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What I look for in corporate performance.

What I Look For in Corporate Performance

Because this is a serious, but not solemn, publication, I may perhaps be forgiven certain lapses from scholarly rigor and precision in what follows. I want to offer some perspective on management performance and on how managements can better discharge their responsibilities to shareholders.

Managements may not like it, or think it desirable or socially useful, but institutional shareholders are slowly yet inexorably reasserting the rights of control that go with ownership. If managements are to have the freedom they desire and need to conduct the affairs of their companies, they increasingly will have to satisfy, or at least mollify, their large, active, and sometimes restive institutional shareholder base.

Every institutional investor with a longterm perspective must confront the issue of evaluating management performance. If we can assume that managements' principal long-term goal is to maximize shareholder value, we can construct a framework for evaluating management behavior. That the prime objective is to maximize shareholder value may seem obvious and unexceptional. It has long been assumed in corporate law, tradition, and policy. The Business Roundtable acknowledged as much in its report "Corporate Governance and American Competitiveness." But the point is not without its critics, going back at least to Berle and Means.

Most critics argue that the corporation has important and social and public purposes that may take precedence over the rights of owners, or that owners' interests ought to be "balanced" with those of other constituencies, such as employees and the community. I will not join that controversy except to note that even the most vociferous proponents of shareholder value acknowledge the need to consider the interests of other stakeholders. To do otherwise would inevitably reduce the long-term value of the enterprise.

I believe that most managements are reasonably diligent and honest and genuinely work to further what they believe are the best interests of the corporation and its various constituencies. Managements seem to assume, though, that if they sincerely serve the corporation's best interests, they are also serving shareholders well. For this to be so, owners and management would have to have identical interests. They do not.

Management's principal interest is in the health, continuity, and growth of the enterprise. The shareholder's main concern is an adequate return on his or her investment relative to risk assumed and to other investment alternatives. Management's future is much more closely tied to a single enterprise than that of stockholders. The shareholder's capital is mobile, and the rational shareholder will not invest or keep capital invested suboptimally. This is the source of the frequently heard, though often misplaced, complaint about the short-term orientation of institutional investors. They are free to pursue investment alternatives in ways that the typical management is not.

Allocation of capital

A long-term orientation requires a long-term perspective on allocation of capital, the single most important task managements have and the single most important determinant of shareholder value. The ability of capital to move freely to seek the highest returns is the reason why a capitalist economic system works. When capital is allocated for non-economic reasons, such as in the old command economies of Eastern Europe, the result is inefficiency, waste, and lower-than-necessary standards of living.

What is true of economies is true of companies. Companies that invest capital in projects that do not earn the cost of capital breed inefficiency, waste resources, destroy value for their owners, and depress their stock prices. It is important to remember that whatever the reasons why capital is so allocated (strategic positioning, customer demand, competition, etc.), the results of systematically so allocating capital will not change. Managements should not be surprised when shareholders rush to sell the stocks of companies that invest below cost; it would be irrational not to, and such sales would occur irrespective of whether one had a long- or short-term horizon.

If managements want shareholders to think long term, be loyal, and support the company's strategies and activities, they need to adopt policies that encourage such behavior. They need to declare that building shareholder value is the prime objective and they need to understand that value can only be delivered in two ways: dividends and increases in the share price. The share price, except in a final, negotiated sale, is a function of expected future dividends. A management that has not given careful thought to dividend policy and how the investor can judge the stream of future dividends cannot seriously maintain that it is interested in maximizing shareholder value.

The key to sound policies is that they be rationally related to the goal at hand. With dividends, this can range from no dividend, as is the case with Berkshire Hathaway Inc., to a profit sharing arrangement, such as the one Alcoa has adopted.

Berkshire pays no dividend because CEO Warren Buffett believes that he can earn a higher aftertax return by retaining capital than his shareholders could if he paid it out. Not only has he been right, but he has pledged to return shareholders' capital to them when he can no longer earn a higher return. Concerning the share price, Buffett's goal is not to have the stock sell at the highest price but to have it sell at a price that approximates business value, so owners' future returns will track the company's progress. Those wishing to sell will also thereby be assured of getting full value for their shares.

