Analysis of corporate governance

Reading time: 8 – 14 minutes

This is the fourth article in a series about Post Modern Security Analysis.

The analysis of corporate governance

The term “corporate governance” came into vogue in the 1990s and now dominates discussion of ethics and morality in investment markets.

For five essays on “corporate governance” on this site, go here.

Stakeholders have different interests ...

Often, the pretense of “good corporate governance” has served to shield ethically challenged management from critical scrutiny by ordinary investors — an exercise in hypocrisy.

However, the corporate governance movement has come up with one important concept: stakeholders. The view that a corporation has many different “stakeholders”, with different interests, is essential to Post-Modern Security Analysis.

Management still talk about “looking out for shareholder interests”, but the influence of other stakeholders can hardly be ignored, especially the stakes of various governments, labor unions, franchise owners, administrators of off-balance sheet assets, license holders, creditors, employees, trading counter-parties, out-sourced suppliers, down-stream customers, banks, and, last but not least, management itself.

The analysis of corporate governance and of the relative importance of various stakeholders should be the first step in Post Modern Security Analysis.

The interests of stakeholders

Investment securities are a combination of contractual agreements and legal requirements merged with expectations of customary behavior. Normal and reasonable expectations of the benefits and risks of a specific investment opportunity vary among the stakeholders in each case.

For example, fifty years ago, common stockholders expected that most profits would be distributed to them in the form of dividends and that hired management would be content to provide faithful service for a fixed salary and occasional modest bonus.

Today, many corporations pay no dividends at all to common stockholders, while professional managers who do not hold a controlling interest in the company are able to pay themselves an exorbitant share of profits in the form of stock buyback-option deals, high salaries, “golden parachutes”, and expensive pension schemes.

Labor and management

Boeing aircraft factory in 2002

In 2009, the Obama government, with strong political ties to labor unions, managed the bankruptcy of General Motors in such a way that ordinary creditors were disadvantaged, receiving far less than they might have expected under normal bankruptcy procedures, with a politically favored share of the assets going to the unions.

In the period 1999-2001, the Boeing Corporation undertook a colossal $9.1 billion stock buyback (25% of equity), the main purpose of which seems to have been to temporarily boost stock prices and give value to executive stock options to the detriment of the interests of long-term common shareholders.

Furthermore, this profligate behavior so weakened the financial situation of the corporation that by 2003 management was seeking financial aid from the US government. Significantly, the Boeing Corporation made a point of boasting of its support for the principles of “good corporate governance”.

See: The Boeing Buyback

Which stakeholders rule?

Before acquiring a financial asset, it is important to determine which stakeholders are most important in a particular venture and whether their interests coincide with your own.

Corporate governance is a 'can of worms'

Common financial ratios, such as earnings-per-share, take on entirely different meanings, depending upon which stakeholders control corporate finances.

The growth of EPS of a company controlled by entrenched professional management bent on stock buybacks and executive option schemes cannot be compared with the EPS of a company controlled by a few large stockholders that are thinking of the long-term interests of the enterprise and who are determined to maximize dividend payout.

Corporate governance is a “can of worms” that must be opened and studied with care.

Facts about corporate governance

Controlling influence over a corporation can come from various sources.

One should not assume that the largest shareholders control an issuer. Often there is no majority shareholder. Even when there is, some other group or groups may have either effective control or a determining influence on corporate finances.

Church ruin: Gary, Indiana (union rust belt)

For example:

1. Labor unions: Companies can be destroyed by government-protected trade unions that put the interests of union leadership above those of stockholders, creditors, and even local populations. Whole areas of the United States, from Flint, Michigan to Gary, Indiana, have been laid waste by trade unionism.
2. Professional management: When executives are not controlled by long-term shareholders, but rather by intermediaries with short-term goals, such as mutual fund managers, the interests of long-term shareholders usually suffer.
3. Franchisers: Companies that are essentially franchisees can be adversely effected by decisions of franchisers. For example, thousands of automobile franchisees were put out of business in 2009 when General Motors went into bankruptcy. Even profitable companies with good prospects were effected.
4. Suppliers: An investment opportunity may be overly dependent upon the interests of a certain supplier. For example, diamond dealers, throughout most of the 20th century, were dependent upon pricing and supply of diamonds controlled by the De Beers Group.
5. Customers: The collapse of General Motors revealed the dependency of many suppliers of auto parts on a single customer. Under situations of monopsony, a customer is able to dictate terms and conditions to suppliers. A company may no longer be an independent player in the market.
   

