Rolls-Royce should welcome a shareholder to its board

In a recent opinionated article (‘Rolls-Royce needs to quietly give activist investor the brush-off’), the FT defends the idea that Rolls-Royce, the British aircraft engine maker, should refuse to grant ValueAct - an activist investor who has taken 10% of the company to become its largest shareholder - a seat on its board.

I could not disagree more.

Rolls-Royce is without doubt a great high tech company and a crown jewel for Britain, but it has also made some major strategic mistakes, faces profit decline and has destroyed almost GBP 12 billion of shareholder value in two years. It has ruined its Stock Reputation® (its reputation on the stock market) by failing to achieve guidance on several occasions. The company can recover, but it needs the support of its shareholders.

Strategic mistakes, mismanagement and financial control failures

Rolls-Royce is intrinsically a long-term business. Aircraft engines take many years to develop, test and bring to market. Revenue from the sale of original equipment and subsequent aftermarket services generate cash flows for decades. A successful product delivers results for years, but similarly failures can have long-term, negative implications.

Several years ago Rolls-Royce made a massive strategic mistake. The company did not propose a new engine for the A320neo, focusing instead on larger engines. Not only did Rolls-Royce miss out on what is now the biggest commercial success of Airbus (4,307 planes ordered at the end of September 2015), but it has also marginalized itself for a long time on the medium-haul segment; the backbone of the global aircraft market.

Unfortunately at the same time, long-haul and large engines market growth has been disappointing. Sales of A380, in which Rolls-Royce invested heavily, have remained behind targets. The Airbus A330, which represents one third of the company’s supplied engines, has reached end of life and its successor, the A330neo has not yet taken over. The British company fell behind General Electric on the market for the 787. As for the A350, for which Rolls-Royce is the exclusive engine supplier, deliveries are still a mere trickle. Finally its Land & Sea division, and in particular the Marine branch in which the group invested significantly, has been strongly impacted by the oil price fall.

The Marine branch aside, these challenges have been well known for years. The company benefits from exceptional visibility provided by an order book representing more than five years of revenue. Also, the expected profit decline of this year should have been predicted, anticipated and managed. The necessary restructuring should have been prepared and planned. Instead the company seemed to suddenly discover such issues. In just over a year, the British engine maker issued four profit warnings and almost as many restructurings, all the while failing to deliver on its cost-cutting effort. This is a major managing and controlling failure.

Board responsibility

When faced with such a situation, should shareholders remain quiet and passive? Should they wait politely outside the boardroom? The FT believes so. It argues that it is “the way these things should be done”, that directors have been elected to manage the company, not to get distracted by vocal investors. “They have a broader duty to advance the interest of the business as a whole over the long term”, it says.

Rolls-Royce’s corporate governance states: “The board is ultimately responsible for Rolls-Royce’s management, general affairs, direction, performance and long-term success. Non-Executive Directors should assess management performance against agreed goals and objectives and monitor how those goals are reported. They should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust and defensible.”

This is true. Non-executive directors are responsible. If they cannot be blamed for strategic mistakes (their seniority on the board averages at three years), they are ultimately responsible for the company’s mismanagement and share price fall. They are responsible for the control failures and multiple profit warnings. They are responsible for Rolls-Royce’s ruined reputation within the investor community. Had things been done as they should, they would have assumed responsibility.

How an active shareholder on the board can contribute to a re-rating

Beyond the corporate governance argument, the FT does not see the value that ValueAct would bring to Rolls-Royce’s board. Indeed the group, who has only recently appointed a new chief executive, is facing major operational problems which cannot be solved directly by an activist fund manager. Having one representative for the main shareholder among the fifteen board members however cannot do any harm; quite the contrary.

First, it would bring some ‘fresh air’ to the board. Rolls-Royce may be a global corporate organisation, its board looks very much like an old-fashioned, cosy English club. The board is composed of 80% British citizens including five from Oxbridge, two Lords and one Lady. All have worked for large corporations, but not one has been a global investor, had experience on the financial market or has GBP 1 billion at risk in the company.

Second, a powerful and active board member can bring significant improvements to the board itself. Not only can they ask for the board to be renewed in order to include more international personalities (American and European in particular, to reflect the nationality of Rolls Royce’s main customers Boeing and Airbus), but also reduce its size to make it more efficient and more accountable. They can improve the executive remuneration system to align it more with the long-term share price performance. They can ensure that the board truly focuses on shareholder value.

