CORPORATE GOVERNANCE - Investors by proxy

Feel sorry for fund managers. Over the last couple of weeks they have been snowed under by dozens of annual reports from companies in their investment portfolios. Many hundreds of hours and endless drafts go into these documents. They are checked at every stage to ensure compliance with the host of accounting and other disclosure standards which listed companies must observe. But do they have any real value?

The way companies communicate with major shareholders is becoming increasingly complex. There is now less reliance on formal channels. And this is creating disturbing inequalities among the share-owning audience. Most investor relations programmes focus on the largest players, leaving the rest substantially dependent on the contents of annual reports and third-party sources.

Investor interest

Unfortunately, annual reports are poor at dealing with the very issues that are of greatest interest to investors – corporate strategy, segmental analysis, market trends and companies’ competitive positions, particularly.

If such issues are not addressed, and the current imbalance between investors continues, it will damage the ability of shareholders as a body both to monitor performance and to play a more positive role in corporate governance.

One indication of the limited role annual reports play in influencing investor perceptions is that their publication seldom triggers a change in share price. The conclusion must be that these glossy, regulated, documents contain little or no new information to cause market participants to change their valuations of companies in a systematic way. In contrast, share prices frequently react (sometimes dramatically) to the publication of annual results through preliminary announcements. Unlike annual reports, prelims appear to contain information which is genuinely new and to which some investors will try to respond more or less immediately in an attempt to enhance the performance of their equity portfolios.

In practice it is quite impossible for fund managers to run portfolios using this kind of information alone. Other sources which are equally useful include interim and quarterly results, trading statements, brokers reports and private meetings with companies. The last of these is particularly important to the UK’s largest institutional investors.

Most fund managers, however, are concerned not to receive this price-sensitive information during meetings. This effectively puts a prohibition on the exchange of information about any near-term financial performance and private discussions tend to focus more on strategic and broader management issues. This allows the institutional investors involved to assess the competence of the executive and the credibility of corporate strategies and business objectives. And the company gets a good idea both of the concerns and priorities of its major shareholders and how well up they are on the business and the sectors in which it operates.

Generally, the biggest fund managers are seen as the best informed. (Indeed, the quality of in-house analysts and portfolio managers, and the impact these have on fund performance, may be key factors driving consolidation in the fund management industry).

The well-known reluctance of institutions to attend AGMs suggests their private meetings with companies are overwhelmingly more important than participation in public events involving other investors. In practice, there are two types of shareholder – those that have access to the chairman, chief executive and FD and those that do not. This division is not between institutions and private investors but between the biggest fund managers and the rest.

Bigger is better

The UK’s top ten, in aggregate, account for more than a quarter of the stock market and the top 50 for around half of total market capitalisation.

Given the practical constraints that many – even the largest – companies have on their investor relations programmes, fund managers outside the top 50 normally have little direct contact with key directors.

An analysis of the top-300 plcs in the UK shows that typically the five largest investors hold a quarter of the shares, and the top 20 nearly half (see pie chart, over page). As these companies often have several thousand shareholders – and the larger ones in the FTSE-100 anywhere between 10,000 and 100,000 – the concentration at the top of their share registers far exceeds the level implied by a conventional 80/20 rule.

The identity of the largest shareholders in top 300 is even more revealing.

Just ten fund managers account for nearly two-thirds of the top-five positions (see bar chart, over page). This means that when companies plan meetings with their most important investors, they are almost always talking to the same people as their stock market peer group, listed customers, suppliers and rivals.

The UK’s major fund managers are in an extremely privileged position – size and importance in the investment community have inevitable benefits.

They are by far the best placed to understand a company’s strengths and weaknesses in terms of commercial and financial performance, as well as the quality of strategy, ‘vision’ for the future, and board and management teams.

The concentration of ownership in the UK far exceeds the level found in the US. On the continent and in Japan commercial and financial cross-holdings feature strongly but they play only a small role here.

Unlike European investors, UK fund managers are seldom directly involved in nominating directors (executive or non-executive). However, there is mounting evidence that they are becoming more influential in the firing of chief executives and in instigating strategic change in ailing or under-performing companies.

Again, it is inevitable that the largest shareholders – which, of course, means the UK’s biggest fund managers – will be most involved in such activities.

After all, they have the most contact with boards and senior management teams, and should be in the best position to understand how the personalities and relationships interplay with corporate strategy and business performance.

It is the top five or ten shareholders in a company who have the most potential to influence events.

Serving the few

Other shareholders are often poorly informed about these ‘behind closed door’ machinations that can put extreme pressure on the directors and lead to CEOs resigning – sometimes at very short notice and without an obvious replacement. Even in other less dramatic cases of investor influence, a small number of shareholders can have a substantial impact on board composition as well as a company’s business profile.

