Good corporate governance is important for your investment portfolio. When you are in business with people who are interested in making sure that you, the owner (shareholder), get a fair shake, you are likely to have better results. A lot of successful investors refer to companies that put the stockholder first as "shareholder-friendly."
To understand what that means, here are seven specific things you can look for that might indicate you are dealing with world-class people who are looking out for your investment. While shareholder-friendly management can't save a terrible business from its doomed fate, it can tilt the odds in your favor. All else equal, it can help make you richer with less risk.
Having a Clearly Articulated Dividend Policy
Allocating shareholder capital is one of the most important jobs management has. How excess profits are handled is extraordinarily important. Whether those profits are reinvested in existing operations, used to acquire a competitor, expand into other industries, repurchase shares, or increase cash dividends to owners, the decision will have a substantial impact on the wealth of the owners.
As Warren Buffett aptly illustrated in one of his shareholder letters, this skill is not something that comes naturally to most executives. “The lack of skill that many CEOs have at capital allocation is no small matter: After 10 years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”
When management articulates a clear and justifiable dividend policy, shareholders are better able to hold them accountable and judge performance. It also tempers the urge to pursue overpriced acquisitions. An excellent example is U.S. Bank, the sixth-largest financial institution in the world.
According to the company’s 2005 annual report, “The Company has targeted returning 80% of earnings to our shareholders through a combination of dividends and share repurchases. In keeping with the target, the Company returned 90% of earnings in 2005.”
It isn't an accident that a few years later—when many banks failed—U.S. Bancorp sailed right through the worst banking crisis in generations. While the Federal Reserve required it to cut its dividend, as it did with all major banks until it could fully assess the situation, that money piled up on the balance sheet, growing shareholder equity. Other bank investors lost everything, but someone who held U.S. Bancorp stock is richer today than he or she was a decade ago despite a brutal period that, at one point, saw the stock drop almost 70%.
Requiring Executives to Own Stock in the Business
All else being equal, you want your capital managed by someone who has “skin in the game,” so to speak. Shareholder-friendly companies typically require managers and executives to own stock in the corporation worth several times their base salary. It ensures that they are thinking primarily as owners, not employees.
The theory is that this makes executives focus on the long-term, about growing sustainable profits, keeping a strong balance sheet, making sure the accounting records are conservative, and that the business will continue to gush cash for decades into the future. The best companies on this front have CEOs and upper managers who receive more of their income from dividends on their stock position than they do in salary. That is a very limited club, indeed, but when you find such a situation, it warrants further investigation.
A Board of Directors Putting Stockholders Ahead of Executives
The board of directors must know its primary job: to protect the interest of shareholders, not management. Throughout financial history, it seems that most corporate scandals had occurred when a board was too comfortable with the executive team. This phenomenon is understandable; when working with people you like and respect, it’s certainly easier to have a friendly clubhouse atmosphere rather than an adversarial fight club. The downside is that this congeniality can result in terribly overpriced acquisitions, strategy blunders, and hiring mistakes.
How can you tell if the directors are on your side? Look for a few key signs:
- Independent directors hold meetings without management being present to evaluate performance based upon objective measures.
- Board compensation is reasonable and not excessive. If the board is constantly voting itself pay increases, they probably don't have your best interests at heart.
- Perks are kept to a minimum. There are cases of an executive who used the company's private jet, at stockholder expense, to fly the family dog to a vacation spot. Things like that can be covered up when you're firing on all cylinders, but it poisons the culture, leading to extremes such as the Tyco scandal, where the CEO reportedly spent $6,000 on a shower curtain he billed to the stockholders. Sooner or later, you're going to have a bad time with folks like that at the helm.
- They only buy back stock when it is attractively valued. The management team would buy fewer shares when the stock was overvalued, and more shares when it was undervalued, so long-term owners benefited the most.
Requiring (With Few Exceptions) Equity and Voting Rights to Be Aligned
In most cases, it is not a good sign for management to own 2 percent of the stock and yet control 80 percent of the voting power. These lopsided arrangements can lead to the kind of shareholder abuse that was alleged at Adelphia.
On the other hand, this isn't always a deal-breaker. Some companies have dual-class share structures with disparate voting rights, while still doing right by minority owners. You could have grown very rich over the past few generations investing in Berkshire Hathaway, The Washington Post Company, Google, McCormick & Company, or other businesses in which the controlling families and entrepreneurs worked for the long-term success of the enterprise.
Insisting on Limited Related-Party Transactions
Does the company lease all of its facilities from a real estate company owned and controlled by the family of the CEO? Are all of the napkins at your pizza chain purchased from the granddaughter of the founder? Although some related-party transactions can be good for business, be aware of situations that could lead to conflicts of interest. Taking our last example, are shareholders going to get the lowest price possible on napkins, or is the CEO going to feel like helping out the granddaughter’s founder by paying more than he knows he could get elsewhere?
Paying Limited and Reasonable Stock Option and Executive Compensation
A CEO paid $100 million may be perfectly justified if the company is among the top performers during their tenure, and it represents a rounding error to the owners. If the business is down, talent is jumping ship, shareholders are revolting, and a massive pay package is announced, there may be very real corporate governance problems.
Settling for Nothing Less Than Open and Honest Communication
As an owner of the business, you have a right to know the challenges and opportunities that face your company. If management is reticent to share information, it may signal a tendency to view shareholders as a necessary evil instead of the true owners. In most cases, your portfolio will be better off if you steer clear.