Archive for the 'Corporate Governance' Category

Does Institutional Ownership Improve Corporate Operating Performance?

Institutional investors are increasingly using their voting rights to influence the management teams at companies in which they invest. In the June 2007 Journal of Banking and Finance, Cornett, Marcus, Saunders and Tehranian examine whether such actions actually improve the operating performance of the investee companies.

Using institutional ownership data from 13-F statements and cash flow ROA as a measure of operating performance, the authors find that operating performance is related to the degree of institutional ownership.  (Higher institutional ownership indicates better operating performance.)

Posted on 10th March 2008
Under: Active Management, Corporate Governance, Governance, Institutional Investing, Investing in Stocks, Investment Returns | No Comments »

Dividend Policy, Shareholder Rights and Corporate Governance

In the Fall/Winter 2006 Journal of Applied Finance, Jiraporn and Ning investigate the relationship between shareholder rights and dividend policy to determine the role of agency costs in dividend policy.

Under the free cash flow theory, higher dividends reduce the cash available to management. This theory suggests that companies with weak shareholder protection will offer lower payouts in order to provide more perks to management. This management opportunism hypothesis suggests a direct relationship between dividends and shareholder rights.

The substitution hypothesis says dividends are a substitute for shareholder rights, and that an inverse relationship exists.

Using the Governance Index as a proxy for shareholder rights, the authors find an inverse relationship between dividends and shareholder rights, supporting the substitution hypothesis that high dividend payments are a method companies use to compensate for having weak shareholder rights.

Posted on 10th February 2008
Under: Corporate Governance, Governance, Investing in Stocks, Investment Returns | No Comments »

Socially Responsible Investing

Ethical or Socially Responsible Investing usually refers to integrating investment decisions with ethical values. The ethical screening used can be positive (seeking companies that have good practices) or negative (excluding companies that engage in activities that are considered unethical.)

Common negative screens include prohibitions on companies in industries such as defense, tobacco, alcohol, gaming and other vices. Alternatively, they may target high polluters, companies that don’t adopt humane animal welfare practices or other factors.  These are the most common types of screens.

When considering the investment performance of a socially responsible fund, it is important to choose a benchmark that reflects similar goals. For example, a portfolio that excludes tobacco stocks should not be graded harshly when tobacco stocks are doing well, and should not be rewarded for avoiding them when they are doing poorly. The benchmark should have the same exclusion on tobacco stocks as the manager.

Although typical SRI portfolios employ bright-line measures such as industry exclusion, it is also possible to have a portfolio based on relative adherence to the social goals. For example, an investor concerned with pollution may choose to avoid industries that are considered polluters, or may want to invest in the least-polluting company in each industry. Advocates of this relative SRI approach argue that it encourages companies to do as well as they can by rewarding the companies that try hardest. Opponents say that the social standards are too important to reward companies that violate the principles even a little bit.

Posted on 24th July 2007
Under: Asset Allocation, Corporate Governance, FInancial Planning, Investing in Stocks, Investment Returns, Portfolio Management, Security Selection | No Comments »

It Pays to Be Fair

Meir Statman published a perspectives piece in the May/June 2007 Financial Analyst’s Journal called Local Ethics in a Global World. In it he notes, among other things, the high correlation between Income per Capita and Freedom from Corruption by country. Less corrupt countries have higher per-capita income levels.

Posted on 5th July 2007
Under: Corporate Governance, Ethics, Research | No Comments »

How Transparency Affects Stock Valuation

Cheng, Collins and Huang published an article in the September 2006 Review of Quanititative Finance and Accounting that considered the effects of shareholder rights and financial disclosure on the cost of equity capital.

Prior research has shown that the cost of capital is reduced when shareholders have strong rights and the company operates in a transparent manner with full financial disclosure. This article studies interactions between rights and transparency, as well as the resulting impact on cost of capital.

Consistent with prior research, both shareholder rights and transparency individually serve to increase value by reducing the cost of equity capital. Furthermore, the authors find that poor scores on either measure can offset strong scores in the other, and that the greatest benefit is accrued by companies that offer both strong shareholder rights and high financial transparency.

