By Joseph Hogue, CFA
This continues our series of articles written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.
As I sit watching "American Greed" on CNBC and another blatant Ponzi scheme, I find myself wondering, “How could these people fall for such an obvious scheme, didn’t they do any due diligence?” It’s always easier to see the fraud after the fact, and schemes run the gamut from obvious to pretty darn cunning. While the victims on the show all failed to do their own research, they also had another thing in common. They thought the government would protect them through regulation and oversight.
Myth #14 in the book is, “Government Regulations Protect Investors.” While the Securities & Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the alphabet of government agencies tasked with market security generally do a good job at keeping investors safe, there is no way they can keep ahead of all the schemes. Investors must do their own research and due diligence to protect themselves and their hard-earned money.
The chapter focuses primarily on the fraudulent and outright criminal schemes over the past few years, with Madoff as the centerpiece. These make the news and are the things of blockbuster movies, but they’re not the most prevalent deception on Wall Street. You are much more likely to fall prey to negligent corporate boards and deceitful management than to get caught in a Ponzi.
The Government Won’t Protect You
There are several reasons why the regulators cannot fully protect investors. Topping the list is the idea of a captured industry. Regulatory agencies need people that have experience within the industry and all its machinations. Additionally, regulators must have connections and contacts with those in the industry to keep ahead of developments and product evolution. Where is the most obvious place to find these able warriors of good but from the industry itself. While the regulator may intimately know the idiosyncrasies of the industry, they also may still have a lot of friends and close connections there as well. Sometimes the line between regulator and lobbyist becomes a little blurry.
Another reason why the regulators cannot fully protect investors is due to the problem of unintended consequences. Several regulations are in place that, while noble in intent, cause as much harm as they do good. Only accredited investors, those with at least a million in net worth or an income in excess of $200,000 per year, are allowed to participate in Hedge Funds and some other “alternative” investment vehicles. Presumably, anyone with that much money knows enough about investments and can protect themselves. This not only locks smaller investors out of good investment vehicles but leaves accredited investors out on their own with a big ol’ caveat emptor. The book details several regulations that actually restrict financial professionals from giving investors advice best suited to their circumstances.
The final reason government regulators cannot protect you from the bad guys … because the worst stuff on Wall Street isn’t even illegal. Corporate finance has an army of accountants, many with the task of artfully making the company look better than it is in reality. A good board of directors will catch or question managerial malfeasance, but unfortunately some boards are explicitly involved in the deceit or complicit in their negligence. The stockholders were the ones to finally oust failed CEO Michael Eisner from Disney. It certainly wasn’t all his friends on the board, like the principal of the elementary school where Eisner’s kids went or his architect.
What’s an Investor to Do?
The Action Strategy in the book details a checklist for investors to ask portfolio managers and avoid outright fraud. It’s good advice for those that can get access to the money managers and hedge fund bosses but won’t help you avoid the investor mistreatment in the boardroom. I will focus here on corporate governance and ways to make sure management has your best interest in mind.
One study referenced in a note by the International Finance Corporation (IFC, pdf) shows that investors purchasing the shares of U.S. firms with the strongest shareholder rights and selling those with the weakest shareholder rights would have earned an extra 8.5% per year over the study period. Another study in the report shows that firms with better governance have faster sales growth and are more profitable than peers.
Companies with sound management and a board of directors that protect shareholder interests will not only help protect you where the regulators have failed, but will also grow the company and provide returns for investors.
There are several organizations that measure and report on corporate governance, most of them charge a fee for the service. Institutional Shareholder Services (ISS) is probably the most well-known. ISS examines a company's governance structure and procedures to assign a risk indicator to the company covering four topics: Audit, Board, Compensation, and Shareholder Rights.
Investors can view the ratings within each of these topics through Yahoo Finance by clicking on the ‘profile’ link in the left-hand menu. This will give you a basic risk measure relative to other companies but will not help to detail corporate governance in the company. Bloomberg Business Week annually writes about the best and worst companies in corporate governance. This, and other such annual reports, may give you a better idea of what to look for or help pick some companies but will not help you analyze most firms. You are going to need to do a little grunt work yourself and look into the annual reports and SEC filings of your investments. It may not be as easy as watching an hour of CNBC and choosing between the ‘ten next high-fliers’ but it isn’t really too difficult if you follow a checklist of red flags. In fact, most companies with a commitment to corporate governance will have a dedicated webpage that will clearly detail their policies.
