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Shareholders who do homework can cut through the corporate fog

By Terence O'Hara and Nancy McKeon
The Washington Post

	JOELLEN MURPHY / THE WASHINGTON POST
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For investors seeking to participate in the governance of the companies they own, annual reports and proxy statements can be as daunting as the great American income-tax form.

Behind the pages of company executives trying to look presidential yet affable, beyond the grinning warehouse employees and the colorful product shots, lurk the dreaded Consolidated Statements of Income, followed by the Consolidated Statements of Comprehensive Income (who knew there was a difference!), then the Consolidated Balance Sheets and the Consolidated Statements of Cash Flows. Followed in many households by the Consolidated Throwing Up of Hands in Despair.

Then the proxy statement arrives, and there is the Proposed 2004 Employee Stock Option Plan to consider, and the Report of the Audit Committee to digest, and the chief executive's compensation package to decipher.

Little wonder that individual shareholders feel powerless to understand, much less influence, how the companies are run.

But small investors may be waking up.

Until relatively recently, shareholder proposals to unseat board members or otherwise change how a company is governed at the board level rarely got more than 10 percent of the vote.

But high-profile corporate scandals and a growing sense that directors don't take their oversight role seriously have led to a rising tide of investor anger and action.

Earlier this month, an astounding 43 percent of the shareholders in Walt Disney Co. withheld their votes to re-elect Chairman and Chief Executive Michael Eisner to the board of directors.

In a recent newspaper commentary, Nell Minow, editor of The Corporate Library, a research firm specializing in corporate governance, predicted that a record number of shareholder proposals — on such topics as executive compensation and splitting the jobs of chairman and chief executive — will win record levels of support this season.

One of the evident truths about companies such as Enron and WorldCom is that the professional investment sector — Wall Street brokerages and their stock analysts, mostly — loved these companies and touted them for a number of years before their spectacular fall.
 
And individual investors mostly played along and were too often left on board when the train derailed.

The lesson, investment advisers and corporate-governance experts say, is to do your own homework. Investors, no matter how small their portfolio, need to understand the companies they buy and to learn how to tell the good from the bad.

To do that, the annual report and the proxy statement must be read and, yes, understood.

The Securities and Exchange Commission and the Financial Accounting Standards Board have made it a priority to make company disclosures clearer and easier for lay people to understand.

Until these efforts bear some real fruit we've asked some investment and corporate-governance experts to list basic ways that investors can cut through the fog of corporate-speak and identify whether a company is being run reasonably well.

The thing to remember is this: Stock investing is a game of chance, so anything can happen. But knowing a few crucial things can increase your odds considerably.

1

Understand that a well-run company is not the same thing as a hot stock.

In the proprietary corporate-governance database maintained by the Corporate Library (http://www.thecorporatelibrary.com/), there are companies rated as high-risk that, the site notes, are doing well in terms of stock price and Wall Street buzz.

But the scores don't reflect present financial circumstances, Minow says.

"I'm trying to predict the future — we all are. I'm saying there are things here that investors really need to take a closer look at," she says.

Things such as board members who are current or former CEOs at other companies and presumably less likely to say no to bloated compensation packages for top executives.

Minow also evaluates the number of corporate boards each member sits on — as many as 14 in one recent database search. Such overextension, corporate critics say, raises doubts about how closely directors pay attention to the business at hand.

2

Take a look at insider selling.

Executives with stock options often give explanations when selling off large chunks of their holdings — estate planning, charitable donations, a big tax bill. No one knows the insides of a company better than the people running it, which is why the SEC requires such sales to be reported.

Changes made last year to disclosure rules for insider sales require most companies to post sales within a few days online. It used to take up to 60 days for such transactions to be posted publicly; even then, they weren't required to be filed electronically.

Critics argue that a pattern of selling may indicate a lack of faith that the stock will go up in value; in effect, insiders seem to be betting against themselves.

Insider sales can be found on the SEC Web site http://www.sec.gov/ and at Yahoo!'s Finance site, finance.yahoo.com.

Finally, compare senior executives' history of selling with the timetable for their option grants and vesting, disclosed in the annual proxy statement. The results can be illuminating

If executives have exercised a boatload of stock options the past year, at the same time they have been selling stock, they may be more interested in making a quick buck than in holding onto the options hoping for a bigger return over the long haul.

3

Determine the qualifications and independence of the board and its committees.

Do directors have relevant business experience? Do their backgrounds indicate they would challenge a chief executive or just go along?

In the company's proxy is a brief biography of each director. Included is a disclosure of any board "interlocks," that is, two executives at different companies sitting on each other's board, creating the possibility of back-scratching.

Also look to see whether the chief executive or chief financial officer sits on the compensation or audit committee, or whether these two crucial committees are run by truly independent directors.

These conflicts or lack of independence are much more rare today than in the 1980s. Most CEOs are aware it's a conflict to sit on each other's, or even their own, compensation committee. But it still happens.

