Mailbag: Corporate Governance
Mailbag: Corporate Governance
Digging into why governance matters and what to look for.
Why didn’t I think of this before?
I got a great question from Muzamel Shah, which made me realize I should be taking more questions from everyone. I think a semi-regular mailbag would be a great addition to regular scheduled programming.
If you have questions. Do you want to dive into a stock you are interested in? Do you have questions about investing processes? Or anything else investing-related (and maybe not investing related. Go wild, AMA), send them to misfitalphablog@gmail.com.
Before we dig into Muzamel's question, one quick housekeeping note.
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If investors were rated on a scale of “how much corporate governance matters to the investment thesis,” I think I would be in the upper quartile. When doing my initial work on a company these days, I find myself opening the proxy statement before the 10-K.
Due diligence on a stock isn’t just seeing if the company can make you a lot of money (preferably at a market-beating rate). Is more important to ensure you won't lose money on an investment. Even the most fertile field of growth needs to be swept for mines before you invest. In my opinion, the proxy statement will likely tell you more about the downsides of an investment than the Risk Factors section of the 10-K.
You need to answer two key questions that can only be found in the proxy statement.
Do management or the board have any conflicts of interest?
Does the board of directors exert a level of strength and independence from management?
The sections of the proxy statement that best answer these questions are related party transactions and the executive compensation sections.
Hopefully, you don’t need to spend long reading the “Related-Party Transactions” section. Ideally, and most of the time, this section isn’t relevant because there aren’t any to report. Related-party transactions present immediate conflicts of interest. Anything that can take management’s eye off the ball because they benefit from some side hustle is a red flag.
There are enough instances of related party transactions where the management team is unnecessarily benefitting from something right under investors’ noses: A company may be renting a distribution warehouse that happens to be owned by the CEO, for example. I’m not going to say that a transaction like this is the reason a company will blow up, but it speaks volumes about the character of management and the board’s willingness to allow such things to happen.
There is no world in which related party transactions ultimately benefit shareholders. Any proxy statement with a related party transaction segment over a couple of paragraphs long is an instant flag that the management team shouldn’t be trusted with a long leash to make decisions on your behalf.
I’ll confess that I spend more time thinking about management compensation than anyone else I know. I know I’m being cliche by quoting Charlie Munger, but “show me the incentive, and I’ll show you the outcome” is a timeless line that not nearly enough investors consider.
Above anything else, every person in management's goal is to maximize their paycheck. It’s not anything nefarious or evil; it’s human nature. If someone presented you with a few goals and said, “I will give you a giant bag of money to accomplish these goals”, chances are you will pursue every avenue possible to get that bag.
It is, therefore, the board’s job to point management in the right direction with a well-structured compensation package. If we are being conservative, we should always assume that whatever goal or target is put in front of management, we will get the most perverse outcome that goal or target can produce.
The other job of the board is to ensure that the goals that must be achieved are challenging and may not always be met. A management team that hits the top end of their bonus tiers every year like clockwork isn’t a sign of a great management team; it’s a sign of a weak board of directors unwilling to challenge management.
I’ve written about what makes an investor-friendly compensation package, and I have profiled some companies with outstanding compensation practices.
ITT Inc. (NYSE: ITT)
Expeditors International of Washington (NASDAQ: EXPD)
UFP Industries (NYSE: UFP)
EVI Industries (NYSE: EVI)
From a corporate governance perspective, an investor-friendly compensation package is a sign of a board’s strength and independence. While boards of directors are supposed to be independent and act on behalf of shareholders, that isn’t often the case. Boards that don't hold management’s feet to the fire with hard-to-achieve goals or rubber stamp management decisions like large acquisitions are doing investors, the people they are supposed to represent, a disservice.
No line item in a proxy statement says a board of directors is strong and exerting their independence over the company. And I can’t say that examining compensation packages is foolproof in determining their strength. However, a board that has structured management targets in the right way and makes those goals hard to achieve is a better sign than most that the board is acting on your behalf.
I hope that answers your question, Muzamel. And I hope we can continue having conversations like this in the future.
Another good substack post idea you could make could be on accounting. I see you have a Buffett like stock screener. one way to improve this stock screener is, instead of looking at LTMs' ROIC, to focus on the last 5-year average ROIC. could be a better way to differentiate a good business and a bad business and could also exclude companies that are quite highly cyclical.
Thanks for making this post. I have a few questions. dont you think per share metrics can also be manipulated? I understand why they are better than non-per-share metrics - you as a shareholder do not want to be diluted- but can't you manipulate per-share metrics by buying back shares regardless of valuation - although it is more difficult to manipulate per-share metrics. You could study IBM for this. In the 2010s, Buffett bought the company, IBM's eps went up, but this was because they were buying back shares and not creating real shareholder value.
would also love your thoughts on earnings based targets vs Cash flow.
also, what are your thoughts on operational performance targets and how do you find out what is the exact target when a company has operational performance related targets when it is listed as part of the remuneration policies. same goes for ROIC metrics. How do you find out if it is based on incremental returns or past returns. this is so to find out if a company has easy or hard targets.
I was also wondering what are your thoughts on past CEO and management on the board. would Coparts board be considered independent when they have Wilis Johnson and Jay addir on the board?
Another question i have is how do you view the chair of the board? what is their role? should they be independent? Could Berkshire's governance policy be considered bad since the chair and the CEO are separate?
I would love a post on Tesla's governance, and elons pay package. could be a great example of what a bad governance looks like since Elons pay package was based on share price movements and not real shareholder value. his brother was also on the board. elon always tries to hype up share prices and talks about future valuations of the company, while real CEOs do not care about share prices and future valuations; they care about the business.