A Commonsense Corporate Governance Definition

A Commonsense Corporate Governance Definition
Photo by Walmart Corporate

In July 2016, a group of leading executives – including Warren Buffett (Berkshire Hathaway), Jamie Dimon (JP Morgan), Bill McNabb (Vanguard), Larry Fink (BlackRock), and Jeff Immelt (General Electric) – released an open letter titled Commonsense Principles of Corporate Governance.

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As these executives wrote in the open letter:

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Well-managed and well-governed businesses are the engine of our economy, good corporate governance must be more than just a catch phrase or fad. It’s an imperative – especially when it comes to our publicly owned companies. Though they account for only 5,000 of our country’s 28 million businesses, our public companies are responsible for one-third of all private sector employment and one-half of all business capital spending, both of which ultimately drive the productivity and health of the country. To ensure their continued strength – to maintain our global competitiveness and to provide opportunities for all Americans – we think it essential that our public companies take a long-term approach to the management and governance of their business (the sort of approach you’d take if you owned 100% of a company).

Having and implementing corporate governance best practices is extremely important; it can be the difference between a company with a bright future that generates positive returns for its shareholders, lenders, employees, and community – and an Enron.

But what is corporate governance anyways? And what is good corporate governance?

A Commonsense Corporate Governance Definition

Investopedia gives this corporate governance definition: Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. A company has many different stakeholders – such as shareholders, management, customers, suppliers, financiers, government, and the community – and corporate governance helps to balance the interest of each of these stakeholders.

This is a neat and fairly lucid definition, yet there has not been a lot of agreement on how exactly a company should go about balancing its stakeholders’ interests (i.e. what is good corporate governance and how can you implement it?).

The following is a series of corporate governance principles for public companies, their board of directors, and their shareholders that the corporate executives came up with. The principles are intended to provide a basic framework for sound, long-term-oriented governance but not every principle (or every part of every principle) will work for every company, and not every principle will be applied in the same fashion by all companies (given the differences in size, products and services, history, and leadership of public companies).

Corporate Governance Principles for Public Companies

The principles are broken down into 8 parts – Board of Directors (Composition and Internal Governance); Board of Directors’ Responsibilities; Shareholder Rights; Public Reporting; Board Leadership (Including the Lead Independent Director’s Role); Management Succession Planning; Compensation of Management; Asset Managers’ Role in Corporate Governance – and include the following guidlines:

  • Truly independent corporate boards are vital to effective governance, so no board should be beholden to the CEO or management. Every board should meet regularly without the CEO present, and every board should have active and direct engagement with executives below the CEO level;
  • Diverse boards make better decisions, so every board should have members with complementary and diverse skills, backgrounds and experiences. It’s also important to balance wisdom and judgment that accompany experience and tenure with the need for fresh thinking and perspectives of new board members;
  • Every board needs a strong leader who is independent of management. The board’s independent directors usually are in the best position to evaluate whether the roles of chairman and CEO should be separate or combined; and if the board decides on a combined role, it is essential that the board have a strong lead independent director with clearly defined authorities and responsibilities;
  • Our financial markets have become too obsessed with quarterly earnings forecasts. Companies should not feel obligated to provide earnings guidance — and should do so only if they believe that providing such guidance is beneficial to shareholders;
  • A common accounting standard is critical for corporate transparency, so while companies may use non-Generally Accepted Accounting Principles (“GAAP”) to explain and clarify their results, they never should do so in such a way as to obscure GAAP-reported results; and in particular, since stock- or options-based compensation is plainly a cost of doing business, it always should be reflected in non-GAAP measurements of earnings; and
  • Effective governance requires constructive engagement between a company and its shareholders. So the company’s institutional investors making decisions on proxy issues important to long-term value creation should have access to the company, its management and, in some circumstances, the board; similarly, a company, its management and board should have access to institutional investors’ ultimate decision makers on those issues.

You can read the full Commonsense Principles of Corporate Governance here.

What Does Corporate Governance Mean for Value Investors?

Whether you run a large public company or are an investor in one, knowing good corporate governance best practices is vital for the success of the company. When you are analyzing a management team as a value investor (Warren Buffett’s third investing principle), you should also be analyzing the company’s corporate governance. Before you invest, you should ask yourself these questions:

  • Is management obsessed with hitting their quarterly earnings forecasts? Or are they more concerned with long-term profitability?
  • Is the company’s financial reporting clear and transparent? Is management forthcoming with information? Or does is seem like management is trying to obscure numbers in order to mask or hide poor performance?
  • Who is on the Board of Directors? Is the Board balanced in terms of diversity, background, and experience? Or is the Board comprised of the CEO’s golf buddies and sister-in-law?

The Principles of Corporate Governance go into much more detail and help raise many more questions that can help you think about the management of a company. The Open Letter and the Principles can be accessed here.

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…
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