Overall stewardship should be biggest focus for shareholders

Saturday 2 June 2012

AS the "shareholder spring" of protest on executive pay continues, does good or bad governance really matter for investors?

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FUNDAMENTALS COLIN McLEAN

Certainly, weak share prices bring executive pay into sharp focus. Yet we know that however large the pay numbers might look, rarely are they material relative to total company value. And all shareholders want to attract the very best management. So, are shareholder revolts just a way of letting off steam? Or does it actually mean anything for how the shares perform?

Despite the fact that most chief executives are rewarded for absolute or relative share price performance, this usually seems to operate as a one-way option. Combined with the common use of earnings per share as a benchmark – which can be readily adjusted to flatter progress – there is a disconnect between incentives and genuine long-term value generation. Cash flow would be a better indicator, yet is rarely a factor in executive pay. Some companies have individually tailored performance indicators, but it is hard for those outside the board to assess how stretching these really are. And the length and complexity of remuneration reports is a real barrier to engagement. Few institutional investors seem to understand these reports and the task seems almost impossible for private investors, unless they narrow their portfolio down to just a handful of shares. Fortunately, reviews initiated by the Department for Business, Innovation and Skills should make the task easier in future. Apart from an effective say on pay, shareholders should receive a single-figure total for the chief executive's reward and a statement that shows how company value generation is distributed around the various stakeholders. Over time, this should build up a picture of how well boards are controlling these proportions. Further action on the remuneration consultants, who often advise boards on so much of this, will also be helpful. However, this seems more a matter of control rather than creating growth. Those who believe passionately in governance think that shareholders in well-behaved companies should be better rewarded. There should be a pay-off for all the effort in reading accounts, complaining to boards and voting. Unfortunately, there is not a lot of academic evidence for this, although some funds emphasising socially responsible investment have performed very well. Governance will only become a priority for everyone when it is seen as a way to achieve better investment performance. Despite the progress, it may be a few years before this dream of profitable governance turns into reality. Meanwhile, there are more practical things that private investors can do. The broader concept of stewardship by company boards – reflecting not only governance but the shrewdness of strategy over time – seems more useful. Some companies seem to make big acquisitions or investments that achieve returns ahead of their cost of finance. We might think of how Whitbread, for example, has evolved its strategy over the years, most recently with the investment in its fast-growing Costa Coffee division. By contrast, some have long-term records of poor investment or bad choices on risks. The last decade would put BP in this category. Investors should not disregard governance but place it alongside an overall assessment of stewardship. Governance may just be one measure of whether a board is functioning well. Over time, the pattern of board decision-making becomes clear – executive pay is just one aspect, but investments and disposals matter too. Winners like British & American Tobacco and Associated British Foods do not emerge overnight. Analysing accounts and voting still matters. But investors might gain more from looking at the totality of stewardship, recognising the potential for processes to persist, whether good or bad.Colin McLean is managing director at SVM Asset Management

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Overall stewardship should be biggest focus for shareholders

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