Tuesday, April 2, 2013

Owners With No Skin in the Game - Accounting Conservatism, Innovation, Shareholder Elections, and Passive Management

This study on the effects of accounting conservatism is worth thinking about:

"tracked more than 70,000 publicly traded U.S. companies from 1976 to 2006 and found that the more conservative a company was with its accounting procedures, the greater the impact it had on its ability to innovate.

Businesses with the most conservative accounting approach filed about 10 percent fewer patents and had fewer patent citations. They invested less in R&D, and, the study found, the cash flows generated by the fruits of this R&D tended to have shorter horizons. 'For the very conservative firms, cash flows from patents are realized 1-2 years out. For the more liberal firms, the cash flow from patents is realized 5-6 years out,' Hilary adds. 'It means you have safer companies, but fewer blockbuster innovations.'"
Yet another reason why you would expect private companies (Mittelstand) and "owner-operators" of public companies to outperform. Permanent capital always allows for longer time preference. Shortest time preference is a non-owner CEO with levered options exposure, close to retirement, who guts the company to boost the stock price.

The real problem is the boards that are hiring these CEOs with no skin in the game. So shouldn't boards be figuring this out and hiring better managements? How could they keep doing such a bad job?

The answer is illustrated perfectly in this recent NYT article, "Bad Directors and Why They Aren’t Thrown Out", about the retention of the HP directors in the wake of the Autonomy acquisition. Shareholders get to "vote", but the outcomes are the same as a North Korean election,
"shareholder efforts to remove directors in uncontested elections rarely succeed or come close, even in egregious circumstances. Last year, there were elections for 17,081 director nominees at United States corporations, according to the service. Only 61 of those nominees, or 0.36 percent, failed to get majority support. More than 86 percent of directors received 90 percent or more of the votes. Of the 61 directors who failed to get majority approval, only six actually stepped down or were asked to resign. Fifty-one are still in place, as of the most recent proxy filings."
There are two reasons the elections don't work. First, they are rigged: company boards of directors decide the number of nominees and they nominate only as many as there are open seats, so that all nominees are elected because they only need a single yes vote.

Second, and ultimately more importantly, the biggest shareholders are beholden to the companies! The largest owners of big cap companies are the big mutual fund and asset management companies, which have a conflict of interest because they either manage company retirement plans or are hoping to win the business. Either way, it must help to have the reputation as a "team player" when it comes to voting their clients' interests.

These big mutual fund companies are seeming more and more like big marketing machines that don't put much effort into security selection or governance of the companies that they nominally own.

A great look into the security selection aspect is this presentation on "active share" -  a measure of the degree to which a fund's holdings vary from the benchmark (e.g. S&P 500). Passive management has become more and more popular over the past decade. Look at the chart on page 15. Once a large cap fund rises about $10 billion AUM, active management falls off a cliff.

I'd guess there are two big drivers of passivity at big fund managers. First the less money you spend on security selection and governance, the more of the fees flow to the bottom line. (And you don't get paid for performance, so a dollar spent on analysts only makes sense if it yields more AUM than a dollar spent buying TV ads on weekend golf games.)

Second, if you can get people to believe in buy-and-hold/indexing/EMH, it absolves you of responsibility for losing money in recessions. No tough decisions about how to handle adverse demographic and political trends have to be made.

1 comment:

PD said...

this is so true.