Say on Pay and Proxy Access – Start Thinking Now About Talking to Investors

The history of legislative and regulatory reform relating to Wall Street is one of egregious excess, followed by financial distress, resulting in laws and regulations being enacted. It first played out with the boom and bust of the Great Stock Market Crash of 1929, which gave us the Securities Act of 1933 and the Securities and Exchange Act of 1934. We saw a replay following the Enron/Adelphia/Worldcom/Tyco frauds in 2000, which resulted in the Sarbanes/Oxley Act. And now we are seeing the same scenario following the financial crisis of 2008 – 2009 as Congress is feverishly putting together a financial reform package.

I generally try not to pay too much attention to the legislative process, as things change frequently and the process is not pretty to watch. However, there are a couple of things that will likely be included in the current bill relating to corporate governance – proxy access and say on pay - that investor relations officers should be thinking about.

Corporate governance issues have traditionally been an area that falls within the purview of the Corporate Secretary or General Counsel with investor relations only becoming involved if the vote doesn’t look good or if some form of a contest is looming. As activist investors have increasingly turned to proxy proposals to agitate for corporate change, investor relations has gradually become more involved in the process because they are the ones that know the investors. If proxy access and say on pay are going to open up corporate governance to more public scrutiny, it behooves investor relations practitioners to start to get more engaged with the people who vote the proxies.

Of course, when you take a hard look at who does the voting, you realize that IR people have their work cut out for them. You can generally break down investor voting blocs into three categories: active long-term investors, passive investors and active short-term investors.

Active long-term investors usually don’t want to be bothered by this stuff. Portfolio managers and analysts want to analysis stocks, not get involved in corporate governance. Their compensation is benchmarked against their performance relative to an index, not against good corporate governance and they spend their time accordingly. The result is that these decisions are handled by either subscribing to one of the services such as ISS/Riskmetrics, handing it off to an internal committee if the firm is large enough, or by voting with their feet and selling the shares if they don’t like what management is doing. As a result, the typical investor relations officer usually doesn’t talk to the person casting the proxy vote.

Passive index investors can’t vote with their feet by selling the stock as long as a company is in an index, so they all have committees and policies regarding how to vote on governance items. From an investor relations perspective however, you never talk to these passive shareholders, so you don’t know anything about their committees.

Active short term investors are here today and gone tomorrow, so by the time they appear on a 13 D report, they may have well sold the shares and moved on.

I would suggest that investor relations departments need to be proactive in discussing potential vote issues with the people who actually vote the shares. I’ve written about this before (see my post of February 10, 2010), but here are a couple of suggestions to bridge this gap: First, well in advance of proxy season, investor relations officers, together with their securities law counsel, should schedule a number of calls to key investors (both active and passive long-term investors) to discuss current disclosure issues in areas such as compensation and governance. The calls should be designed as a dialogue to discover how these investors view the topics, not as advocacy. as you can’t solicit votes without a proxy statement. What investors are interested in can then be incorporated into your compensation and governance disclosures. Secondly, when you’re out on non-deal road shows, ask to spend five minutes at the end of a visit discussing the firm’s views on disclosure issues, whether they be compensation, governance or social responsibility. This actually makes for a nice break in the road show meeting rat race as it introduces a new topic into the discussion. In the larger firms this will mean that they will have to bring in someone at the end of the meeting, as there is usually a separate person that deals with proxy voting, but it is well worth the effort as it gives upper management an opportunity to hear investors’ concerns and thinking.

This doesn’t solve all issues, as sometimes the interests of investors about compensation and governance structures are different from management’s, but at least you’ll know prior to the vote being cast and can do more accurate predictions at proxy time.

Corporate Governance Ratings – What Are They Good For?

Way back in 1970, there was a Motown record that had as its catch phrase, “War, what is it good for? Absolutely nothin’!” Today, there is research that suggests that the same can be said about corporate governance ratings.

