Last week, we talked about two keys to minimizing your exposure to undue risk in your stock selections. The first is to resist being seduced into overpaying for high growth. The second is to avoid companies with lame governance. A strong board helps you get good sleep at night, and all other things being equal, the academic evidence is pilling up that strong governance leads to excess returns.

We discussed how impossible it is-from a distance, as individual investors-to spot weak/strong boards by direct observation. However, we can spot clues and behavioral patterns that tend to reveal a strong/weak board. To recap the first three questions about governance: One, who sits on the board, where are they from, do they have more than a few full-time jobs?

Two, does the executive compensation program have "teeth?" (We don't really care how much they get paid. We want to see if the board is pushing a shareholder agenda with these programs). Three, does the board actively manage stock dilution, or do they passively allow dilution to leak value without any cost/benefit analysis? Let's add three more.

Good transparency is when the board and its committees are candid and frank in their reports. You can easily recognize boilerplate statements after a while, and the mere existence of a "good governance charter" or board mission statement is meaningless. A board concerned with transparency explains its role in concrete, company-specific language.

For example, they ought to explain how they evaluate the CEO and the status of the succession plan (which should always be in place).

We want to see clues that the board is actively involved in major transactions like acquisitions. Admittedly, active involvement here is difficult to spot, but it is not hard to tell when a board passively "rubber-stamps" acquisition after acquisition. It's a lesson that just keeps on teaching: serial acquirers are a huge risk. If management has cash to spare, they should buyback shares or pay a dividend.

Minority voice
: this is often neglected but it is an important signal about board's priorities. Does the board care about individual shareholders? Do they preannounce meetings with sufficient information? Are they accessible and do they really want shareholders to be able to bring proposals to a vote?

You will note that I did not include items that sometimes figure into corporate governance calculations. For example, are the chairman and CEO roles separate? It is probably easier to argue that they should be separate, but there are advantages to a fused role and certainly a fused role does not need to inhibit an independent and well-functioning board (or an independent lead director, if you like). Also, the number of meetings held doesn't concern us greatly. If the meetings are really dinner-socials where tough questions are not going to be asked, and sleeves aren't rolled up, does it matter how many they hold?

Siebel Systems (SEBL) is a company that illustrates weak governance. A brief tangent: we would already avoid this stock for its lack of a long-term economic moat. Sure, there is formidable competition from big ERP players like SAP and Oracle (ORCL). But what really concerns us is competition from disruptive innovators. (CRM) has a very attractive "no software" (application service provider) approach.

And if that weren't enough, in the long run, this space is looking at dramatic price deflation with the entry of companies like sugarCRM (privately funded), which delivers really affordable customer relationship management applications via cheap open-source code. The new CEO, who led the online grocer Webvan before its spectacular flameout is no stranger to big capital outlays, apparently relishes a challenge.

Siebel has excessively diluted shareholders with their egregious option grant practices. Siebel's most recent proxy claims an option overhang of 26% because they define overhang as the options already held by executives and employees, but they do not include options available for future grant. This is an absolutely, unequivocally incorrect definition. Overhang is potential dilution (i.e., what is the going-forward exposure?) and always includes the options available for future grant. It looks to me like there might be an additional 38% available for future option grants – a number I hesitate to claim, even after re-checking it, simply because a 60+% overhang defies credibility. Let me just say for the record, I am pretty sure it's high.

In an effort to demonstrate they care about performance, the Compensation Committee granted restricted stock units that only vest if certain aggressive revenue growth targets are met. So far, so good-right? One glitch: if the targets are not met, the units vest anyway "on the fourth anniversary of the grant date." These units have guaranteed value in four years. In fact, they are actually sweeter than standard-issue stock options because while they typically vest in four years, options might end up underwater but these units will have certain value.

I hope that helps explain our view of governance. We think it is critical but it is only one piece of the picture. We won't eliminate a company just because it doesn't have great governance all the way around (e.g., a few of our recommendations elect staggered boards – a common but unfortunate practice with few redeeming features except to ensure board seat continuity), but weak governance does warrant a big red flag on our red flag checklist.

Related Articles
  1. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  2. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  3. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  4. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  5. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  6. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  7. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  8. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  9. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  10. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  6. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
Trading Center