Third, like other non-executive board members, an active investor should not directly manage the company but support the new CEO in his restructuring and reengineering plans. Yet an active investor can contribute positively to the strategy. One specific field in which they can be helpful is capital allocation and investment strategy. Fund managers are experts in investment risk and returns. They also know how to make a balance sheet more efficient with an appropriate dividend policy and financing strategy. Rolls-Royce’s announcement that it may cut its dividend sent both its share price and investor confidence plummeting.  Considering that the group does not have a financing issue and a low gearing, any fund manager would challenge this decision.

Fourth, an investor who is constantly looking at the financial market and equity research can quickly alert management to fast-changing economic trends. Rolls-Royce might be a long-term business, but it failed to predict the oil price fall. An investor, who is better informed than most, may not have seen it but would have been in a better position to anticipate it. Similarly, whereas non-executive directors base their opinions mainly on information provided by the company, a fund manager receives the support of a team of buy-side analysts who are constantly studying the industry and the company’s competitors. Better protected from internal influence and therefore more independent, investors are better equipped to challenge management when necessary.

Last but not least, an active shareholder on the board can help the company rebuild its relations with investors and Stock Reputation®. As part of Rolls Royce’s turnaround plan, the new CEO rightly identified disclosure and controlling issues (lack of transparency, inconsistent guidance, difficulties in predicting performance, etc.) and announced a major change in forecasting systems.  This is all great, however an experienced fund manager can give valuable advice on how the company should determine guidance and communicate to investors.  They can also play an active role in promoting the company and communicating to the financial market. They can help convince investors to re-enter the shareholder register and lead a re-rating.

At the end of the day, the FT should remember that shareholders are not corporate enemies but partners.

The GOOGL re-rating

Achieving a share price re-rating is never easy. There are always goods reasons why a listed company is undervalued. It can be due to poor financial performance, but it generally goes beyond this and often results from investors’ mistrust in the company and a low reputation on the stock market (Stock Reputation®). A good reputation will be positively valued in the share price, because it lowers investment risk and provides investors with confidence in the future behavior of a company and its share price. On the contrary, a bad reputation with investors will lead to a valuation discount.

In many cases, achieving a share price re-rating requires a company to rebuild its Stock Reputation®. It can take time, but in all cases it requires self-questioning, moving the company’s priority back to shareholders and major change - major change and real strategic transformation that companies and management are not always willing to make when it affects the status quo.

To get a re-rating, Google has decided to disturb its status quo – a remarkable thing for a company of such size and stature.

Google is one of the most successful corporations in the world, but it has not always been a strong investment for its shareholders. From the end of 2014 to July 2015, Google’s share price remained almost unchanged. Over the same period, Microsoft gained 20% and Apple 60%. This underperformance was largely explained by the faster increase in costs compared to revenues (see graph). It was also due to some unfriendly shareholder decisions such as the issuance of non-voting shares and the sentiment that shareholder value was not the company’s real focus. Investors questioned Google’s investment discipline. They doubted its “moonshot” projects such as Google Glass and driverless cars. They were unhappy with its disclosure that prevented them from following the performance of Google’s different business lines with accuracy.

                        Google revenue and cost growth (base 100)

On July 17, Google’s stock price surged by 16.3% and since then it has outperformed Microsoft and Apple by 5% and 15% respectively. To achieve this spectacular re-rating, the company changed CFO, reduced its costs, but first and foremost it created a new company: Alphabet.

For the common person, Alphabet was just a new name for Google but for investors it meant much more. It signaled the company’s focus on shareholder value again. Alphabet is a collection of letters, but it also means alpha-bet (Alpha being the investment return above benchmark). More importantly, it is a holding company separating Google’s profitable and core internet operations (search, YouTube, Android, etc.) from its various other “moonshot” businesses. Not only will Alphabet allow to clarify cash allocation and investment strategy, but it will facilitate the valuation of the company. Assuming that the value of its long term projects is positive (despite losses) and the core businesses can finally be fairly valued, Alphabet is likely to look undervalued on a sum-of-parts basis.

Skeptics will argue that this reorganization has not changed anything to the underlying profit drivers of the company and that the new shareholder value focus remains to be seen in concrete terms. They are right, but the stock market is looking ahead and investors believe in promises when they come from trusted companies.