   Stakeholders usually have cross-purposes

6. Government: Nations, states, and municipalities often play a determining role in the fortunes of a company. As a shareholder, government is likely to staff management positions with political favorites. As a customer, government may delay payment or renegotiate contracts at will. As a creditor, government may insist on being paid first, before other creditors.
7. Economic groups: When a company is part of an economic group, the interests of the Group may be favored over those of shareholders of a particular member of the group. Companies controlled by a group may find profits being transferred from one group member to another by over- or under-invoicing and similar tricks.

“Stakeholder review” is a first step in Post-Modern Security Analysis.

Stakeholder analysis: the basics

If you are seeking income and the principal stakeholders of a venture are not interested in paying dividends, it is only commonsense to conclude that this particular investment is not for you.

If you are looking for short-term speculative opportunities, then perhaps a company that invests for the long-term, shunning stock buybacks and operations that tend to increase price volatility, like frequent entertainment of merger and acquisition proposals, is not an appropriate vehicle for your money.

What are you looking for in an investment?

The first step in stakeholder analysis is to determine which investment characteristics are most important for your purposes:

• Short-term security price swings;
• Current income;
• Long-term income growth;
• Long-term financial stability;
• Safety of principal;
• Long-term growth of investment value;

Next, gather facts about a company to determine which “stakeholders” have the most influence with regard to the investment characteristics that interest you.

This requires research that determines such things as identifying the principal shareholders, management personalities, creditors, suppliers, customers, or government agencies that might effect the ability of a company to provide the investment results you seek.

Finally, try to find facts that indicate whether or not the motives and goals of the stakeholders that you have identified coincide with your own.

If not, it probably is best to not waste time researching this opportunity further.

It usually doesn’t matter whether the price earnings ratio and growth prospects of a company are attractive or not, if the controlling stakeholders have no intention of paying dividends and this is what you seek.

Furthermore, a history of high dividend payouts would be irrelevant if you find out that control of a company has changed and that new management favors cutting dividends.

Governance:  an ethical issue?

Any company should have good internal controls and be able to protect its assets and report results accurately to stakeholders.

However, beyond that, corporate governance should not be thought of as “good” or “bad” in any ethical sense.

Much of the corporate governance movement is nonsense, such as the concept of “independent directors” to oversee “management”.

However they may be named and classified, there is no such thing as an independent director (unless, of course, one is referring to an angelic being that pays its own salary and can maintain its post as long as it chooses, working for the “common good” of all stakeholders from purely altruistic motives).

Philosophers have long struggled to define morality and ethics. There have been many conclusions but no consensus.

An impossible consensus

In terms of a global capital market with participants from all cultures, religions, and belief systems, it is too much to expect that agreement can be reached on what constitutes moral behavior. In secular society, often what is “legal” serves as a substitute for “morality”, but with hundreds of legal systems in the global market, we can never reach a conclusion regarding morality and ethics based on law.

Independent directors are nowhere to be found ...

However, this is all irrelevant if we simple know what kind of behavior we ourselves expect from the stakeholders in a venture and then determine whether or not particular stakeholders are up to our own personal standards.

In this sense, “good corporate governance” is a relative concept, based on one’s own personal investment goals. With so many investment opportunities to examine, this conclusion serves as a first guideline in simplifying the task of security analysis:

1. Other than practical things (like information about internal controls or reporting procedures) don’t waste time trying to analyze “compliance” with some organization’s “Corporate Governance Standards”;
2. Eliminate companies from your list of potential investments when the purposes and intentions of the controlling stakeholders do not coincide with your own.

Next Lesson: Post Modern Security Analysis: Part Five (Managing Complexity)

Photo credits: Gary Indiana by Rick Harris from flickr