By Baruch Lev
Managers need to be able to respond to investors’ concerns and regain their trust, but their response is seriously hindered by the numerous myths and misconceptions they hold about investors and capital markets. This article explains why.
I bet you believe that most investors are short-term oriented, obsessed with quarterly earnings; that the wide criticism of executives’ pay is unwarranted, motivated by misinformation and envy; that activist shareholders are politically motivated and intruding hedge funds just look to make a quick buck; that guiding investors about the company’s future performance is misguided; that overvalued shares are good; and that independent boards enhance business performance. If you do hold to such beliefs, you are in good company; most executives and board members do. Have I a surprise for you!
In my just-published book – Winning Investors Over (Harvard Business Review Press, 2012) – I show that these and other deeply-rooted managerial beliefs about investors and capital markets, which shape their strategies and actions, and false, rejected by rigorous economic and finance research.
But slaying myths and misconceptions is only the fun part of my book. It’s the charting of an operational, systematic capital markets strategy to regain investors’ trust and support that constitutes the main mission of the book. And there has never been a time when regaining investors’ trust was more urgent.
Investors in stocks and bonds just came off the worst decade of losses in recent history. If that wasn’t bad enough, they endured a world-wide parade of corporate accounting scandals, led by Enron, WorldCom, Parmalat (Italy) Satyam, (India), Olympus (Japan), Healthcare Locums (U.K.), Nortel (Canada), and SinoTech Energy (China) – a very partial list – as well as a long series of managerial pay excesses and stock options manipulations. No wonder that investors and the public all over the world developed deep resentment and suspicion toward corporations and their managers. And investors vote with their feet, deserting equities in droves and pushing hard for legislation constraining managers’ power and decision space: “say on pay” regulation in the U.K. and U.S. mandating shareholder vote on executives’ pay, and the very costly Sarbanes–Oxley Act (2002) and the recent Dodd–Frank (2010) legislation in the U.S. Investor resentment comes at a stiff price.
For the sake of their companies’ success and their own careers, managers obviously need to respond to investors’ concerns, and regain their trust. But managers’ response is seriously hindered by the numerous myths and misconceptions they hold about investors and capital markets, which are a recipe for strategic failure and stagnation. What’s needed is debunking the misconceptions and charting a coherent, practical managerial strategy for dealing with investors and the public at large. Let me briefly present some of the major building blocks of such trust–building strategy.
I. Pay for no–performance.
The evidence shows that the wide criticism of managerial compensation is largely warranted. Figure 1, pertaining to the U.S. S&P 500 companies – the largest American enterprises – says it all. The Figure pits the mean 2003–2007 total CEO compensation (horizontal axis) for each S&P 500 company against the company’s same–period mean performance, measured by the return–on–assets (ROA) on the vertical axis. If executive compensation really incentivizes and rewards performance, as advertised, then the dots in the figure should be located closely around a steep, upward–sloping line: the higher the company’s ROA, the larger the compensation. But that’s clearly not the case. In fact, figure 1 is a mess, with no discernable trend. The multiple dots on the lower right side of the graph represent highly paid CEOs who generated meager, if any, return on assets, whereas on the upper left side of the graph are many low–paid CEOs who delivered handsome asset returns. In between are the expected high-pay-for-high-performance and low-pay-for-low-performance managers, but they are swamped by the outliers, as indicated by the overall statistical correlation of executive compensation and ROA, which is an unbelievable zero! The inescapable conclusion: for too many companies, there is only a tenuous relation between managerial reward and performance; in essence – pay for no performance. Investors and the public cannot be faulted for being irked by that. I didn’t conduct this analysis for other countries, but I doubt the results are very different, because managers’ incentives and corporate governance systems are similar in developed economies.
What should be done to restructure managers’ pay systems? Here are the essentials:
• Renumerate performance only. Except for the fixed salary – a safety net – all other compensation components (bonuses, stock grants, etc.) should be strictly linked to the company’s performance, measured relative to peers. No automatic bonuses or stock grants.1
• Measure performance by hard-to-manipulate indicators. Net income is easy to manipulate to enhance compensation; “organic” revenue growth (excluding acquisitions), gross margin, and fundamental value – drivers (customer growth, order backlog, cash flows), are “harder” performance indicators.
• Grant stock options smartly. Options are useful for attracting talent by high growth, cash–strapped, or early–stage companies. Options also contain managers’ risk, motivating them to invest in growth (R&D, brands, talent). But directors should beware and avoid the widespread options abuses (backdating, repricing).
• Heed say on pay vote. This mandatory vote in the U.K. and U.S. is non–binding, yet studies have shown that substantial negative votes tend to occur in firms having excessive, detached from performance managers’ pay. So, a considerable negative say on pay vote should trigger a compensation soul–searching by the board.