In Alcoa's case, a base dividend of $.40 per quarter is augmented by an annual payment of 30% of all profits in excess of $6.00 per share. This allows shareholders to participate pro rata in the company's profits, obviating the need to speculate or guess about the dividend policy.

|The driving force'

Consider how the best-managed bank articulates the issue: "Lloyds Bank's primary objective is to create value for its shareholders - by increases in the dividend and appreciation in the share price. This is the driving force behind our decisions and actions. Our goals are: to earn a post-tax return on equity of not less than 18%, steadily to increase the dividend payout ratio...."

Each year Lloyds' CEO Brian Pittman begins his letter to shareholders by reporting how shareholders farced: "It was another good year for shareholders. The share price rose by 40% and the dividend was increased by 19%." He also reviews the past five years' results, not of the bank but of the shareholders' investment: "One thousand pounds invested in Lloyds Bank shares on 1 January 1985, with dividends reinvested... would be worth 3,890 [Pounds], a compounded growth rate of 31% per annum" (Lloyds Bank PLC, "Report and Accounts 1989").

I chose Lloyds because banking is a leveraged, cyclical, commodity business plagued by overcapacity. It is not the pharmaceuticals business or the tobacco business in which steady, predictable results are the norm. In 1990, a dismal year for stockholders in banks - the Keefe Bank Index was down 32.6% - Lloyds was flat, before dividends. I believe a major reason for this was the company's loyal shareholder base, which did not head for the exits when the short-term picture darkened.

Shareholders may wish that all managements had the skills of Brian Pittman or Warren Buffett, but they cannot expect it. What they can and should expect is that the managements be capable and sound stewards of their investment.

Barometer of competence

Managements' capabilities are best judged by comparing their performance with peer businesses on a multi-year basis. The same financial measures that are a barometer of business health are also a barometer of management competence. Returns on equity, total capital and sales, operating and cash flow margins, inventory levels, and days receivables provide a point of departure for owners' evaluation of management.

Standards of evaluation are both absolute and relative. Rarely do shareholders complain about management when dividends are raised regularly, the stock performs well, and the financial ratios are the picture of health. I have had little success in persuading people that Philip Morris Cos. Inc.'s management, whose performance is otherwise exceptional, has made repeated and significant errors in capital allocation. The business performs wonderfully, the stock goes up 25% per year, so how could one be critical of such performance? That every few years management decides to give billions of its shareholders' money to other companies' shareholders ($11 billion in 1988 to Kraft owners) to acquire stock that the owners could have acquired themselves much more cheaply, seems not to awaken the company's shareholders from their contented slumber.

Even if the absolute returns are poor but compare well with peer companies, most shareholders are satisfied with management performance. Complaints usually are reserved for cases in which both absolute and relative performance are weak. Here, the shareholder can do little but complain and hope that directors will do their duty and not let such situations persist indefinitely.

Concerns about compensation

Other areas of shareholder concern include compensation and proxy issues, such as poison pills and staggered boards. With compensation, for example, we look particularly closely at stock options. It is far from clear why shareholders who do not work at the company should have to pay for their shares while having to give up part of their interest so insiders can get the benefits of capital appreciation without paying for them. Particularly odious is the practice of reducing the option price when the share price declines significantly. This further dilutes existing owners who have suffered real economic loss to the benefit of those who not only have avoided loss, but may have caused it. In these as well as the other issues discussed, shareholders should be entitled to management actions that are rational and fair.

Rationality and fairness may not seem exacting standards, but few business managements appear able to consistently meet them. We search diligently for companies that are rational in their business policies and fair in their dealings with stockholders. Such policies are no magic elixir. Itel Corp. and FMC Corp., two companies with well-deserved reputations for shareholder-oriented managements, did not perform particularly well in 1990. They still, no doubt, retain the loyalty of their shareholders. Those managements whose performance is the result of, or is motivated by, standards other than rationality in capital allocation and fairness will face increasingly difficult relations with their owners.

William H. Miller III is President of Legg Mason Fund Advisor and has primary responsibility for the firm's equity mutual funds. He joined Legg Mason in 1981 as the Director of Research and was appointed Director of Investment Management for Legg Mason Inc. in 1985.
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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests
Author:Miller, William H., III
Publication:Directors & Boards
Date:Mar 22, 1991
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