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Stewardship Goes Back to the Fundamentals

New rating system for stocks judges companies on how well they protect shareholder capital.

Elizabeth Collins, CFA, 06/08/2012

A history of value-accretive acquisitions, optimal financial leverage, ideal dividend and share buyback policies, and investments that enhance competitive advantages—these are the marks of exemplary stewards of shareholder capital.

Certain corporate practices, such as poison pills and staggered boards, are easily visible and garner much attention in governance analysis circles. Unfortunately, focusing on governance practices tends to poorly predict a firm’s ability to generate improving returns on invested capital and shareholder returns. Instead, fundamental investors should conduct a more thorough analysis of manage- ment stewardship of shareholder capital.

Morningstar equity analysts’ focus on competitive advantages and credit analysis puts them in a unique position to assess this type of stewardship.

The Need for a Change
In June 2011, Morningstar equity analysts began an in-depth review of the methodology of the Stewardship Grades for stocks. The purpose of the Stewardship Grades had always been to identify how well management teams are acting on shareholders’ behalf. In our review, however, we determined that the methodology was focusing too much on particular corporate-governance practices instead of actual capital-allocation decisions that lead to the creation or destruction of value for shareholders. The thinking was that corporate-governance practices can be good indicators of actual stewardship of shareholder capital. But we found that good corporate governance is not a foolproof predictor of good capital-allocation decision-making and the creation of shareholder value. A change to the stewardship methodology was needed. For the past year, Morningstar analysts have worked to create a much more holistic methodology for rating stewardship of shareholder capital.

Analysts have always had the subjective leeway to place a greater emphasis on capital-allocation decisions and a lower emphasis on corporate-governance practices; now, it’s more explicitly incorporated into the methodology. There are many examples of Morningstar awarding a company with traditionally frowned-upon corporate- governance practices a favorable Stewardship Rating because of excellent capital-allocation decisions, and vice versa.

Focus on Capital Allocation
Under the new methodology, Morningstar equity analysts assess companies on items such as financial leverage, investment strategy, investment timing and valuation, dividend and share-buyback policies, execution, compensation, related party transactions, and accounting practices. Instead of giving letter grades, analysts will assign companies one of three Stewardship Ratings: Exemplary, Standard, and Poor. Analysts judge steward- ship from an equity holder’s perspective, not a debt holder’s. Ratings will be determined on an absolute basis. Companies will be judged not against peers within their industry, but against ideal stewardship of shareholder capital. Some industries may have a disproportionate share of companies with Exemplary or Poor ratings. Most companies will receive a Standard rating, and this should be considered the default rating in the absence of evidence that a management team has been exceptionally strong or weak in its capital-allocation decisions.

Because the new methodology is more comprehensive and doesn’t hone in on particular governance practices, the new rating methodology will be applicable globally, whereas the old methodology was relevant only in the United States and Canada.

Ford Motor Co. F provides a good example of how our stewardship assessment is changing with the new methodology. In the past, we gave Ford a D (poor) Stewardship Grade. Under our previous methodology that focused on corporate governance practices, we penalized the company for having two share classes.

Under the new methodology, which places a much greater emphasis on strategic decisions, investments, and other actions that concretely affect shareholder value, Ford management’s wise moves partially offset the concern of the dual share-class structure. Therefore, we award the firm a Standard rating. Alan Mulally joined Ford in 2006 as CEO and the changes he made allowed the company not only to survive the global financial crisis but also to thrive as a highly profitable automaker. In particular, Mulally’s financing moves in 2006 helped Ford weather the downturn without any taxpayer-funded bailout money. After Mulally’s product moves, Ford started making cars people wanted. Mulally also put in place significant manufacturing efficiencies and improved product quality.

The Specifics
Here is a breakdown of what Morningstar’s analysts will examine when determining a company’s Stewardship Rating.

Investment Strategy
Given Morningstar’s focus on competitive dynamics, analysts pay close attention to a company’s investment strategies. A key question for all companies is, Has the firm strayed from core competencies in the pursuit of growth? A company with exemplary stewardship will be one that has made investments and acquisitions that support its competitive advantages and core businesses. Moreover, exemplary firms will divest underperforming or non-core businesses. Express Scripts ESRX earns an Exemplary Stewardship Rating, for example, because the company’s acquisitions of NextRx and Medco strengthened its existing competitive advantages.

Investment Valuation
Unfortunately, investments that make sense from a strategic perspective can still destroy shareholder value if the price paid is too high. Therefore, analysts consider the price of acquisitions and the cost of major invest- ments. For example, Eldorado Gold EGO has an Exemplary rating because of its managers’ wise investment decisions from both a strategic and valuation perspective. Eldorado is one of only two companies in our gold mining coverage universe that has earned an economic moat, which is largely attributable to CEO Paul Wright and his management team amassing a portfolio of low-cost, long-life mining assets without paying an arm and a leg in terms of capital spending. Wright has accomplished this by focusing on under-the- radar mining jurisdictions such as China, Turkey, and Greece (where the competition for quality mining assets is less intense), as well as through prudent capital allocation.