For the past ten years or so, investor relations practitioners have been drawn into the debate on corporate governance. It’s not that IR practitioners have a special expertise in corporate governance, or that many of them really want to become experts. It’s just that Boards of Directors have been under increasing scrutiny to comply with a list of “best practices” compiled by groups such as Institutional Shareholder Services (“ISS”), Governance Metrics International (“GMI”) and The Corporate Library. Directors do not like it when shareholders withhold their proxy votes for failure to meet minimum corporate governance scores. And it’s investor relations that talks to the shareholders, so IR people find themselves working with the Corporate Secretary and the General Counsel to find out how they can achieve the highest possible corporate governance scores to present to shareholders while actually changing corporate practices as little as possible.

The underlying premise of the governance rating services is simple, yet compelling on its surface: companies that focus on corporate governance as indicated by high ratings will, over time, generate superior returns and economic performance and lower their cost of capital. Conversely, companies weak in corporate governance as shown by low governance scores represent increased investment risks that should be penalized by a higher cost of capital.

But did you ever take a step back and wonder whether the corporate governance ratings have any value in actually predicting poor corporate governance or performance? I certainly have. And so too, it seems, have Professors Robert Daines of Stanford, Ian Gow of Kellogg and David Larker of Stanford. In a recent scholarly article, “Rating the Ratings: How Good Are Commercial Governance Ratings?” which is to be published in a forthcoming issue of the Journal of Financial Economics they look at how effective corporate governance ratings are in helping shareholders figure out if companies with high corporate governance scores are actually better governed. The findings are so startling and unequivocal that I am going to quote the article abstract in its entirety:

Proxy advisory and corporate governance rating firms (such as RiskMetrics/Institutional Shareholder Services, GovernanceMetrics International, and The Corporate Library) play an increasingly important role in U.S. public markets. They rank the quality of firm corporate governance, advise shareholders how to vote, and sometimes press for governance changes. We examine whether commercially available corporate governance rankings provide useful information for shareholders. Our results suggest that they do not. Commercial ratings do not predict governance-related outcomes with the precision or strength necessary to support the bold claims made by most of these firms. Moreover, we find little or no relation between the governance ratings provided by RiskMetrics with either their voting recommendations or the actual votes by shareholders on proxy proposals.

Inside the article the language is even stronger. Here’s my favorite quote: “One especially interesting result is that CGQ (perhaps the most visible governance rating) [Corporate Governance Quotient, a measure devised by RiskMetrics/ISS] exhibits virtually no predictive ability, and when CGQ is significant, more often than not it has an unexpected sign (e.g., higher CGQ seems to be associated with lower Tobin’s Q, and in some models more class-action lawsuits).” In other words, high governance scores have virtually no value, and companies that put in all of the so called best practices are actually more likely to be worth less and get sued more often.

What all of this suggests to me is that good oversight by the Board of Directors and good management of the shareholders’ assets is not a function of a formula or a list of practices. Rather, the way Boards and managements function needs to be examined by investors on a case-by-case basis in relation to their cultures and their track records. How Boards function does need more transparency so that investors can judge for themselves if they are practicing good stewardship. But those that think that good governance can be boiled down to a single number score are just kidding themselves. And if you are paying to get advice on how to increase your governance scores, you’re wasting corporate assets.

Corporate Life Cycles and Investor Relations, Part 2

In my last post I wrote about the commonality between the product life cycle chart and corporate life cycles and some of the implications this has for investor relations. To recap, where you are in terms of your corporate life cycle is a large determinant in whether you get Growth, GARP, Value or Deep Value investors. As each of these different styles of investors is willing to pay differing amounts for your future earnings, the valuation you get in the stock market will in no small degree be influenced by where investors view you in your life cycle. To carry this one step further, in this post we will look at how companies seek to avoid the point at which they transition into a mature, and then declining company and how successful this is in avoiding a declining P/E ratio.