                 GOOGL share price (USD)

Cnova: How to make your IPO fail in seven steps

Over the last months, I have looked at the stock reputation of many companies. I take this opportunity to share with you a case that I find very interesting.

For those who do not know, Cnova is a growing company and one of the e-commerce leaders in France and Brazil. Majority owned by the Casino group, a French mass retailer, Cnova was listed last November at half its targeted value (EUR2.3bn realized versus EUR4.1-4.6bn hoped initially). Despite that, the company’s share price has lost 25% since the IPO and is valued today at less than 0.5 times sales. E-commerce players are generally traded at least two times sales.

One: Undertake an IPO for the wrong reasons

Officially, the main goal of the IPO was to create Cnova as a company in its own right - an ecommerce pure-play - and consequently accelerate its growth. Reality, however, was different. Cnova did not need to raise capital to finance its growth and still remained dependant upon the Casino group (e.g. purchasing, logistics…). The only achievement of the IPO was to highlight to investors the undervaluation of the Casino group.

Two: Put in place a poor corporate governance structure

To make sure Cnova remained under its control, Casino put in place a governance structure unfavorable to minority investors. The Cnova Board of Directors is mainly composed of non-independent managers representing Casino. The group has not unified the management and instead maintained two separate CEOs at the top of Cnova (one in France, one in Brazil). It has multiplied management changes (CFO, General Counsel, IRO…). Finally, it has really not aligned the incentivization of the Cnova management with its share performance (no share ownership or stock-options).

Three: Limit the number of shares available to the market

Again, in an effort to retain control, the Casino group has maintained the highest possible level of ownership in Cnova. Less that 7% of the equity was offered to investors. Once a few large institutional investors obtained shares, there were not enough shares remaining in the market to ensure an appropriate level of liquidity.

Four: Chose the wrong listing

In order to benefit from the Alibaba IPO in New York, Cnova did its transaction on the Nasdaq. By doing so, Casino excluded French and European investors who should have represented the natural shareholder base of the Franco-Brazilian company. Also, American investors, for whom Cnova was only a small foreign company and an option in their portfolio, did not rush to participate in the IPO.

Five: Hire too many “prestigious” advisors

For this IPO, Casino hired no fewer than ten investment banks, including Morgan Stanley, JP Morgan, and Merrill Lynch. As well as expensive (EUR16m representing 30% of the net losses in 2014), this glut of advisors was counterproductive. Fighting for their position within the syndicate, investment banks could not take the risk to correctly advise Casino. Indeed, acknowledging a mistake to the client could potentially result in a downgrade within the syndicate.

Six: Don’t be transparent

Just like many corporates who are apprehensive and limit what they say to the market in order to avoid making any comments on their real performance, Cnova did not disclose critical and key indicators. Namely: 1) the profitability split between France and Brazil and 2) the financial details of its payments to Casino resulting from its agreement with the mother company. On this last point, without a precise and fully transparent disclosure, Casino will always be suspected of taking advantage of its relationship with Cnova.

Seven: Oversell your results

Under the pressure of a poor share price performance, it can be tempting to oversell results. In Q1, Cnova proudly highlighted a gross margin improvement of 18 bps, whereas its operating losses deepened from EUR7m to EUR48m. Cnova has not yet published it Q2 earnings but focused already on the strong growth of its activities and revenues. In reality, its sales increased by 11% compared to 18% growth in the previous quarter.

Since the beginning of the year, Cnova has been trying to correct its mistakes. The company opened a Euronext listing, recruited a new Investor Relations officer and asked Exane BNP Paribas to increase its liquidity. This is good news but far from enough. If Casino wants Cnova to be valued two times sales, the group would have to completely change its overall approach. A change is clearly achievable but only if priority is given to shareholder value.

Measuring consistency: the retailers cases study

As mentioned in my article “How to measure stock reputation”, communicating on strategy and targets is critical, but actually realizing this strategy and achieving targets is even more critical for stock reputation. Say what you do and do what you say. For this study, I decided to analyze the consistency of the largest listed retailers in the world, namely Walmart (US), Costco (US), Carrefour (France), Tesco (UK), The Kroger (US), Metro (Germany), The Home Depot (US) and Target Corporation (US).

Consistency in strategy

To start, I looked at the announced strategy for these companies at the end of 2011. Then I reviewed their communication over the last three years in order to spot inconsistencies, strategic changes and more broadly, all initiatives that were not in line with this announced strategy. According to the frequency and importance of those changes (either major or minor), I rated the consistency in strategy from zero to seven.

