It’s time for a confession…
Before I began writing Penny Sleuth, I was a fund manager for about 30 years. I mostly ran UK equity portfolios, and even ended up as head of the institutional desk at one of our larger independent fund management houses…
… which means I probably share some of the blame for the state of corporate governance in the UK.
This unhappy thought struck me after writing one of last week’s Sleuths. I had grumbled about how unfair and ineffective it was to fine companies when their employees break the law. In practice, this punishes the shareholders most.
But we need to remember that shareholders are not powerless, and it’s time they got their collective act together and sorted out the directors.
After all, directors are meant to be running companies on behalf of the shareholders. So if they do a bad job or fail to control their employees, the shareholders need to step in.
Now, this is a lot easier said than done, of course. But shareholder activism can sometimes bring about meaningful change, and as investors, it’s worth knowing what the state of play is.
The big problem with fund management
When I was managing money, I was under a lot of pressure to generate performance. If I failed to produce good returns for my clients, they would quite rightly take their money away!
That’s why fund managers focus on making sure their portfolios are in the best shape possible. And the quickest way to deal with a badly-run business? Sell the shares!
But as the fund management industry has grown, it’s started to recognise its ownership responsibilities.
Part of this is pragmatism. Selling a poor performer isn’t an option for passive or index-tracking funds that will hold a stock for as long as it exists. And very large fund management houses will often own pretty much everything anyway… so it makes sense to try and improve those companies if you’re stuck with them.
It’s also the right thing to do!
Here’s a fund that’s leading the charge in this form of shareholder activism.
Put bad companies under the spotlight
As the second largest US public pension fund with around $250bn under management, US investor Calpers (the California Public Employees’ Retirement System) has a lot of clout.
So how has it been looking after shareholders’ interests?
Well, every year since 1987 it has put selected companies on a ‘focus list’. This is a list of underperforming businesses that Calpers will work with to improve governance. Of course, the great thing is that the publicity generated by putting a company under the spotlight can usually be enough to galvanise change.
Calpers’ scale and reputation makes this a viable approach and studies suggest it has met with some success over the years. And other fund managers are taking note.
Following on from Calpers’ early lead, all major UK fund managers nowadays will have a dedicated corporate governance unit. But is it enough?
Not another box-ticking exercise
Having standardised codes of governance is no doubt helpful. For example, our board structures are now much healthier than some of those in the US.
But this system encourages a focus on rules rather than principles – which I believe is the core of the problem. It creates a mind-set where, if you comply with the checklist and tick every box, everything must be fine, right?
Well no, actually.
The fact is, we’ve become too rules-based. As a result, excessive pay is seen as OK so long as we’re given a detailed remuneration report and all the regulations about performance hurdles have been met.
Because when you give people rules, they end up ‘gaming’ them. They run the business to meet short-term targets that trigger bonuses, rather than thinking about the long term and the business’ reputation.
And in a world where the average CEO lasts a mere five years, is this a big surprise?
A call to arms for shareholders
To fix this, there are two big problems to overcome.
The first is our current business culture. It’s easy to set out rules and get a diverse group of shareholders to agree on them. It’s far more difficult to formulate and monitor matters of principle and culture. They require a much deeper engagement with management than merely running through a checklist.
The other problem is that society has changed over the last couple of decades. We now depend on following rules. Common sense has been dispensed with and we are left with an army of regulators, compliance officers and lawyers.
So it almost feels like we’re trying to turn back the social tide. But shareholders have to try if we’re going to raise standards. The response to the crisis of confidence in banking has been more rules and lots of fines. We desperately need to look in a new direction.
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