In product development, when a product threatens to become mature, the marketing people move in and try to rejuvenate and refresh the brand by introducing new product features and formulations or market applications. The idea is to boost sales volume and market penetration. Nobody wants to get to the point where a product is mature, verging on stale, and headed for inevitable decline. In graphical terms, what they do looks like this:

Companies do the same thing. A great example of a company continually reinventing itself via new products and markets is Apple. First Apple was a computer company. Then they introduced the iPod and iTunes. This was followed by the iPhone, Apps and now, the iPad. Apple has been incredibly successful in this approach, helped by great design and engineering, creating a tightly integrated suite of products that customers love. And the stock market has richly rewarded them for this. As of this writing, Apple stock is trading at a P/E ratio of 23.8, placing it in very exclusive territory for companies with over $100 billion in market cap.

Companies do not do this with just new products, however. Companies attempt to extend their progress up the growth curve through acquisitions, entering new markets, entering new territories, going global, reengineering their work processes, expense initiatives and a raft of other things too numerous to mention. In doing this they hope to extend their growth and the premium investors will pay for their future earnings. The problem with all of this, from an investor’s viewpoint, is that the new products, programs and initiatives don’t have a track record. Therefore, the certainty with which future earnings from these programs can be predicted is less than it is for existing operations and the willingness of investors to pay up for the incremental earnings is less. Unless and until a company can establish a track record for successful entry into new products or markets or initiatives, investors will discount the future earnings at a greater rate than the old familiar type of earnings. Investors just don’t like uncertainty. So revenues may go up; earnings may in fact also go up, but P/Es will fall until a company can demonstrate that it has as one of its core competencies the ability to extend its growth with new initiatives.

Again, if we look at Apple, the first Ipod was introduced on October 23, 2001. Following the announcement of the new product, one that turned out to be revolutionary, Apple’s stock price didn’t do much for the next couple of years. Investors had a wait and see attitude.

This, of course, drives corporate management nuts. They have invested millions of dollars in a new initiative through design and engineering, consulting fees and countless meetings and studies. They are embarking on a bold new strategy to push their company forward for the next millennium. And yet, in their view, the market doesn’t get it.

Investor relations professionals should learn to recognize this type of fact pattern and be ready to explain to management why the stock didn’t jump when the CEO’s latest initiative was announced. Much heartburn can be avoided if companies take a realistic approach to how the market values new corporate actions. There is no real way around this – companies have to prove themselves to investors on new initiatives to a far greater extent than for existing operations. But as witnessed by Apple, it can be done.

Corporate Life Cycles and Investor Relations

I’ve written before on some of the relationships between marketing and investor relations and I’m at it again today. In marketing there is a well-known graph known as the Product Lifecycle Curve, which I’ve set out below.

The graph points out how products are first brought to market and purchased by early adopters, then go through a phase (if they are lucky) of rapid takeoff and growth. Once the product has achieved wide spread acceptance, the growth cycle slows down, and after a period of maturity, decline inevitably sets in. The speed at which all of this occurs depends in large part on the nature of the industry and the aggressiveness of competitors. Tech gadgets, for example, have much shorter product life cycles than say, breakfast cereals.

The interesting thing about the product lifecycle is that it has applicability to a number of other things, corporate lifecycles included. Stop thinking about products and substitute corporate development and the graph doesn’t change. Where this is of interest to investor relations professionals is in the type of investors each phase of the cycle attracts. Set out below is the same graph with investor segments sketched in.

One of the interesting things about the graph is that as you move on the life cycle line from left to right, the price/earnings ratio that investors are willing to pay for a stock declines. This is because investors perceive that the rate at which future earnings will accrue to the company is slowing and they are therefore willing to pay less for that future stream of lessened earnings.

Companies often struggle with this, particularly at the inflection points between stages. Company executives will say, “We’re a growth company – look at our record. The market is undervaluing us.” Investors, on the other hand, will look forward and say, “Nope, you’re a mature company. Your big gains are over and we’re not going to pay a premium for a company that is going to grow at the rate of the market.” Many an antagonistic relationship has been fostered based on this differing view of the world.