II. Directors’ independence is not a panacea.
Jeffrey Gordon, a Columbia University law professor and a leading expert on corporate boards summarized the empirical evidence on the relationship between board independence and company performance as practically non–existent. How can this be? Directors’ independence was the mantra, cure–all–ills solution for corporate governance failures in recent years. However, Enron and WorldCom had boards with a majority of independent directors, as had practically all the financial institutions that collapsed in the financial crisis (Lehman Brothers, Merrill Lynch, Countrywide Financial and AIG). Independence doesn’t assure expertise, vigilance, or courage to face a powerful CEO. That’s why independent directors without specific expertise in the firm’s business (former government officials, civic leaders, certain academics) don’t enhance company performance. “Busy directors,” serving on multiple boards – a common phenomenon worldwide2 – even if independent, are too distracted to contribute to company performance. And directors with fat consulting arrangements with the company, or close friends of the CEO are too subservient to act as effective monitors of executives.
Needed are directors who will augment and complement the top executives’ skills. Proven experts in the company’s business and technology and persons who can facilitate the opening of new markets. Precious board seats should not be wasted on friends of the CEO and over–the–hill big names. And yes, research does show that directors with considerable investment in the firm’s equity do contribute to performance.
III. Guiding the misguided.
Earnings guidance, managers’ published forecasts of the company’s future earnings and sales, got a bad rap in recent years. Influential organizations, such as the U.S. Business Roundtable and the Chamber of Commerce implore their members to stop guiding investors because guidance is an “unproductive and wasted effort” of managers, it “neglects long–term business growth in order to meet short–term expectations,” and the pressure to satisfy myopic investors drives public companies to the arms of private equity firms or to foreign listing. Warren Buffett too doesn’t like guidance and Google announced during its IPO (2004) that it won’t provide earnings guidance.
And yet, a full third of U.S. public companies and many in other countries release regularly quarterly and/or annual earnings guidance, many predict sales too. Why? Because, as research shows, guidance confers lots of benefits on investors, firms and managers. Managerial Guidance keeps investors’ expectations, and particularly analysts’ forecasts, within a realistic range, thereby decreasing share price volatility and avoiding unpleasant surprises to investors. Warnings prior to an earnings disappointment is considered by judges a mitigating factor in shareholder lawsuits that often follow such disappointments. And, successful guidance, the ability to predict future performance, increases managers’ credibility in capital markets and draws more analysts to cover the firm. All good things.
And what about the argument that earnings guidance plays into the hands of myopic investors? Well, as I show in my book, while some investors are indeed short–term oriented—and there is nothing wrong or illegal about that—capital markets are clearly dominated by patient, long–term investors. How else can one explain investors’ support of about a trillion dollars annual investment by public companies in long–term growth (R&D, IT, brands, human resources), while such investments are decreasing current earnings? My computation, exhibited in Figure 2, shows that in practically all industries, the long–term component of stock price—reflecting investors growth expectations—exceeds 50%, and in some industries even 70%. So much for myopic investors.
But guidance shouldn’t be provided by everyone. Make sure that you are a better prognosticator of future earnings than analysts. Furthermore, guide where investors’ uncertainty about the firm is high: innovative, high growth companies, intensive in intangible, hard–to–value asset, and companies undergoing restructuring. And be sure to warn investors ahead of a disappointing quarter/year.
IV. Activist investors and hedge funds are a nuisance.
Investor’s deep resentment of public companies and their managers, mentioned above, leads to increasing shareholder activism. Shareholder resolutions in general meetings, proxy contests, and most ominously for managers—hedge funds’ attempts to intervene in directors selection, corporate strategy, or shareholder distributions (special dividend, share buyback), are on the rise. Increasingly activists target manager’s compensation, lax boards and underperforming firms.
Managers often treat shareholder activism as a nuisance, arguing that it is motivated by politics (labor unions’ activism), greed (hedge funds), or misinformation. Researchers beg to differ. Studies show, for example, that shareholder resolutions aimed at managers’ compensation tend to target companies with excessive pay considering managers’ performance, and that after the vote managers’ pay is reduced. As to hedge funds, research documented large stock price increases upon the announcement of hedge fund investment in target companies, reflecting investors’ strong expectations of an improvement in companies’ performance brought about by the “intruders.” This is consistent with the findings that hedge funds target undervalued companies and those having governance deficiencies.
So, ignoring legitimate concerns of activists shareholders is poor strategy. Better engage the activists, understand fully their concerns and implement the warranted changes: replacing ineffective directors, restructuring managers’ pay, or distributing excess cash.
Summarizing, these cases of managers’ misconceptions about investors and capital markets, and more, hinder their efforts to regain and maintain investors’ trust in companies and their leaders. A significant change in managers’ attitude and actions is urgently called for.
About the author
Baruch Lev is the director of the Vincent C. Ross Institute of Accounting Research and the Philip Bardes Professor of Accounting and Finance at Stern School of Business, New York University. Professor Lev is the author of several books and numerous articles. This article is adapted from his latest book Winning Investors Over: Surprising Truths About Honesty, Earnings Guidance, and Other Ways to Boost Your Stock Price (Harvard Business Review Press, 2011).
1. Fortune magazine (December 12, 2011, p. 144) recounts Bank of New York Mellon’s directors being “extremely critical” of the CEO, yet awarding him a $5.6 million bonus for 2010.
2. It was reported, for example, that Gerhard Cromme, former chairman of giant Thyssenkrupp, also served on the boards of seven German companies and three French ones.