Corporate governance: What Next?

Corporate governance is all about the relationship between investors and the companies in which they invest. But what does investor relations really mean? To the practitioner, it means a craft of communication striving to be a profession. To a shareholder receiving its output, it is a necessary way to understand markets and companies. To corporate officials, it is a convenience to fend off the time-consuming quest for information that is often a distraction from running a business. All these views are correct but they are far from the story of investor relations today.

An unprecedented eighteen-year bull market has multiplied all financial service tasks. Abby Joseph Cohen of Goldman Sachs notes that compensation for financial service workers has been the only area of wage inflation in the present business cycle. And many others note that financial assets are the only inflating assets in a deflationary economy. It is reasonable to look at the macro-influence of a bull market creating the need for ever more competent and ever more highly paid investor relations people. But that is not the whole story either.

At its base, investor relations is about communication of fact. Usually, it is what is today called "push" through releases, attractive venues and targeted sources. Investor meetings and lunches have given way to conference calls and internet group emails in turn to global videoconferences. Facts are still distilled by lawyers but, curiously, with the most important facts withheld during blackout periods when the most significant developments are taking place.

With computer databases and search capabilities, remarkable things can be done to turn masses of data into information. Most of the innovations have already taken place in the corporate world, especially in comparative retail sales. Now, they are finding their way into finance: for example, screening of the type used at www.fortuneinvestor.com can survey sixteen thousand securities on six hundred variables; and charts of historical activity on almost anything are available at www.bigcharts.com and www.yardeni.com. Hundreds of tools like these are converting the "push" from investor relations into a "pull" by users in control of what they want, what they do with it and the conclusions to be reached.

Investor persuasion is moving to the user through the empowerment of technology. The nub of judgment remains in an elusive corner of agency finance, behavioral sciences and computation. But each single user has access to machinery to do the chores, which is low-cost, readily available, global and instantaneous. Like Microsoft endorsing the internet, which may ultimately be its downfall, so the alert investor-relations person will provide these tools to make the user's job easier and better.

Understanding Corporate Governance

Shareholders demand high returns on their equity investments, while executives of public companies typically want a peaceful life with good remuneration and minimal outside intervention. These conflicting interests and how to achieve some kind of alignment between them to give corporate managers the incentives to act in the best interests of corporate owners are the central questions of corporate governance. They have become increasingly important in the 1990s as instead of choosing exit simply selling their holdings in underperforming companies investors are beginning to exercise their voice telling managements to change their ways.

In the 1980s, the most powerful external pressure on executives for stock market performance was the threat from corporate raiders, poised to bid for companies with underperforming shares. Latterly, challenges have come more from institutional investors, the activist shareholders who demand long-term value creation from the companies whose shares they own. This activism has been most dramatic in the United States, and has been supported by regulation: for example, the SEC has mandated the reporting of value creation in the proxy statement.

In the UK too, the pressures have shifted from the threat of takeovers to shareholder activism, often around the subject of top managers' pay and its weak relationship to corporate performance. For example, guidelines on remuneration published by the investing institutions' professional bodies (the National Association of Pension Funds and the Association of British Insurers) demand a clearer link between performance and pay. In turn, many UK companies now explicitly target the creation of shareholder value.

Understanding Counterpoint

If contrary thinking is so good, why doesn't everyone do it? In the first place, if everyone did it, then it would not work because there would be fewer panics and speculative orgies. Second, it can be very uncomfortable to be wrong and contrary at the same time: the humiliation of going against the crowd when the crowd is right and that can happen is devastating. And third, much of our training and socialization teaches us that the majority is right, or at least, Is contrarian strategy profitable? There is some indication that former loser stocks perform better than winners, but is this because they are riskier? And what about the transactions costs of a short-run contrarian strategy? The quantitative evidence on these questions, as in most investment documentation, seems to depend on the case the researcher wishes to support more than the case itself. Nowhere is the adage, "if you torture the data long enough, it will confess to anything," more clearly observed than in the examination of investment techniques. But a mixture of contrary instincts and investment skills seems to be a part of most investors we admire.

Finally, is contrarian strategy inconsistent with the concept of market efficiency (see Market Efficiency)? The efficient market hypothesis (EMH) in its strong form contends that security prices are always correctly assimilating information. Today, investors generally expect that the weak form of EMH is operative, which means that sometimes it is possible, with generally available information, to gain an advantage over other investors. Contrarians look for these small opportunities by noting where the consensus seems to be clustered and they examine the other, independent alternatives.

Contrary thinking can be a challenge to assumptions that are so deeply embedded in our understanding of the world that we often do not even realize they are there. Three contrary questions in particular may be helpful in guiding us to contrary answers. Contrarians should ask questions like these that are often not even being considered.

The first is, why do investment markets assume that growth should be the sole objective of economic enterprise? Primarily, because of a fifty-year expansion in bull markets, but in most cases, the pursuit of growth comes with the possibility of volatility and risk. Stability and survivability can also, under some conditions, be worthwhile objectives. Contrarians are likely to value these features, which are considered valueless by other investors. Corporate control through proxy voting, for example, is often considered valueless and even a potential conflict for a manager in his client relations. And yet, in a merger or acquisition environment, proxy power is quite valuable: some studies have estimated it at about 15% of total share price. Contrarians might be quicker to identify these underlying mispricings.

Second, we are raised on the notion of continuous time. Nobel Laureate Robert Merton (see Risk Management) wrote a fundamental text with that idea in the title. We learn that time is a horizontal axis on a time chart with each unit of time connected to its neighbor and all units of equal space and importance time is continuous, time flows, time moves on, time in any one period is connected with any other period, time reveals trends. But in the physical world, time may be discontinuous and unconnected with any other time period sometimes coming in bursts, separate packets of information, unique in themselves. And investment time could be like that: Humphrey Neill wrote "sudden events quickly crystallize opinion." Our assumptions about time having a root in the past leading to clues about the future may be wrong.

Third, there is the built-in notion of an equity premium. After a fifty-year period of expansion, we take it for granted that equities produce higher returns, and we think that this is because they have higher degrees of risk. Are we prepared for the time when risk produces lower returns for equities? Or that on closer examination, risk itself becomes something other than volatility but risk of loss and risk of being knocked out of the game?

Understanding Contrarian Investing

Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their intrinsic value (see Value Investing). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism

To a third group, contrarian investing is the reverse, a steadfast adherence to value- or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as "buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield."Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit. He uses traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the nifty fifty growth stock era of his apprenticeship in investments

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a herd or crowd, the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of the empty file drawer idea than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.

Predicting market

The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are pockets of predictability. This offers some hope to "disciplined" active managers if they can come up with innovative techniques to achieve superior long-term returns

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of nearly an eighteen-year bull market in equities by some counts, a fifty-year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see Value Investing).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see Initial Public Offerings), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, the quality stocks have done much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good if nothing happens or bad because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.

Bill Miller's Advices

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there and it is but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.
One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go technology stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.

Active Portfolio Management

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing buying diversified portfolios of all the securities in an asset class is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds ).

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments. These decisions, often referred to as market timing as investors try to reallocate between equities and bonds in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements. Then there is security selection picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.

Active investing involves being overweight in securities and sectors that you believe to be undervalued and underweight in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market. Compared with passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (. And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.