What to look for in Corporate Governance
A report called, “The Financial Aspects of Corporate Governance,” often referred to as The Cadbury Report, details structures and policies that protect shareholder interests. Nine of the most important recommendations for good corporate governance are:
- The board should have an independent chairman. All too often the chairman of the board is also the company’s CEO. This allows management to set the agenda and procedure for the board.
- The majority of the board should be independent. Independence is arguably the most important thing to look for in good boards. Independent directors are those with no business, familial, or management relationship with the firm. Directors with some kind of a relationship with management are more likely to collude with executives or rubberstamp policies.
- The audit, compensation, ethics, and nominating committees should be dominated by independent directors. Again, the propensity to question management and remain unbiased is the key here. The audit committee is in charge of conducting the internal check on the firm’s financial reports and works with the external auditor as well. An audit committee ruled by insiders might have undue motivation to help management hide discrepancies. The compensation committee sets the executive pay and bonus structure. Is it any wonder why you would want an independent and neutral arbiter on the committee?
- Independent board members should meet regularly without management present. Management, especially those with something to hide, can be strong-willed and controlling. A regular meeting of only independent directors can help to promote shareholder interests.
- The board should be able to seek outside advice at the firm’s expense. Many boards exclusively use the company’s general counsel to advise on legal and ethical matters. This somewhat dilutes the purpose of an independent board if they are being advised only by those beholden to the company.
- Directors should be required to hold a minimum amount of equity. This helps to align director and shareholder interests.
- Director compensation should be equity-based. This one is a little more controversial. While an equity-based compensation structure further aligns director/shareholder interests it also causes a moral hazard and motivates directors to aid in cover-ups.
- Directors should have a mandatory retirement age. This, and other limits on board participation, help to make sure a board does not get entrenched.
- Self-evaluations of the board should be conducted yearly. These evaluations, especially if made public, help to keep the board accountable for their goals and responsibilities.
Examples of Good Corporate Governance
There are a few names that perennially make it to the top of corporate governance rankings. This does not mean that their boards cannot adopt anti-shareholder policies in the future, but companies with a history of good corporate governance usually have a strong culture of ethical behavior and strive to maintain it.
Intel (INTC) conducts a virtual annual meeting allowing for broader participation and voting, especially from geographically dispersed retail investors. The company also holds an investor/analyst meeting a week prior to the annual meeting to make sure everyone has the most up-to-date information on the company’s business. The company receives the ‘low concern’ ranking in all categories by ISS. Intel’s governance website is available here.
Best Buy (BBY) is a standout in many governance rankings. The company created a new reporting network to develop its global anti-corruption and compliance systems and is particularly well-known for its strength in shareholder communications and transparency. The company created a c-level executive for ethics and named Kathleen Edmond as Chief Ethics Officer in 2003. Edmond uses an online chatroom to conduct interactive question and answer sessions with employees and is extremely active within the company. The company receives a ranking of ‘low concern’ from ISS in the Audit and Board categories but a ‘medium concern’ in the categories of Compensation and Shareholder Rights. Best Buy’s governance website is available here.
Colgate Palmolive (CL) is another favorite of governance rankings and has ranked in the top ten boards by Business Week for three years. Nine of the company’s ten directors are independent and these members meet regularly without the CEO. The board has adopted rules that directors are required to own company stock and ownership is a majority of overall compensation. Additionally, the board has direct access to management and makes frequent visits to onsite operations. The company receives the ‘low concern’ ranking from ISS in the categories of Audit, Board, and Shareholder’s Rights but receives ‘medium concern’ in Compensation. Colgate’s governance website is available here.
Carl Icahn, in a note to Forest Labs (FRX) shareholders this year evidenced an ISS report criticizing the company for flawed corporate governance, the appearance of nepotism, and poor compensation practices. Icahn raised a red flag in the long tenure of Chairman & CEO Solomon and the fact that his apparent successor is also his son, David Solomon. Icahn or shareholders may eventually be able to turn the company around, but the stock’s performance of -11.7% relative to the S&P500 over the last year speaks volumes about how the company is run. Forest Lab’s governance website is available here.
Investors expect regulators to protect them from sham investments or negligence, but are not surprised by reports of ineptitude and malfeasance in other areas of government. With tales of the daily three-ring sideshow freely streaming 24/7 can you rationally assume that the government can keep ahead of the fraudsters in the markets? Checking each of your investments against a short checklist of best practices in corporate governance is a good start to making sure that management has your interests in mind. Visit our website for a complete list of the articles in this series.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.