There’s more that can be said about this (and I will in later posts), but if I don’t run out now and buy an iPad, I will lose my status as an early adopter…

Bells Are Ringing

If you ever get the chance to participate in a bell ringing ceremony for the New York Stock Exchange, grab it. It’s a lot of fun. Recently, the Jones Graduate School of Business at Rice University held a panel discussion on the Future of the Capital Markets. One of the panelists was Duncan Niederauer, the CEO of NYSE Euronext, and as part of the program, the Jones School was honored by being allowed to remotely ring the closing bell on the New York Stock Exchange for the close of trading on March 29, 2010.

For those interested in the actual mechanics, the bell actually starts to ring 15 seconds before the close of trading and trading stops when the gavel comes down. The interval between the start of the bell ringing and the gavel coming down is to allow traders to complete their trades. Given that we are talking about professional traders and New Yorkers to boot, it’s never a problem completing trades in that last 15 seconds.

When you ring the bell at the New York stock Exchange, the only one who has a challenging role is the CEO, who has to simultaneously depress a button and remember to bring down the gavel 15 seconds later. This is the corporate equivalent of walking and chewing gum at the same time. As most CEOs are used to having someone else perform such complex tasks, it can sometimes be a challenge. Everyone else on the podium simply has to clap and look engaged.

Doing it remotely is a lot more fun. You get these cute little commemorative cowbells and you get to ring them and shout like mad for 15 seconds. Everything else gets taken care of back in New York. At Rice last Thursday, it seemed as if the entire school was in attendance. We rang our bells and shouted like mad and it was great. And yes, I’m in that picture somewhere.

Know Thine Enemy

As a matter of self-defense, one should always try to understand their enemies. For those of us that are in the business of dealing with the equity markets, this would include trying to understand class action securities lawyers. These are the people who bring lawsuits against companies alleging fraud and seeking to recover the lost value of stock for shareholders following some event that has caused the stock price to go down, while simultaneously collecting large fees for their firms. If you want some insight into the mindset of these plaintiff’s lawyers, I suggest you get a copy of the book, “Circle of Greed” by Patrick Dillon and Carl M. Cannon.

The book tells the story of the rise and fall of Bill Lerach and his firm, Milberg Weiss Bershad Hynes & Lerach. In its day, the firm was perhaps the most feared and reviled securities class action law firm around, bringing cases against a veritable who’s who of corporate America, from Fortune 500 companies to Silicon Valley high tech pioneers. One of the key insights of the book is that the mindset of a plaintiff’s lawyer is to immediately assume fraud on the part of a corporation when something unusual happens and the stock price goes down. It doesn’t matter that the process of running a complex corporation in a highly competitive environment is fraught with difficulties that mean that things don’t always go as planned and that the markets are unforgiving in such a case. In the minds of lawyers like Bill Lerach, if a stock has been going up and suddenly declines, the company has clearly been hiding something and defrauding shareholders. If this was compounded by management making optimistic comments and selling stock, the company was clearly guilty and large settlements could be extracted. My own personal experience confirms this: Many years ago I was on a continuing legal education panel with a lawyer from the firm of Milberg Weiss and he told me that the best research tool for new lawsuits he had was that day’s edition of The Wall Street Journal. He would read it every day and look for stocks that had taken a large decline in the previous day’s trading and assume that company was ripe for a lawsuit.

After reading the book, I want to add securities class action lawsuits to the old saying that legislation and sausages are things you don’t want to watch being made. In the old days, before the Private Securities Litigation Reform Act of 1995, securities class action lawsuits were little more than a legalized form of corporate extortion. A company’s stock price would go down, a lawsuit would be filed and, faced with the prospect of producing boxcars full of documents, tying up management’s time and attention with depositions and trial strategy, and a hostile jury willing to vote for the small shareholder against big corporations, most companies made the economically rational decision to settle. All you needed to do was file a lawsuit and you had a gun pointed at the head of the company. The 1995 Act has changed things a bit in that plaintiffs have to actually allege specific acts of fraudulent behavior before they can get certified by the court to lead the class action suit. But importantly, it hasn’t changed their mindsets – they still believe corporations are guilty – they just have to work harder to prove it.