Overall, American retailers get good ratings on this criterion. Costco and The Home Depot are perfectly consistent throughout their publications. Their strategy and priorities have remained the same over the last three years and remain valid today.

On the contrary, the Europeans have been particularly inconsistent during the last three years. They all changed their CEOs and, with them, their strategy. This occurred at Carrefour in 2012 and it adjusted it strategy again in 2013. The CEO of Tesco was appointed in 2011, put in place a new strategy in 2012, and made a further adjustment in 2013, before being sacked in 2014.

The achievement of guidance and targets

The achievement of targets and guidance represents the second level of consistency analysis. A profit warning will of course strongly impact reputation but systematically better results than guidance is also not a positive. Not giving guidance is not a solution as it increases uncertainty. As previously, I reviewed in detail the publications from the last three years (12 quarters) for each company in order to spot profit warnings and revised targets. Then, I rate from zero to seven each company according to the frequency and importance of their profit warning (or any difference with expectation).

Over the last three years, The Kroger and The Home Depot have not issued any profit warnings. On the contrary, almost every quarter, they have done better than their guidance. It is for this reason that they do not receive the maximum points. This  raises investor expectations and increases potential disappointment risk for the day when those companies will only just make guidance.

Target and Tesco are at the bottom of the ranking. In three years, Tesco has been forced to issue two major profit warnings (at the beginning of 2012 and during the last change of CEO). Target did the same in the first quarter 2013 and during the second quarter 2014.

It should be noted that Carrefour and Cosco obtained a below average rating because they do not give guidance.

Reporting consistency

Reporting consistency is the last factor to analyze and rate. Once again, I reviewed in detail results publications, presentations and reporting in order to spot changes that would negatively impact understanding and visibility. Depending on the importance (major or minor) and the frequency of those change, I rated reporting consistency from zero to six (this criterion is slightly less important than the two others).

Just like the other criteria, the American retailers are doing much better than their European competitors. The annual report and accounting presentation of Costco in 2014 are identical to those of 2012 (no restatement). The Home Depot and the Kroger are also particularly consistent from one publication to the next.

This is not the case for Metro. Over the last three years, the German retailer’s reporting has been extremely difficult to follow. Metro made some accounting adjustments in 2012, but most importantly changed its divisional reporting and its reporting calendar in 2013 (the reporting year end changed from December to September). Carrefour has not been much better with accounting revisions and important reporting changes taking place almost every year.

Conclusion

By adding the results on these three criteria, it was possible to rate the consistency for each company. This rating gives the last measure of stock reputation.

Overall, the American retailers appear to have done much better than their European competitors. The Home Depot, The Kroger and Cosco are particularly consistent in their strategy, reporting, targets and achievements. On the contrary, the Europeans have issued multiple profit warnings, and changed their strategy and reporting many times. Their operational difficulties and CEO changes are, without a doubt, the reason for this.

Measuring the quality and effectiveness of the equity story communication: the cement industry case study

As mentioned in my article “How to measure stock reputation”, the quality and effectiveness of communication is the fourth criteria to rate stock reputation. For this case study and to follow the news, I decided to analyze the communication of the seven largest listed cement producers in the world, namely Anhui Conch (China), Lafarge (France), Holcim (Switzerland), CNBM (China), HeidelbergCement (Germany), Italcementi (Italy) and Cemex (Mexico). For this review, I mainly referred to information available on their websites (annual reports, investor presentations, financials results…).

Note that although the needed documentation was available in the Investor Relations website section for the western companies, it was not always the case for the Chinese companies. Their English language websites do not work well, are not up-to-date and disclose very limited information. To make my analysis and study the latest annual reports and results press releases, I had to go to the Hong Kong Stock Exchange website, where it is mandatory for listed companies to publish.

Business model communication

The first thing to look at in order to measure the quality and effectiveness of communication is the way companies communicate of their industry, their business model and their key profit drivers. Based on their disclosure, I rated communication by these companies from zero to four, with four being the highest.

Overall, western companies describe their activities and positioning relatively well. They highlight their strengths, but do not say much about their risks and weaknesses. Similarly, they could communicate more about their industry and are not specific enough on their key profit drivers. They do not explain much about price and volume dynamics and do not give details on their costs.

