Corporate governance is complicated, and I usually don’t like to think too much about it because it’s just hard. However, I recently came across two very interesting and insightful articles, one from Harvard Business Review and the other from Atlantic with conclusion against each other on Activism. I hope this thinking process will be beneficial to me, and to my readers, in building up knowledge base and investment philosophy.

 

First, let’s go through a quick summary of the articles.

HBR, in their 2017 May-June magazine, published a package of articles titled “Managing for the long term” [link here], with a core article of “The Error at the Heart of Corporate Leadership” written by two well-regarded HBS professors Joseph Bower and Lynn Paine. The article started with the Valeant-Allergan acquisition drama involving Bill Ackman (by the way, I agree that Valeant was a questionable company which adopted questionable business practices and didn’t create social value. So I am with Allergan and this article on this point), and followed by challenges on the most widely used agency-based model in context of the corporate governance and proposed a new entity-based model which essentially proposes to gives company more discretion (i.e. power) by loosening them from the agent-principal handcuff. A quick summary chart exempted from the article below.

This article is thoroughly contemplated and aimed justifiably at the core issue of the capital market – Short-termism, however may have gone too far to directly link Short-termism to Activism. Thus, I have some reservation on some minor points, mainly due to this linkage (which could be a separate write-up, so I won’t elaborate here), but overall think it’s a great step to tackle such a socially important issue and think this new model may have profound impact on future corporate governance.

The Atlantic article, “Frank and Steven’s Excellent Corporate-Raiding Adventure” [link here], on the other hand, is a fascinating story about two law professors practiced classical activist playbook on small cap public company, Tejon Ranch [$TRC], for about two years and finally threw towel on it. Based on their interaction with the management and board, their closing note is “From our perspective, corporate America is now too well guarded. There are too few, rather than too many, of us activists out there banging at the gate.”

By the way, the two protagonists in this Atlantic article are elite school academics as well. Frank Partnoy is a Yale JD and teaches at UCSD, while Steven D. Solomon is a Columbia JD and teaches at UC Berkeley. So why these best-educated and most insightful thought leaders reached such totally opposite conclusion? One reason could be that they are, to some extent, biased by the role they played in the social system and whom in corporate world they interacted with. Supposedly, the two Harvard Business School scholars would serve consultant to the largest and most prestigious corporations and most of time interact with highly-respected, honorable executives; while the two law professors, by nature, would often interact with misconducts of unethical business practitioners.

But let’s back up a bit, and first try to define the purpose of the modern financial system, with that notion established, we can then try to define the role of shareholders, corporation and management. To me, modern financial system is a resource allocation tool (from idle savings of general public to credible business that need capital to expand) to maximize social welfare growth (note I use welfare which is a board term including not only fortune, but also health and happiness, etc.). With that defined, shareholders are general public that provide capital and are entitled to fair share of the economic growth, corporations are entities responsible for maximizing social welfare for all constituents (including shareholders, customers, suppliers etc.), confined by legal & political limits, and management are proxy of the corporation to achieve the corporation’s goal. These definitions are utopic as most of time “welfare” is replaced by “wealth” in many constituents’ mind, for which Bower and Paine’s entity model to some extent tried to solve as well. But let’s also acknowledge that capitalism is supposed to do the great good driven by individuals’ financial motivation, in other words, a well-designed capitalism system should allow constituents to maximize economic incentives at the same time maximize welfare for the society.

 

Reconciliation

To reconcile the points from two sides, we need to think through following questions at the heart of this management vs. activists issue.

– What is “shareholder value” and how to evaluate it?

Both management & activist use this term to support themselves and condemn the other side being destroying shareholder value, so what exactly is it? Going back to my definition above, it is “the fair share of the economic growth”. Key word here is fair, which determines if shareholders ask too much or corporation (proxied by management) give back too little. To evaluate it, one must forecast and discount future cash flow, which is by nature subjective. It’s a question naturally won’t have a definite answer.

But let me offer a comparison to the public service model. Think corporation as a country, shareholders as citizens & management as the government, imperfect but close. How does society judge whether the country under government’s leadership does a fair job? The typical way is unsurprisingly… vote. Corporates do vote, however the problem is shareholders (referring to general public)’s involvement is extremely low, and more often than not the participation is through proxy as most of assets are held through mutual funds & hedge funds. Thus, corporate proxy vote is a poor representation of the real shareholders’ will, this is consistent to what the Atlantic article depicted “The reality is that, with the exception of a few well-known large companies such as Berkshire Hathaway, almost no one attends shareholder meetings. (Some companies are even doing away with in‑person meetings, instead having virtual meetings where personal interaction is impossible.)”.

To make this system work better, it would require better interest alignment on two levels: first on the money management intermediaries representing general public; and second on the board representing money management intermediaries and direct public shareholders. This seems to getting more complex than the US electoral voting system. One quick thought though is that seems the wave of moving to passive investing may not be a good thing for this point, as passive managers are usually agnostic about specific company’s performance.

 

– Who are “activists” exactly?

With the ultimate “shareholders” defined as general public, “activists”, and any money manager for that matter, are merely the agents of the real shareholders. This coincidentally make the term “proxy fight” very accurate, as that’s indeed two proxies (management for corporation & money managers for shareholders) fighting.

But are activists always short-sighted corporate raiders, as depicted in the HBR article? The Valeant-Allergan example shows so, but there are certainly others that not necessarily are. Take 3G Capital as example, it usually comes in (although through full acquisition) and makes heavy cut on both physical resources (corporate jets, offices and employees etc.) and financial resources (zero based budgeting). Are these actions short-sighted and value-destroying? Well, at least Warren Buffett doesn’t think so. To me, a better and fairer definition of activists should be business owner-minded investor, who think they understand the business and could do a better job if they were in the management’s role.

Although activists are now neutralized as partners under my definition, I still understand concerns of the management (especially the good ones). A simplified comparison is like this: My buddy and I pool together some fund to compete in a poker tournament. Because I think I’m better at playing, we agree that I will be playing on behalf of both of us. While I’m playing at the table, my buddy is watching behind me and keeps nudging me from time to time. It’s just annoying. The HBR article made a great point that, to qualify for the partner role (as opposed to passive shareholders), activists should be held more accountable, possibly by imposing some restrictions on selling & conflicting positions.

The HBR article also claimed that the activist investing is wealth transfer rather than wealth creation. It doesn’t hold true if we see the problem from this activist-as-agent perspective because it’s transfer from long term gain to short term gain, within general public’s own pocket. Being said, whether activists (or hedge fund), as financial intermediary, take a larger than deserved cut of the pie is a different topic, and I do think the hedge fund fee structure is unfair, allowing manager to take an undeserved high compensation with un-proportional accountability.

 

– What’s the best way of evaluating management’s performance?

A simple and accurate answer is by “shareholder value” creation. However, since we couldn’t objectively evaluate it as discussed in the first question, it would be a dead end if keeping going down this route.

To approximate “shareholder value”, the prevalent way (based on agency model) is to use stock price performance (or shareholder return), the HBR article proposed other metrics like company value; achievement of strategic goals; quality of goods and services; employee well-being. Although I agree these new metrics are meaningful, evaluating most of them requires subjective judgments (presumably by board). And subjective judgments are easy to be manipulated, especially given the close board and management relationship nowadays.

A comparison I find useful for my thought process is the difference in college admission systems between Far East and Western countries. Now think corporation as universities, shareholders as admission committee and management as prospective students.

Far East (Japan, South Korea & China) system all have annual college admission tests, and students will be admitted to corresponding universities solely by their performance in that exam. Whereas Western system works on a more holistic and somewhat subjective manner to determine which prospective students to be admitted based on multiple factors including but not limited to standardized test scores. I think the Western way is better, however it works because the Western countries universities has a great incentive system – the endowment model. Since universities in Western world are mainly funded by their own endowment which subsequently mainly funded by charitable donations (from mostly alum-related entities), the admission officers have strong incentive to admit whom they deem have the most potential to succeed and give back to the schools and they will try to make the evaluation as fair as possible. By the way, it also explains some not-so-merit-based admissions, which most of the case can be tied back to the endowment model. On the other hand, Asian countries’ universities are mostly state funded, thus the admission officer has no incentive to try to evaluate candidates’ potential fairly. If such discretion is given, it will very possibly be susceptible to rent-seeking. Is the sole standard test score based model fair? No. But will the holistic model work better for Far East countries? Probably not.

Now coming back to the financial market, the key questions is whether the future profit of corporation (university endowment) is mainly from the management (prospective students)? If so, shareholders (admission committee) will do their best to evaluate the quality of the management. Unfortunately, I believe the answer is no. It would be the business model itself as Charlie Munger witfully put “Invest in a business any fool can run, because someday a fool will.”

 

Lessons From the Good One

Next, let’s look at the good ones, just so we can see future is still bright. Amazon [$AMZN] has never turn profit (on accounting basis) during its entirely life, why there is no activists after them? Simply, because their shareholders are all happy as they see value of their holdings appreciating consistently and significantly .

But how could stock price, challenged as not optimal to represent company performance, be so consistently right about Amazon? I think the answer is lying in the management’s mindset and communication. Looking at Jeff Bezos’ first annual letter from 1997, it listed out very clearly how management approach the business and what shareholders could expect from the company. With that laid out loud and clear upfront, shareholders (including intermediaries of shareholders) had a fair and consistent evaluation model to verify the company and the management’s performance. Plus, Bezos also put himself into investors shoes and try to define his (and he thought to be the “right”) investment philosophy. Following are the exempt for that letter.

Because of our emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies. Accordingly, we want to share with you our fundamental management and decision-making approach so that you, our shareholders, may confirm that it is consistent with your investment philosophy:

• We will continue to focus relentlessly on our customers.
• We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
• We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.
• We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.
• When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
• We will share our strategic thought processes with you when we make bold choices (to the extent competitive pressures allow), so that you may evaluate for yourselves whether we are making rational long-term leadership investments.
• We will work hard to spend wisely and maintain our lean culture. We understand the importance of continually reinforcing a cost-conscious culture, particularly in a business incurring net losses.
• We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.
• We will continue to focus on hiring and retaining versatile and talented employees, and continue to weight their compensation to stock options rather than cash. We know our success will be largely affected by our ability to attract and retain a motivated employee base, each of whom must think like, and therefore must actually be, an owner.
• We aren’t so bold as to claim that the above is the “right” investment philosophy, but it’s ours, and we would be remiss if we weren’t clear in the approach we have taken and will continue to take.

Thus, it is no surprise that all shareholders understand that even without accounting profit, Amazon possesses tremendous economic value and potential. To me, laying out your principals as transparently as possible and attract the most suitable shareholders and customers, is the “right” way of conducting business.

 

Last, some quick takeaway as an investor from this lengthy thinking process:

• Activists are not evil, they are mostly business owner thinking partners, however the existing system does disadvantage management by giving activists power without corresponding accountability.
• Short-termism is a human nature, that’s hard to overcome. A good system is one that can utilize constituents’ pursuit of short term incentives, to achieve bigger (social) goals. This type of system is hard to design and hard to come by. The university endowment system seems to be one.
• The best investors are the one with business-thinking mindset, and the best businessmen are the one with investor-thinking mindset. Look for management think like investors.
• Transparency upfront is a good way of conduct business, either corporate or investment management.