4

Find out how invested the board members are.

"Do the directors of the company own stock?" Minow says she likes to see directors who have a truly vested interest in the progress of the company. It doesn't matter whether they buy the stock or get options, she says, just so their prospects align with those of other shareholders.

5

Read what the company has to say for itself.

James Spellman, spokesman for the Securities Industry Association, points out that the letter from the chairman in the front of a company's annual report is well worth reading.

"They sweat and toil to get it right," he says.

Notice particularly how the chairman deals with troubling issues. Spellman points to the way Citigroup Chairman Sanford Weill, in the 2002 annual report, addressed the scandals and lawsuits that hit Citigroup.

And the letters written by Louis Gerstner Jr. of International Business Machines and Andrew Grove of Intel, the former now retired, were "tours de force in delineating strategies" of their firms.

If you don't understand what a chief executive is saying in the shareholder letter, or if you think the letter dances around key issues and doesn't say much about the business, trust your instincts and be skeptical.

6

Evaluate the company's strategy.

Does it even have one? And does it stick with it?

Reading the chairman's letter for the past five years, for example, will show whether this year's pronouncements are yet one more attempt to find a way to grow the company or are the natural progression of plans put in place some time ago.

An example of such consistency can be found in Marriott International. In 1993, the company spun off its real-estate holdings and said it would focus on managing hotels, not owning them. In the past decade, that strategy has stayed essentially the same.

This direct, fairly easy-to-understand strategy — one that reduced Marriott's debt and focused everyone at the company on gaining market share by signing up more hotels under the Marriott flag — has paid off for shareholders.

Despite the Sept. 11, 2001, terrorist attacks and ensuing hotel recession, Marriott stuck to its strategy. The stock today is trading near where it was before the attacks.

7

Look at earnings over time.

Philip Tasho, chief investment officer of Tamro Capital Partners of Alexandria, Va., points small investors in the direction of the venerable Value Line Investment Survey.

Just by reading Value Line at the public library, he says, investors will have 15 years of a company's history. You want to see "a good history of revenue and earnings growth vis-a-vis a company's peers over five or 10 years," he says.

No single line on a balance sheet or income statement tells the whole story, however. The financial statements are only one part.

Profit, in fact, may not be the best way to judge how a company is performing.

Every company and industry is peculiar, and some disregard profit altogether as a performance measure. Ever hear of "funds from operations"? If you own a real-estate company stock, you should know what it means.

The security industry's Spellman suggests finding out whether one number has increased: a company's dividend. Dividends can't be faked; they're real money in investors' pockets.

"The check has to be valid," he says.

8

Look at who's running the ship.

The stability of senior management is important, Tasho says. If the brass has been at the helm for years, how has the company performed during that time?

If top managers are new, what is their record at other companies?

Don't look only at the chief executive. Determine how long the entire executive team has been in place and whether, for example, the No. 2 slot has been a revolving door.

If executives under the CEO come and go quickly, that's an indication talented executives, and possible successors, are being lost.

9

Take a good look at the chief executive's compensation package.

Minow considers the chief executive's pay package "one of the best possible indicators" of what's going on inside a company's board, which has to approve executive compensation.

Back in 1991, a year of layoffs in the factory but big payouts in the executive suite, Congress ruled that executive salaries would be a tax-deductible business expense for companies only up to $1 million.

Any amount above that had to be incentive pay tied to performance to be considered a business expense.

"Because of the law of unintended consequences," Minow says, "that turned $1 million into a new minimum salary for CEOs and started the trend to automatic stock options."

At the very least, she suggests, look at the chart in every proxy statement that shows the movement of the company's stock relative to broader stock indexes.

Referring back to the CEO's pay, she says, "at least they should be moving in the same direction."

Writing more than 10 years ago, Bloomberg News columnist Graef Crystal, then a professor at the University of California, Berkeley, warned of "runaway compensation," the seeds of which he saw sown in guaranteed annual bonuses, multiple long-term incentive plans and executive stock-option exercise prices that can be revised downward if the market price drops.

Last week, Crystal contrasted the 2003 compensation for the chief executives of three leading home-building companies — D.H. Horton, Toll Brothers and KB Home, all of which performed extremely well last year.

Horton, whose cumulative return since 1998 was 480 percent, paid its chief executive $5.8 million.

The return at Toll Brothers in that period was 294 percent, but Robert Toll received $23 million, $20.3 million of which was his annual bonus.

The worst-performing of the three, KB, turned in a still-respectable return of 212 percent. But the KB chief executive's pay package for was $27 million.

All three companies have net sales between $2.5 billion and $9 billion.

These types of basic comparisons of management and board behavior and company performance can take some time, but they are the nuts and bolts of evaluating how well a company is run.

For any investor who wants to be empowered, doing this homework is the first step.

Copyright © 2004 The Seattle Times Company