Saying that, HeidelbergCement is better rated than the average on this criterion due to a detailed presentation made for their investor day and specific slides which comment on key profit drivers. On the contrary, Anhui Conch and CNBM are poorly rated due to the limited description of activity in their annual report, which, beyond financial numbers, does not allow the investor to really understand and analyze their business model.

Strategy communication

The communication of the strategy is the second element to study. The strategy has to be properly explained and communicated, has to go beyond day-to-day management, and has to include quantitative targets. As I did previously, based on disclosures, I rated the quality and effectiveness of this communication from zero to four.

Holcim’s communication on strategy is excellent. The Swiss producer gives a good explanation of its strategy in its documentation (in particular its investor day presentation), clearly highlighting its priorities, and precisely quantifying its targets. Also, Holcim goes beyond its day-to-day management and explains its long-term vision with the Lafarge merger. Also, if the merger would not take place, this will represent a major set back for the group.

Alternatively, the Chinese communication on strategy is particularly poor. Anhui Conch explains that its strategy is to adapt and CNBM to reduce cost and debt (the contrary would have been surprising!). The two producers are willing to expand their activity internationally and to participate in M&A activity but are not providing any rationale for this.

Capital allocation communication

Besides strategy disclosure, capital allocation– including the dividend policy – needs to be formerly disclosed and explained. Once again, I rated this communication from zero to four.

Once again, Holcim and HeidelbergCement obtain the best rating on this criterion. HeidelbergCement is the only company of our sample to formally disclose a dividend policy (a targeted pay-out ratio). Holcim only provides some indication about its dividend intention but, on the other hand, is explicit on its approach to capital allocation and priorities for the use of cash (a section is dedicated to this area in its investor day presentation). 

On the other end, despite distributing a dividend, the Chinese groups do not mention cash allocation or dividend policy anywhere in their publications.

Results and performance communication

Beyond communication on business model, strategy and capital allocation, the way that results and performance are communicated is critical. As before, this communication was rated from zero to four.

Overall, western companies have a good level of disclosure and very similar communication results. All publish detailed quarterly results, with investor presentations, and the investor conference call is available on replay. Holcim is also adding a downloadable Excel model of its accounts.  They all communicate on outlook and annual trends but, unfortunately, none provide formal and quantified quarterly guidance.

Once again, Chinese corporate are at the bottom of the ranking. Their quarterly communication (outside annual and interim results) is extremely limited. In addition, no presentation is available and they do not organize any calls with investors (at least officially).

Communication coherence

Coherence is the last thing to look at in order to judge the quality and effectiveness of communication: not only the overall coherence of the equity story but also the right information, which allows the building of a good financial model. One last time, I rated this communication from zero to four.

Until yesterday, Holcim and Lafarge would have been excellent on this criterion. Both gave all necessary information needed to generate a good financial model, but mainly they were presenting a convincing equity story resulting, in particular, from their merger project. Their announcements that they may not pursue their merger impact strongly their communication coherence and credibility.

Chinese companies are also again badly rated but CNBM is doing better than its domestic competitor due to the annual disclosure of several divisional indicators allowing for the building of a proper financial model.

Conclusion

By adding the results on these criteria, it was possible to globally rate the quality and effectiveness of the equity story communication of each company. This rating will give the fourth stock reputation measurement.

As expected the Chinese cement producer are at the bottom of the ranking. Clearly, they seem willing to only disclose the strict minimum required under Hong Kong securities law. As a matter of fact, they are primarily China's state-owned companies and do not have to be concerned about private shareholders.

On the contrary, until yesterday, Holcim would have obtained the best rating and Lafarge a good rating. Not everything was perfect, but the two companies were explaining their equity story in detail and extensively communicate on the merger benefit. Their latest statement re-challenging their merger is a strong setback. This shows to investors that they have been subjected to months of misinformation. Whatever happens (the deal does go ahead or not), this story will impact their reputation on the stock market for long.

Measuring shareholder structure quality: the Dax case study

As mentioned in my article “How to measure stock reputation”, the quality of the shareholder register is the third criteria to rate stock reputation. In this case study, I have decided to examine the 30 companies of the DAX, the largest German stock index.

“Major” institutional investors ownership

The shareholder structure of a listed company is indicative of stock reputation. Indeed, the more prestigious the shareholder base, the better it is for the company’s reputation on the stock market. Generally, the most prestigious investors are the largest (even if there are exceptions to this rule). Therefore, I identified the 150 largest institutional investors (including sovereign wealth funds) managing assets of more than USD 100 billions and named them the “major” ones. Then, for each company of the DAX, I measured how much of the free float those “major” institutional investors owned.