In such situations, the board acts as the investors’ ‘agent’ far more directly than is normally the case. But the principals on whose behalf they act are not the shareholders in general but a small and identifiable group of institutions. So, questions about the effectiveness of corporate governance processes and the rights and role of shareholders really revolve around the activities of the UK’s top 10 or 20 fund managers.

It’s natural that they should take the lead on such issues, particularly when these appear to have a significant impact on shareholder value.

Recognising the importance of their position, a number of the UK’s leading institutional investors have appointed internal corporate governance specialists to work in parallel both with their portfolio manager and, more closely than would otherwise be possible, with companies where there are particular issues at stake.

Equal rights

The inequality between the largest shareholders and the rest is fuelled by the limited exposure that many companies give to issues like corporate strategy, performance against set objectives, industry trends, market share and position, and business segment analysis. Research shows that these are among the most important issues to institutional investors.

At the same time, these are the areas least well served by disclosures in annual reports and other public documents. Despite the opportunity provided by the Operating and financial Review (OFR) framework to educate shareholders about the key issues for the future, few companies take the opportunity to address these in ways comparable to the content of their ‘behind closed door’ discussions. As a result, shareholders place great reliance on the oversight role of top-rung investors.

Investment models incorporate the assumption that the major fund managers (unless they consistently sell shares at the first sign of potentially bad news) are effectively responding to all the information they receive – from all sources – and are providing feedback to the companies in which they hold stakes; directly in meetings, through the investor relations’ functions and also to brokers, merchant banks and other company advisors.

There are a number of problems with the idea of the most important fund managers providing a protective umbrella for the benefit of others.

For a start, it depends on the protectors being universally effective in their role as corporate monitors. And the evidence suggests otherwise.

Although the very best fund managers do appear to be able to outperform the market for sometimes sustained periods, there is a strong reversion to mean performance. It appears that effective corporate monitoring across a broad portfolio may not result in gains in shareholder value that significantly impact overall portfolio performance. There may be individual successes but boardroom putsches and demergers carry their own risks for investors and by no means automatically reverse the historical trend of the underlying business.

Relying on the effectiveness of major institutional investors is unlikely to guarantee a free ride. Unless they are committed contrarians, fund managers will inevitably try to avoid under-performing companies or any which appear unlikely, for whatever reason, to realise their potential.

The best-informed investors and those with the most insight will successfully shirk the lame ducks and leave the shareholders to their own fate, exposed to management fallibility and failure, without a guardian angel.

The frequency of profit warnings – particularly serial ones – also suggests there are significant limits to the role that informal channels of communication relationships can play between companies and their shareholders.

These kinds of problems are perhaps best addressed through greater attention to existing formal channels, particularly disclosure through the annual report and other widely broadcast company announcements. These will attract the attention of many more shareholders and other investors than those who are in direct and regular contact with the company at board level.

Unfortunately, most annual reports suffer from being substantially backwards-looking and are often highly economical in their statements about the future and those aspects of the business most important to investors.

The narrative content of most reports is a poor relation to the financials.

It should explain as well as describe but too often there is merely a catalogue of carefully selected activities and achievements without any convincing glue – the ‘why’ rather than ‘what’.

Real information

The reluctance of many companies, particularly those outside the FTSE-100, to supply shareholders with really useful information reduces the quality of investor relationships because the frameworks used to assess performance and future potential are weaker than they should be, and based on sparse information.

Since both narrative content and the importance of OFR-type issues to investors are so variable, there are strong grounds for making the OFR mandatory, basing the required standard on existing best practice not the highly selective disclosure evidenced in many annual reports.

Some companies would inevitably prefer to boilerplate their OFRs rather than use them as a means to improve their communications to their shareholders.

Even so, overall standards should rise and consistency in disclosure both between companies and year-on-year improve substantially.

Few companies will publicly articulate their corporate strategy in any depth, or explain to their investors how each part of the business is developing in relation to past objectives or to external factors like their competitive position.

Any references that are made are weakened by being over-general and indirect.

Market share and growth data are routinely excluded, symptomatic of the aversion to referring to competitors by name.

The importance of statements about corporate objectives, strategy, competitive strengths and weaknesses is that they have to be closely related to each other to be credible and make sense to all investors. At the same time, agreeing ‘the words’ should impose an important discipline on boards which have to articulate and then be publicly accountable for what has been said – a key component of corporate governance, both internally and externally.

Levelling the playing field means taking a broader view of investor communications throughout the year. It’s about harnessing the potential to harmonise the narrative content of prelim announcements and interim reports as well as addressing the content of annual reports.

Much attention has been paid to financial disclosure but if the cure is not to prove as damaging as corporate misrule itself then the principles of openness and good governance must benefit every investor – not just the cosy cabal of big-name institutions.

Matthew Gaved is the author of ‘Closing the Communications Gap: Disclosure and Institutional Shareholders’, published by the English ICA, editor of the monthly newsletter GOVERNANCE, and is completing a PhD at the London School of Economics on the relationships between institutional shareholders and listed companies.