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.






Transparency:
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).




Acquisitions:
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. Salesforce.com (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.



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Tickers in this Article: SEBL, ORCL, CRM

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