“Circle of Greed” tells a compelling story, the Greek drama of how one person rose to the peak of his chosen profession, but was ultimately undone by his own seeds of fraud sown early in his career. While Lerach was publicly taking a high moral tone, claiming to recover money for the little shareholder, he and his firm were engaged in an ongoing scheme to pay illegal kickbacks, covered up by perjury, to people who agreed to act as named plaintiffs in their cases. Having a ready stable of plaintiffs meant that Milberg Weiss could get to the courthouse first and capture the lion’s share of the attorney’s fees. In the end, disbarment, jail time and significant fines were the fruit reaped by their actions.

While engrossing, the book is not perfect. It’s probably about 100 pages too long, with so much detail that you start to think the authors are trying to prove how thorough they were. It’s really not necessary to tell the reader where every one of the many lawyers in the book went to law school. More disturbing to me is the fact that the authors can’t seem to make up their minds about who the bad actors are. At one point they seem to point at the plaintiff’s bar, at others they seem to think almost all of corporate America is corrupt and the securities law plaintiffs are serving a useful enforcement purpose. At the end of the book I came away with the feeling that the authors believe the whole system is corrupt, but their sympathies lie much more with people like Lerach than corporate America.

(Author’s note: I received a free copy of this book from the publisher. No promises were made about reviewing the book in return, but after reading the book I thought readers of this blog might be interested.)

Sales, Marketing, Relationships and Investor Relations

There is an old saying that goes, “When the only tool you have is a hammer, everything looks like a nail”. So those of us who went to Kellogg Graduate School of Management are often accused of seeing everything as a marketing problem, because that’s what Kellogg is best known for. But in getting ready for this year’s investor relations class at Rice, I pulled out Philip Kotler’s “Marketing Management” and was quite surprised by how many of the principles of marketing apply to investor relations, so maybe there is some truth in the old saying.

For example: Boiled down to its essence, investor relations is consultative selling. You want the right type of customers (investors) to buy a piece of your company (stock) and to have a good ownership experience (own the stock for a long period of time). The purchase and sale decisions regarding your product (stock) are, for institutional investors, done in a complex, multiparty transaction involving sell side analysts, salesmen, buy side analysts, portfolio managers and traders, with information about your company being judged against a competing universe of offerings.

Marketing fundamentals tell us that any time you have complexity in the way a purchase decision is made with lots of competing choices, the process takes a longer period of time to analyze the pertinent data and come to a decision. Rivel Research has stated in one of their studies on the buy side that it can take 3 – 5 “touches” with management before a purchase decision is made. I have personally known investors who took 4 – 5 years of following a company before they made a significant investment decision. Yes, there have also been occasions where investors make a purchase after a single visit, but usually there has been significant research done before the visit.

Marketing also tells us that complex purchase decisions require more upfront effort by all parties involved. This is why it is important to realize that investor relations is a relationship business. It is much harder to sell a product if you do not have rapport with the customer. On the IR side of the fence, this means treating analysts fairly and consistently, helping them understand your company and industry, chasing down the details that help fill in the picture for the customer and eliminating some of the informational uncertainties that go with buying stocks.

Often managements have an “us or them” mentality when it comes to investors. You are either in the boat pulling on the oars and helping the stock price go up, or you are out in the water circling the boat awaiting an opportunity. It doesn’t have to be that way. As a partner at Goldman Sachs once said to me, “There are good companies and there are good stocks – they’re not always the same.” Stock prices fluctuate, and not always because the firm’s underlying intrinsic value has changed. This is where relationships come in. Patient, long-term investors may follow you for a long time before they find the right entry point. If you have built a relationship with them, they may be more likely to pull the trigger when the opportunity presents itself. Similarly, in times of market turmoil, investors are much more likely to stick with your company if they know you, believe that you are telling a straight story, respect your work and have been treated fairly by you in the past.

Of course, if you are completely owned by index funds, quants, quick buck hedge funds and day traders all this goes right out the window…