Stewardship Grades Get a Makeover

As it is with so many things in life, change is a necessary part of our analysis at Morningstar. With an issue like corporate governance, that change has been driven by many of the scandals that have plagued our landscape over the past decade. In fact, if it weren't for some of the complete meltdowns we saw at companies like Enron, Tyco , and WorldCom--where top executives were busy lining their own pockets as boards rubber-stamped anything that management was doing--we would not have seen much change in the status quo.

Despite some of the criticism that has been levied at the legislation and regulations that have been implemented over the past five years (in an effort to increase the transparency and reliability of financial information provided by publicly traded companies), we believe that we are in a much better place than we were just a few short years ago. With that in mind, we've upgraded our own corporate governance grading system in order to highlight many of the changes that have occurred in the marketplace, and we've also made a concerted effort to focus on the key issues that we think impact investors not only domestically, but globally, as well. With the new format, we hope to eventually have Stewardship Grades in place for each of the nearly 2,000 companies we cover.

A Bit of Stewardship Grade History
As you may recall, Morningstar originally created the Stewardship Grades to help investors identify companies that we believe consistently align their interests with those of shareholders. We called it a "Stewardship Grade" because we view corporate managers as stewards of investors' capital. As such, companies with strong track records of putting their shareholders first have tended to score well, while those that have treated shareholders poorly have ended up at the other end of the spectrum. Remember, our Stewardship Grades are awarded on an absolute scale from A (excellent) to F (very poor).

Unlike scores generated by most other governance rating services, we don't look at how well a company has performed relative to others within its own industry (or some other benchmark). Instead we focus on the crucial elements that we believe impact how a company's management team and board of directors regard their shareholders. If a company engages in practices that run contrary to those that we believe are essential for it to be a good steward of investors' capital, then it will receive a poor grade regardless of how other firms in its industry (or country of origin) have scored. We do this because we want to award grades based on how companies are actually treating their shareholders, rather than give credit to firms with poor stewardship that may just happen to be the best of a bad bunch.

The Updated Stewardship Grade System
In the past, our analysts had focused their attention on three broad areas: transparency; shareholder friendliness; and incentives, ownership, and overall stewardship. In light of the many changes we've seen in the regulatory environment over the past couple of years, as well as our own efforts to globalize our corporate governance grading system, the Morningstar Stewardship Grades will now reflect our analysts' assessment of the four broad areas discussed below.

Transparency
Without adequate and reliable accounting practices in place and financial disclosure that is truly transparent, investors may be placed at a distinct disadvantage. As such, our analysts evaluate a company's accounting practices and financial disclosure, aiming to identify firms that provide investors with insufficient or potentially misleading information. Key areas of interest include whether a firm utilizes aggressive accounting methods, overuses "one-time" charges, institutes major changes in accounting procedures or reporting controls, or fails to provide sufficient enough information for investors to make an educated investment decision. While all of these issues will serve to reduce a company's score, we do provide our analysts with an opportunity to reward firms that have disclosure that we think goes above and beyond what is required by law.

Board Independence
In theory, shareholders (who are the owners of publicly traded companies) delegate their control to a board of directors, which is responsible for overseeing the management team hired to run the firm and act in the best interests of all shareholders. In practice, many boards fall short of this objective. Our analysts take a hard look at a company's board of directors, highlighting firms where the chairman of the board is also the CEO, where related-party transactions are an impediment to board independence, or where directors lack the qualifications or independence to truly act in the best interests of all shareholders longer term. This is one area where we have really expanded our insight, in an effort to highlight companies where boards may be following the "letter of the law" but are far from independent. This includes situations where external forces (such as holding companies, trade unions, or governments) could serve to undermine a board's ability to act in the best interests of all shareholders.

Incentives and Ownership
When companies align the long-term interests of management with those of shareholders, primarily through the use of appropriate incentives and required levels of ownership, investors tend to be better served in the long run. Our analysts penalize firms that lack clear goals and objectives for their compensation practices, change stated goals and/or performance benchmarks mid-stream, or simply overcompensate their top executives. While we prefer to see managers and directors taking meaningful equity stakes in the companies they represent, we want to make sure that they aren't giving away too much of the firm in stock options or restricted stock.

Shareholder Friendliness
This final category assesses the power of shareholders relative to management by looking at key issues like voting control, the existence of cumulative or majority voting rights in board elections, the ability of shareholders to recommend and/or approve changes to a company's structure or policies, and the existence of takeover defenses or other limits on shareholders ability to protect their rights as owners of the firm. We believe that shareholders should be allowed the opportunity to challenge the decisions and actions of management and/or the board of directors (especially when they run contrary to shareholders' best interests), and we tend to reward firms that provide investors with greater access to the tools necessary to voice their concerns.

What to Expect from the New System
Overall, we've made a concerted effort to highlight issues that we think not only impact U.S.-based firms, but also many of the companies we cover that are based in other countries. As we already focused on many of these issues in the past, we don't expect to see too many significant changes in the Stewardship Grades that are in place for the domestic firms we cover. That said, our analysts are spending much more time these days looking at critical issues like board independence and executive compensation, so don't be too surprised if a Stewardship Grade changes or the commentary provided in the management and stewardship section of our analyst reports is altered to reflect the heightened focus.

We also believe that the grades we'll eventually be posting for companies based in more-developed markets outside of the U.S., such as Canada and the United Kingdom (where disclosure is as good, if not better, than it is domestically), will resemble the types of scores we've seen over the years from many of the U.S.-based firms. That is, companies with strong track records of putting their shareholders first will score well, while those that have treated shareholders poorly will fall to the other end of the spectrum. Bear in mind, though, that the average grade for U.S.-based firms is a high C, which means that most domestic companies are doing just a fair job of looking out for individual investors, and we don't really expect things to be that much different globally.