Posted on 6th June 2007
Under: Corporate Governance, Governance, Research, Securities Regulation, Valuation | No Comments »

Operating Leverage: A Case Study

Consider two companies, Arkansas Best and Landstar Systems, both of which are classified as trucking companies. According to Landstar’s 10K filing for the year ended December 30, 2006 (p. 5), “The carrier segment markets its services primarily through independent commission sales agents and utilizes Business Capacity Owner Independent Contractors and Truck Brokerage Carriers. Using a stylized example:


Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. This can be seen from the Arkansas Best example, where adding capacity caused the “fixed” costs to rise at a higher rate than revenues in 2006. It can be difficult even for someone inside the firm to accurately measure fixed costs versus variable costs. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

(Percentage Change in Operating Income)/(Percentage Change in Revenues)

For Arkansas Best, if we assume that the change between 2004 and 2005 represents a “normal” level of operating leverage (in reality a longer data series would be needed) we can approximate the operating leverage as 8.2%/6.0% = 1.37 or 137%. A 10% increase (decrease) in sales would result in a 13.7% increase (decrease) in operating profit.

It is unrealistic to expect fixed costs to remain constant indefinitely. As the company grows, fixed costs may need to be increased periodically in a stepwise manner. For example, headquarters administrative costs might be fixed for a company’s current level of production and for small increases in production. However, if production were doubled, some of these fixed costs might increase.

For Arkansas Best, it wasn’t an actual increase in sales but planning for anticipated future increases that hurt margins in 2006. If we calculate the operating leverage from 2005 to 2006 we get 6.2%/9.5% = 0.65. Operating leverage less than 1.0 implies that profitability declines when sales increase. This is clearly not normal. In future years, the company’s profit margin should improve as sales grow into the new fixed costs. At some time in the future, though, the company will again reach a level of activity where fixed costs must increase, and the profit margin would generally be expected to decline in that year.

Posted on 12th April 2007
Under: Common Size Analysis, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Research Digest: Company Officers as Pension Trustees – Who are they Working For?

In the Financial Analysts Journal for January/February 2007, Joao Cocco and Paolo Volpin published a study of the corporate governance of defined benefit pension plans in the U.K. In particular they want to determine whether pension trustees who are also corporate officers tend to act in behalf of the company or of pension beneficiaries in their decision making.

If the pension trustee is acting on behalf of the company, the authors would expect to find a higher asset allocation to equities, particularly if the company is leveraged. The added risk represents a wealth transfer from debtholders to equity holders. It will also, if the equities perform well, allow the company to contribute less into the plan. The authors thus predict that pension funds with more insider trustees will make lower contributions to the plan. Both of these hypotheses are supported by the findings.

A more favorable view of insider trustees is that they facilitate information flow between company and plan. One manifestation of that would be allowing the company to borrow more and invest the proceeds in bonds for the fund. The borrowings would reduce taxes while the earnings on the plan’s bonds would be tax free, resulting in a tax arbitrage without increasing total company risk. Another would be that plan contributions would increase in years the company faced a higher tax rate. These hypotheses were not supported by the findings.

Posted on 4th March 2007
Under: Corporate Governance, Research | No Comments »

What is Earnings Quality?

Management may use discretion when selecting and applying accounting methods. This discretion reflects the fact that the economic impact of a given transaction will vary across firms as a function of their fundamental business characteristics. For example, companies that operate in distinct industries may use a specific machine, such as a generator, for two entirely different purposes. Additionally, firms within the same industry may use and wear out the same generator at dramatically different rates. Accordingly, it is appropriate to permit alternative depreciation methods and depreciable lives to reflect these inherent differences.

However, with this discretion comes the possibility for both honest mistakes (a poor estimation of product returns, for example) and intentional earnings manipulation (changing the estimate in order to “make the number.”) Therefore, the investor should separately assess the quality of the reported financial results.

Earnings quality is in the eye of the beholder. It has variously been defined as :

• Earnings that reflect underlying economic effects.
• Earnings that are better estimates of cash flows.
• Earnings that are more conservative (lower).
• Earnings that are predictable.

These definitions are often in conflict. Consider accelerated depreciation methods. They reduce earnings in the early years (are more conservative) but increase earnings in future years (at which point they are less conservative.) Straight line depreciation will more closely reflect cash flows and will be more predictable, but accelerated methods are probably more reflective of the underlying economic effects.

Many of these potential impacts on the income statement were discussed above in the context of the line item they affect. Analysts can estimate the effect of changing discretionary options by adjusting the reported financial statements.

