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Stock Strategist

The Traits of Trustworthy Companies

A study of our Stewardship Grades reveals some surprises.

What makes a company more likely to treat shareholders with respect?

This was the question we tried to answer when we launched our Stewardship Grades last month. I thought I'd share with you the results of a small study of our grades I recently completed that yielded some fascinating results in terms of which aspects of corporate governance are better "leading indicators" of the overall trustworthiness of a management team. Interestingly, we found that corporate-control issues like takeover defenses and multiple share classes were weaker indicators than areas like accounting transparency and compensation structure.

We look at three broad areas when assessing corporate stewardship, rating companies on 20 separate issues overall, so a natural place to start was looking at which issues affected the largest percentage of companies that we've rated. Bear in mind that the data I'm about to present covers only about one third of our 1,500-stock coverage universe at the moment--generally the largest, best-known, and highest-quality firms.

Stewardship Surprises
Would it surprise you that 10% of this mainly large-cap universe failed our "reporting controls" question, which asked whether the company had restated earnings or delayed a financial filing for any reason other than a mandated change in accounting rules? It sure surprised me, especially given how much the business community has been whining recently about this issue.

There's a portion of the Sarbanes-Oxley Act set to go into effect soon that requires managers to attest to "adequate internal controls" for all public companies, and I've read more than a few articles quoting corporate managers complaining about the high cost of implementing the necessary controls and paying accountants to certify compliance. While I have no doubt that accounting and consulting firms are happily extracting their pound of flesh from corporate America, the fact that 10% of the country's largest firms had to restate earnings over the past few years hints that there's some kind of problem here that merits a solution. (Is "SarbOx" the right solution? I don't know--but clearly, something's amiss.)


 Stewardship survey results
Question % "yes"
Reporting controls: Has the company recently restated earnings for any reason other than compliance with an accounting rule change? Has the company had an unexpected delay in making regulatory filings or reporting quarterly results? 10%
Related-party transactions: Has the board or management engaged in significant related-party transactions that cast doubt on its ability to act in shareholders' best interests? 18%
Moving goalposts: Has the board granted one-time "retention bonuses," redefined management's performance goals midstream, or repriced options? 13%
Over the past three years, has the firm given away more than 3% of shares annually as options? 21%

Some other interesting aggregate results: Almost one fifth of the companies had a related-party transaction significant enough that our analysts felt that it cast doubt on management's ability to act in shareholders' best interests, and 15% had moved management's compensation goalposts--either by repricing options or changing the performance targets for top managers. Finally, about 20% of the approximately 500 firms we looked at gave away more than 3% of the share base each year as options, which we think is too much. I have sneaking suspicion this will change over the next few years as options start to show up on income statements as an expense, but maybe I'm an optimist.

Influential Factors
Next, I looked at which aspects of corporate stewardship were most closely related to other aspects that we rated. In other words, were firms that received poor marks in one area more likely to perform poorly in others?

Not surprisingly, companies with aggressive accounting were much more likely to have restated their numbers over the past few years--if you push the accounting envelope, it shouldn't come as a surprise that you have to fess up now and then. Also, companies that issued lots of options were more likely to have moved compensation goalposts at some point. Again, this is pretty intuitive because both practices point to an out-of-control compensation culture that rewards entitlement over performance.

The fascinating thing was that these two areas--accounting standards and compensation practices--were linked to some degree. Companies that had restated earnings were more likely to have changed compensation standards midstream than the average company. It seems that management teams that think they can play fast and loose with accounting rules also think they can rewrite compensation guidelines whenever they like--in both cases they're either bending or ignoring previously agreed-upon rules.

Leading Indicators
Finally, I wanted to see which of the questions that we used for our Stewardship Grades, taken by themselves, were stronger or weaker indicators of a company's overall level of stewardship. In general, I found that corporate-control issues--such as takeover defenses and multiple share classes--that are frequently used as proxies for corporate governance were weaker indicators than areas like accounting transparency and compensation structure.