Financial Leverage
A company’s strategy with regard to financial leverage can have a big impact on shareholder returns, uncertainty, and volatility. Analysts look unfavorably on cyclical, capital-intensive companies that carry a high debt load. Likewise, mature, stable companies with minimal reinvestment needs that sport too little debt are clearly not doing everything to maximize shareholder value. We unfavorably view stewardship at basic-materials companies such as Vulcan Materials VMC, Alpha Natural Resources ANR, and Arch Coal ACI—who each leveraged up to purchase peers during peak industry conditions. Shareholders suffered the negative consequences of too much financial leverage.

Dividend and Share-Buyback Policies Dividends and share repurchases are used to return cash to shareholders. Just like with financial leverage, a Morningstar analyst is like Goldilocks, looking for an ideal amount of returning cash to shareholders that’s neither too little nor too much for a particular company. A company with many opportunities to invest cash at high rates of return within the business or even with acquisition opportunities should probably de-emphasize dividends and share repurchases. Meanwhile, a mature company with minimal profitable investment opportunities should look to return cash to shareholders.

Execution
A robust portfolio of attractive operating assets and skilled human capital, assembled with favorable valuations, can’t create shareholder value if a company has frequent operational and execution missteps. Industrial accidents, customer service problems, or product recalls can depress operational results and destroy shareholder value. Conversely, praiseworthy execution can lead to a company significantly outperforming its peers on operational metrics and shareholder value creation.

Chubb Corp. CB, for example, earns an Exemplary rating. Chairman and CEO John Finnegan has been at the helm since 2002 and, along with the rest of his management team, has done an exemplary job in his stewardship of shareholders’ capital. Before Finnegan’s tenure, Chubb was consistently losing money on underwriting, a trend that was sharply reversed by the decisions and policies put into place by current management. Chubb refocused its business on the most profitable and moaty businesses. Furthermore, it is now a much more disciplined company in terms of underwriting margins. While on the surface it seems obvious that insurers should consistently strive for profitable underwriting, there are many pressures that cause companies to cut prices, especially during the competitive periods in soft pricing markets. Chubb has largely managed to avoid these temptations, a testament to management’s quality. Chubb is now among the most profitable underwriters of the insurance companies we cover.

Compensation
In most cases, a company’s compensation practices will not materially affect our Stewardship Rating for stocks. However, egregious compensation can keep an otherwise admirable management team from earning an Exemplary rating. In certain cases where compensation is especially outrageous, where a material amount of value is being directed to managers at the expense of owners, companies can receive a Poor rating. We look unfavorably on Gamco Investors GBL, in part because we take issue with CEO Mario Gabelli’s outsized pay package. Aside from collecting an annual management fee equivalent to 10% of the firm’s pretax profits each year, he also takes home pay for his role as a portfolio manager. This netted Gabelli more than $60 million in annual compensation in 2011, equivalent to 19% of Gamco’s total revenue in 2011. Although Gabelli’s pay was down from the more than $70 million that he collected in 2007, it is inching its way back in that direction, and he remains the highest-paid CEO among the publicly traded asset managers that we cover. 

Related Party Transactions
Like compensation, related party transactions shouldn’t materially affect our Stewardship Rating in most cases. However, when related party transactions indicate a material redirection of value to managers and their friends and family at the expense of a company’s owners, analysts will assign a company a Poor Stewardship Rating.

Accounting Practices
Deceitful accounting practices are good cause for a Poor Stewardship Rating.

Management Backgrounds
Morningstar analysts assess the backgrounds of a company’s managers and whether or not they’re a good fit for the position. Factors such as relevant and sufficient experience influence our consideration of this factor.

Health, Safety, and the Environment
Because Morningstar analysts are assessing stewardship from a shareholder—not a stakeholder—perspective, the default stance on a company’s health, safety, and environment practices is agnostic. However, if a company’s track record has had a demonstrated impact on operational performance or shareholder value, then we take that into consideration in our assessment of stewardship of shareholder capital.

Ownership Structure
Morningstar analysts take note of a company’s ownership structure: Is it family owned and controlled? Does the government have a controlling stake or a golden share? Is it majority owned by another company? These structures reduce the power of minority shareholders, but in many cases, we don’t consider them cause for concern by themselves, especially when the controlling shareholders’ economic interests are significantly aligned with minority shareholders’. However, when the ownership structure has led to value-destructive capital-allocation decisions, we certainly take this into consideration when assigning Stewardship Ratings. For example, we give Cablevision CVC a Poor Stewardship Rating. The Dolan family’s tight-gripped control over the company is entrenched by a longstanding dual share- class structure, which gives the Dolan clan 70% of the voting power while retaining only a 21% economic interest. This control gave managers the leeway to issue a $10-per-share special dividend in 2006. The company funded this dividend with borrowed money, adding $3 billion in debt to the company’s balance sheet, hurting the company’s financial health. We estimate that the dividend funneled as much as $650 million into the Dolan family coffers. Because the Dolans stood to benefit the most from the dividend, we think capital-allocation decisions have been made in the family’s best interests to the detriment of new would-be shareholders.

Stay Tuned
On May 1, Morningstar’s equity analyst team launched the new rating methodology. It will be available in Morningstar Office, Morningstar Principia, and Morningstar Direct. With the launch, ratings under the new methodology were published on more than 250 companies, with supporting written content. Analysts will roll out the methodology to the remainder of the coverage universe throughout 2012.

Elizabeth Collins, CFA, is an associate director of equity research with Morningstar.
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