Tickers in this Article: EDGR, BBBB, FDC, FNM
At night, we like to sleep. We get the best sleep when we recommend stocks that are unlikely to suddenly plunge in value. It is easy to forget while casting about for ten-baggers, but while you hunt for big game, you would do just as well to avoid stepping on landmines. The first key is obvious, un-sexy and repeatedly forgotten: try not to overpay for growth.

In the Core portfolio, we look for a margin of safety – Cory J. is dedicated to, almost obsessed with, this criteria. Good enough for Buffet, good enough for us. But looking for a margin of safety does not necessarily imply a strict value style. We look for a margin of safety in Undiscovered Growth, too. Here we are just trying to pay reasonable price and find them a bit early. (A caveat: this is not true of the Swing for the Fences portfolio.

In this portfolio, we are willing to brave minefields. For example, EDGAR Online (EDGR) has almost doubled in value since we recommended the stock at the beginning of the year. The stock no longer has any margin of safety but we still recommend it for the upside. It would never meet our criteria for the Core or Undiscovered Growth, but it is perfect for the Swingers).

When you pay too much for growth, the bummer is that you have to hold your breath every quarter. And, believe it or not, quarterly earnings releases should not be the stuff of high drama – they should be a progress check against your investment idea.

The second key to avoiding disaster is more difficult: try to buy stocks in companies with strong Boards. The reason is that, as investors, we cannot really monitor the company to the degree we would prefer. Instead, we entrust this awesome responsibility to a well-compensated Board of Directors. A weak Board is sufficient cause to avoid a stock forever, or until the Board is replaced, whichever comes first. CalPERS (the California Public Employees' Retirement System) invests a staggering $180 billion in every asset class imaginable.

In the year 2000, after two decades of experience as a shareowner activist, they started a fund devoted exclusively to governance. The fund actively encourages public companies to install governance metrics and improve their governance generally. It is currently their best-performing fund according to Mark Anson, CalPERS' Chief Investment Officer, having returned 16.9% annually since inception versus a loss for the S&P 500 during the same period.

If you look behind many (most?) of the recent public company fiascos, you will find a weak Board. But it is incredibly difficult to identify Board strength. I recently purchased Standard & Poor's first reference book on governance, Governance and Risk, because I respect their credit work and I was eager to learn more about their approach to grading governance.

Guess which company is featured as one of two case-studies for exemplary corporate governance? Fannie Mae (FNM). From the book: "Standard & Poor's (S&P) has assigned Fannie Mae a corporate governance score of 9.0 on a 10-point scale, reflecting corporate governance practices that are consistently strong or very strong across each of our areas of analysis." Oops! I think the book was published about a month or so before Fannie Mae's scandal started to unravel publicly-a scandal that featured some of the most egregious examples of lame governance that I have ever seen. I do not mean to slight S&P, a company I truly respect, but rather to illustrate how incredibly difficult it is to quantify governance.

Institutional Shareholder Services (ISS) markets a statistic called Corporate Governance Quotient (CGQ)-it quantifies governance practices into a single statistic from 0-100% so that you can compare it to peers. Institutional investors are not as interested in the product as ISS had hoped. (I recently completed a survey of pension funds and hedge funds, and, on average, they do not think governance statistics are especially useful, at least when reduced to a single number).

Instead, companies are the primary buyers of the quotient-service, apparently in a defensive action, so they can adjust their policies in order to improve their own reported quotient. That's understandable, I guess...but some of this is what's called check-the-box-compliance. That's when the company adjusts its policies just enough to raise its governance statistic without any corresponding fundamental reform.

But Boards are about personalities, processes and power, in addition to mere policies. The problem with these statistics is they tend to count things like the number of meetings and lean on technical definitions of independence, things that aren't really helpful in assessing the quality of the Board. NYSE and NASDAQ both installed governance rules (e.g., at least one-half of the Board must be independent, based on slightly different definitions of independence). This is not a bad step, but hardly a panacea. You now have hundreds of companies engaged in mere check-the-box compliance.

So, what do we do? At Advisor, we look for the signs, hints, and artifacts of either really great, or really lame, governance. In short, we look for breadcrumbs. Boards leave you plenty of breadcrumbs that betray their priorities. In my experience, the "middle 60%" is tough to distinguish, but you can indeed recognize great governance and lame governance. Here are some of the breadcrumbs we look for. First, who sits on the Board?

For example, Blackboard (BBBB) meets our great governance test. Their institutional ownership includes a diverse set of seasoned, active investors; i.e., not passive mutual fund interest. One Board member is Partner of a very experienced private equity firm that owns a significant percentage of the stock. Another is a seasoned venture capitalist. The others are experts in the industry. For board seats, we like inside investors, seasoned investors, industry experts, innovative thinkers and, of course, financial expertise. We do not like to see either passive mutual funds or "marquee names" – seats filled by recognizable names who do not have industry/content expertise and who are too busy running another company and sitting on several other board seats to do a proper job.

Second, how are executives compensated? Not how much, but how. More than any other single item in the proxy statement, the compensation program will tell you whether the Board is independent or in management's pocket. Is the program really pay-for-performance, does it really have teeth? We also prefer that executive bonuses are not tied to EPS growth. EPS growth is an outcome produced by strong operating results. It falls out a lagging indicator, so why pay for it and encourage manipulation? Management should focus on the underlying operational and business drivers that produce long-term gains in EPS.

Third, does the Board have a proactive plan for stock option dilution? Or do they just go back to the shareholder trough whenever they need more shares, or worse, install a mindless evergreen provision (e.g., automatic annual dilution)? Strong boards are reacting to FASB's requirement to expense stock options as an opportunity to re-visit their option plans against company incentive and performance goals. Far too many boards are betraying their weakness by reacting to this regulation with a focus on window dressing. Several companies are going to accelerate the vesting on their outstanding options before the rule goes into effect. This is equivalent of tucking the expense under the rug and hoping shareholders won't notice (not to mention, they've sweetened the incentive for no real reason).


Consider the opposite reaction. First Data (FDC) sets a good example by keeping their employee stock purchase plan (ESPP). They acknowledged doing so will ding their reported earnings. But the cash flow economics are unchanged and they believe the program is important to the broad employee base (and we totally agree, for the cost, ESPP are almost always a great tool even if underutilized by employees). When management is under pressure to produce earnings, we must trust the Board to keep managers honest, and to have the courage to ignore window-dressing and in favor of real fundamentals.

These are just three clues that tend to reveal strong or weak governance. In the next blog, I will continue with more clues and some examples.

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