For example, 16% of the companies we've looked at have a separate share class controlled by an insider. Although this question does a decent job at separating out companies with excellent or very good stewardship (none of our A-graded companies have a separate share class, and only 5% of our B-graded ones do), it's not very good beyond that--19%, 22%, and 17% of our C-, D-, and F-graded companies, respectively, have separate share classes. So, separate share classes aren't all that much more common among our worst companies than among all the companies we've rated.

The same thing holds for takeover defenses, which are often considered a hallmark of poor corporate governance. Although our A-graded companies were half as likely to have some form of takeover defense as the average company, and virtually all of our F-graded companies had takeover defenses, companies that fell in the B, C, and D categories were just as likely as the average company to have a poison pill, staggered board, or what have you. I dug into this point further by looking at not just whether companies had takeover defenses at all, but also at the strength of those defenses. It turned out that the average strength of companies' defenses did vary somewhat, but not nearly as much as you might think--in fact, the A-graded companies with some form of takeover defense actually had modestly stronger defenses, on average, than B-graded companies.

 Stewardship Survey Responses by Grade
 Question A B C D F Total
Share classes: Does the company have a separate voting class of shares that an insider controls? 0% 5% 19% 22% 17% 16%
Takeover defenses: Does the company have takeover defenses in place that, if exercised, would significantly dilute existing shareholders or favor the interests of management over shareholders in a takeover situation? 35% 62% 67% 69% 92% 67%
Charges/presentation: Does the company overuse "one-time" charges or write-offs? Does it consistently disregard GAAP earnings and point to pro forma numbers (i.e. "excluding charges...")? 0% 6% 19% 43% 43% 20%
Clear goals: Do the goals set out for top management by the board's compensation committee encourage short-term actions rather than long-term value creation? Is the board's disclosure of such goals insufficient, too generic, or too fuzzy to allow you to answer the previous question? 0% 9% 32% 43% 58% 25%

However, financial transparency and compensation turned out to be very potent indicators of overall corporate stewardship. Firms that overused "one-time" charges, had aggressive accounting, or restated earnings were all much more likely to have poor overall grades. Overusing charges was particularly strong as a one-off indicator--about 20% of all companies received a negative score on this question, compared with no A companies, 6% of the B companies, 19% of the C companies, 43% of the D companies, and 43% of the F companies.

On the compensation front, three questions were good overall indicators: compensation structure (rewarding management for being employed, rather than making smart decisions), moving compensation goalposts midstream, and having clear performance goals from the board of directors. For all of these questions, companies with overall grades of D or F scored poorly twice as often as the average company, with A- and B-graded firms receiving negative scores only rarely.

Conclusion
As we expand the number of companies for which we have Stewardship Grades, I'll revisit this study to see whether the conclusions still hold. Since the approximately 500 companies with grades at the moment are, on average, larger firms, the data could change. Still, I think there are a couple of interesting conclusions that can be drawn at this point.

First, being insulated from a hostile takeover--whether via a poison pill, staggered board, or a separate share class controlled by an insider--might not necessarily be an indicator of poor corporate stewardship by itself. (Of course, it might be when looked at alongside other issues.) Anecdotally, there's evidence for this: think of  The Washington Post (WPO) or  John Wiley & Sons (JW.A), both of which have delivered great results to shareholders over time while treating them respectfully as well. However, I'll be very interested to see whether this finding changes as we expand the number of companies with Stewardship Grades, since the archetypical insider-controlled firm run for the benefit of insiders is usually not a large blue chip. I suspect this finding will change.

Second, the data support an idea we felt strongly about when we designed the Stewardship Grade, which is that how a company chooses to present itself to investors (financial transparency) and how it chooses to pay its executives (compensation structure) are strong indicators of overall corporate governance. If a firm attempts to snow investors with aggressive accounting or serial one-time charges, it's trying to stretch the truth and present itself in a more positive light than it deserves. In a similar fashion, if a board of directors pays executives for being employed, rather than for creating shareholder wealth, it's sending the signal that financial performance is less important than glad-handing or internal corporate politics.

In my mind, both of these issues point in the same direction: Honesty is always the best policy, and management teams that cannot bring themselves to deliver bad news to investors, or boards that have trouble delivering bad news to executives, are unlikely to be good stewards of your capital.

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