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?