Posted on 22nd February 2007
Under: Accounting, Adjusting Reported Financial Statements, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Security Selection | 1 Comment »

Corporate Governance: A Silicon Laboratories Case Study

When you own your own business you can make sure that any managers working for you are acting in your interest. It is different for public companies, where management is not directly answerable to shareholders. In corporate governance terms, this is called the agency problem. How can a shareholder be sure management, who acts as the shareholder’s agent, is acting in the shareholder’s interest? In theory this is done through the Board of Directors.

For the board to be an effective guardian of shareholder interests, it should strive to mitigate conflicts of interest between stakeholders, and in particular between management and shareholders. Managers left to pursue their own agendas unchecked can grant themselves excessive pay, use shareholder funds wastefully, engage in nepotism and do many other things that could potentially be harmful to the shareholders.

Long-standing best practices and recent regulatory changes under the Sarbanes-Oxley act require that the board be independent from management, have the appropriate expertise to evaluate management performance and have the authority to act independently from management when necessary. However, independence can be subjective and difficult to judge. McEnally and Kim (CFA Institute, 2006) suggest that factors indicating a lack of independence include:

  • Former employment with the company
  • Business relationships
  • Personal relationships
  • Interlocking directorships (serving on multiple boards together, particularly if executives of one firm serve on the compensation committee of another board member’s firm)
  • Ongoing banking or other creditor relationships

Based on these criteria, we have concerns over the relative board independence at Silicon Laboratories (SLAB). Of eight board members, three are company executives or founders. Of the five classified as independent, four are either venture capitalists or investors, three were former executives at companies ultimately acquired by Hewlett Packard (and thus likely have personal relationships outside the Board of Directors) and 2 attended the Massachussetts Institute of Technology.

Any particular one of these relationships would not necessarily be sufficient cause for concern. Furthermore, it is possible that the ownership stakes held by the investor and venture capitalists make them treat their board responsibilities more like shareholders. All told, board members and executives hold more than 11% of the shares outstanding, which itself serves to link their interests to those of shareholders. However, according to the Silcon Labs proxy statement:

Silicon Laboratories believes that the backgrounds and qualifications of the directors, considered as a group, should provide a diverse mix of experience, knowledge and skills.

As diverse as any collection of venture capitalists can be, we suppose.

The other concern we have also relates to the share ownership, much of which is derived from option grants. Each director is granted 30,000 options upon joining the board, and each year every non-executive board member receives an automatic option grant of 5,000 shares and a discretionary option grant of 5,000 shares (which has always been granted.) Our concern is that, since responsibility for granting the discretionary options appears to fall to the CEO and one of the co-founders, these board members have reason to believe that they work for management rather than the shareholders.

While companies ignored any cost for options until recently and Silicon Labs still reports their value as the amount they are currently “in the money” (have exercise prices below the current share price) in the proxy statement, all one needs do is call up a quote to realize they are quite valuable. For example, as of yesterday’s close the July 2007 call options with a $35 exercise price (slightly out of the money) closed at $5.10 each. With 10 years to expiration and issued at-the-money, Silicon Labs directors options are clearly much more valuable than those quoted. Still, even at $5.10 each the directors receive a discretionary grant worth $25,500 each year (about the same as their cash compensation.) This is on top of an equal-size grant that is automatically awarded. In all, between cash and options the directors receive compensation worth at least $90,000 per year (equivalent to $10,000 for each board meeting attended.) And that is not counting the initial option grant, which is worth hundreds of thousands of dollars.

To be sure, some boards pay far more than that. But Silicon Labs is a relatively small company, with less than $500 million in annual sales. For example, newsprint manufacturer Bowater (BOW) only offers 1,500 shares of restricted stock (although it pays slightly more in cash compensation.) Bowater has annual sales of $900 million. Apparel retailer Buckle (BKE) has approximately $500 million in annual revenue and pays only $22,000 in cash compensation and 3,000 stock options. The level of director compensation at SLAB in comparison is another indicator that their interests are not completely independent from management.

The last bit of concern we have over the governance being provided results from their high level of CEO turnover recently (3 CEOs in as many years.) The initial candidate hired to replace the founders, Dan Artusi, was let go after a relatively brief stint. While it is true that things sometimes do not work out, his separation package allowed him to collect $165,000 in cash plus immediate vesting of options he was able to cash out for $2 million. These options, purportedly issued as “long term incentives” ended up rewarding a very short term indeed.

Posted on 21st February 2007
Under: Case Studies, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »