Seeking Good Governance

7/5/2010


Corporate governance is a topic investors seem to care about only when high-profile companies come under attack.

In recent weeks, the misadventures of BP ($28; BP) and Goldman Sachs ($134; GS) have captured the investment community’s imagination. While BP and Goldman Sachs will eventually fade from the public eye, shrewd investors will not lose their focus on corporate governance.

Governance practices typically have little effect on near-term corporate performance, but they can make a big difference over longer periods. A study by the MIT Sloan School of Management found that companies with superior corporate governance earned 20% greater profits than other companies. While most academic research on this topic suggests that companies with good governance tend to be more profitable and command higher valuations than those with poor governance, the metrics considered in such studies are difficult for individual investors to obtain.

The Corporate Governance Quotients provided by Institutional Shareholder Services are useful for assessing management. ISS considers 65 factors related to the board of directors, the financial audit, anti-takeover measures, and executive compensation. The CGQ Index Score compares companies to a market index, while the CGQ Industry Score compares companies to industry peer groups. To find scores for your stocks, visit finance.yahoo.com, type in a ticker symbol, and click on the “Profile” link to the left.

From a governance standpoint, insider ownership is a good thing — to a point. Companies tend to trade at higher valuations when executives and directors own stock and stock options, presumably because they have an incentive to maximize the share price. However, that benefit erodes when insiders control more than 25% of shares outstanding, presumably because they have too much control.

The table below lists eight companies with solid corporate governance, as measured by the three statistics discussed above, and strong fundamentals, as measured by Quadrix® Overall scores. Two of the companies are reviewed below.

CORPORATE-GOVERNANCE LEADERS
All eight of the A-rated companies below score higher than at least 50% of companies based on Corporate Governance Quotients and are at least 1% owned by insiders. All also managed to boost operating profit margins over the last 12 months, suggesting management is squeezing more profits out of its revenue. Stocks recommended for purchase are presented in bold.
Corporate
Governance
—– Quotient —–
Operating
—– Profit Margin —–
Company (Price; Ticker)
Insider
Ownership
as % of
Shares
Vs.
Index
(%)
Vs.
Industry
(%)
Quadrix
Overall
Score
Last 12
Months
(%)
Previous
12 Months
(%)
Advance Auto Parts
($50; AAP)
1.5
94
93
95
11.4
10.9
BMC Software
($35; BMC)
1.1
56
95
84
35.8
33.9
Kohl’s ($48; KSS)
11.5
76
92
87
13.7
12.6
LabCorp of America
($77; LH)
1.2
59
91
85
24.4
23.5
McKesson
($67; MCK)
2.3
81
97
88
2.3
2.0
Microsoft
($23; MSFT)
13.8
99
100
90
41.8
40.7
St. Jude Medical
($37; STJ)
3.3
50
89
90
31.4
29.0
Travelers
($50; TRV)
1.5
67
92
95
24.1
18.0
Note: Quadrix scores are percentile ranks, with 100 the best.           
Sources: ISS, Compustat.

Microsoft ($23; MSFT) scores better than 99% of the companies in the S&P 500 Index and is tops among software companies as measured by the ISS Corporate Governance Quotients. The company’s nine-member board of directors contains only two company executives — Chairman Bill Gates and CEO Steve Ballmer.

The software giant was one of the first companies to routinely award stock and options to its executives, and more than 13% of the company’s shares are held by insiders. Gates once owned 40% of Microsoft shares, but through a series of large divestitures, his stake has declined to just over 7%. Microsoft is a Long-Term Buy.


Insurance is a convoluted business, notorious for a lack of transparency. But Travelers ($50; TRV) stands out from the crowd, scoring higher than 92% of insurers in the ISS Corporate Governance Quotient. The company’s governance guidelines require that three-fourths of the directors be independent. Travelers also pays at least 50% of independent directors’ compensation in some form of equity and requires private meetings for independent board members, with no company managers present. These and a number of other provisions in Travelers’ guidelines suggest a commitment to good governance. Travelers is a Focus List Buy and a Long-Term Buy.


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