Return on Assets in percentage from 2003-2008. He found that the stock performance of the company was unrelated to pay. The correlation between the two variables is 0. The numbers don’t lie, but it would be interesting to look at this correlation in a different time period, or for a longer extended time period.
Lev went further. Overwhelmingly, companies beat the consensus estimate from analysts expectations quarter after quarter. Consider that for a moment. It’s a pretty amazing statistic. Not only that, but 70% of companies beat analysts consensus by 1, 2 , or 3 cents! The only conclusion that can be reached is that companies are managing earnings to look better than they really are.
This brings into questions the requirements of Generally Accepted Accounting Principles (GAAP). Do they mean anything when it comes to company analysis? Based on what Lev presented yesterday morning they don’t. The pretty annual reports that you receive aren’t worth the paper they are printed on. The information is manipulated and obsolete. For example, a tremendous asset to Pfizer ($PFE) for years was Lipitor. But, it wasn’t shown on its balance sheet. However, the physical building that the company resided in was. Today, information on balance sheets is so bad, that only 40% of it can account for the reflection of earnings and book value into the price per share. Back in 1977 it was as high as 80%.
My opinion is that because the public information of companies is of such poor quality, it gives aggressive investors incentive to try and get an edge in any way they can. This leads to things like insider trading scandals, because if you have better information than the market, you can beat the market. Without better information than the market you are going to lose, or simply be as efficient as the market (just like Mr. Eugene Fama hypothesized).
Mr. Lev believes what’s interesting to investors is the things that are important to the operation of the company. Most of this data is Non-GAAP. For example Netflix($NFLX) shows their customer acquisition costs in their financial data. CME ($CME) shows the average rate per contract it collects per trade. That’s transparency that relays valuable information to the market which doesn’t have to be revealed.
As far as board composition, Mr. Lev felt that many board members were over boarded. He thought that “independence” pendulum had swung too far. In board rooms today there are a lot of independent board members that don’t know anything about the business. Boards need to listen very attentively to active investors, hedge funds, and short sellers. There can be important messages they can transmit to the company. Boards aren’t support mechanisms or sounding boards, but more like checklists CEO’s procedurally go through before they try and get things done.
Interestingly, when an “over boarded” (serving on more than two boards) board member resigns, stock prices for the other company boards they serve on do better!
But, from the research and sentiment it’s clear that public boards haven’t grasped the level of reform that shareholders want. Their eyes and ears are covered. In many cases, instead of becoming more transparent, boards have become less responsive and stuck. This brings them into direct conflict with their shareholders.
There were some other data points that Professor Lev articulated, but he summed up with these points. Companies ought to link managers’ compensation tightly to company performance evaluated against leading peers. Measure performance by hard to manipulate indicators, like churn rate or organic growth. Boards shouldn’t buy into financial engineering to boost share prices. Repurchases of shares are basically worthless to long term shareholders. Acquisitions fail 80% of the time, so businesses should buy other businesses for strategic reasons and not to boost short term earnings. Eradicate earnings management and stop “walking down” analysts’ forecasts. Provide non-GAAP data that investors really need to learn about the company.
It comes down to a company’s integrity, transparency, and how they really value their shareholders. 100% of company CEO’s will say that they want to build shareholder value. A well intentioned board can make sure that they do.