Without surprise, the “major” institutional investors are the main shareholders of the DAX companies. The German economy remains the reference in Europe and attractive to these investors. On average, they own more than 20% of the German blue-chip stocks.

Volkswagen is the company, which has the greatest percentage of these prestigious shareholders. The car manufacturer benefits notably from a significant ownership by the Qatari sovereign funds (QIA). Volkswagen also has the Norwegian sovereign funds (Norges) and Capital Research in its shareholder register. Similarly, the semiconductor manufacturer Infineon, has an excellent rating on this criterion due to its long-term shareholders Dodge & Cox, Capital Research and Allianz Global Investors.

On the contrary, the fertilizer and salt producer K+S has relatively few large institutional shareholders. That can be explained partly by its relatively small size compared to the other DAX companies, but is probably not the only explanation.

Shareholder loyalty

The shareholder register quality also has to be measured in terms of shareholder loyalty. To measure this, I looked at a period of two years to see how many funds were selling their positions each quarter and how many remained as shareholders. By comparing these two pieces of data, I was able to measure the proportion of funds exiting the shareholder register.

Overall, the shareholders of the German DAX companies are relatively loyal. On average, only one shareholder out of 13 leaves a register each quarter. Nevertheless, there exist major differences between companies.

Bayer’s shareholders are particularly loyal to the chemical and pharmaceutical company. Only one shareholder out of 25 sells its position each quarter. More generally, the chemical companies (Henkel, BASF) have succeeded to retain their shareholders.

Alternatively, Commerzbank is suffering from high shareholder turnover. 12% of its investors are leaving the company each quarter, which is three times more than Bayer. This lack of loyalty is also visible in the share performance. Commerzbank has significantly underperformed the DAX index over the last two years.

Conclusion

By combining results concerning the ownership of “major” institutional investors and the ones concerning shareholder loyalty, it is possible to rate the shareholder structure quality of each company. This rating will give the third stock reputation measurement. Within the DAX companies, the car manufacturer BMW has the best rating. This is due to the important ownership of large and long-term funds such as Dodge & Cox and Harris Associates, but also to the high loyalty of its shareholders. On the contrary, the K+S shareholders are not very prestigious or loyal. 

Measuring shareholder value focus: the Dow Jones case study

As mentioned in my article “How to measure stock reputation”, the focus on shareholder value is the second thing to look at in order to measure stock reputation. For this case study, I looked at American companies on the Dow Jones Index.

Focus of the Board

To begin with, the focus on shareholder value has to come from the board of Directors.  In order to rate this focus, I looked in detail at board composition and governance for several companies. In particular, I identified the presence (or not) of significant shareholders on the board and the separation (or not) of the CEO and Chairman roles. To refine my analysis, I looked at other secondary criteria to answer the following questions: Is a significant shareholder the Chairman of the Board? Is the CEO the main shareholder of the company? Is there a State shareholder with a representative present on the Board? In case on a combined CEO and Chairman role, is there a Lead Independent Director on the Board? Is a majority of the board composed of independent board members? Are there only independent board members when excluding the CEO and significant shareholders? Finally, based on these two main criteria, as well as secondary ones, I rated the shareholder value focus of each board.

This analysis showed that few boards have a strong focus on shareholder value, but that is not the case for the majority. Two-thirds of Dow Jones companies are rated below average and two elements explain this.

First, most of these companies were founded decades ago and do not have any reference shareholder. They are fully public and owned by institutional investors who do not sit on the board.

Second, most of the time, the CEO is also the Chairman of the Board. Despite corporate governance best practices and shareholder pressure, American CEOs cling to this traditional model that gives them the power and allows them to control the board. Facing criticism, they have recently accepted to name Lead Independent Directors to their boards, but those board members still do not have enough power to really threaten CEOs in the case of share price underperformance.

Focus of the CEO

Next, to measure how much of a priority is given to shareholder value, the CEO’s incentive linked to the share price performance needs to be analyzed. Indeed, the best way to align the interests of executives and shareholders is to pay executives a high proportion of shares and stock options. Also, I looked at the number of shares (and stock options) owned by each CEO. More precisely, I measured the value of the CEO’s stocks ownership and compared it to his annual salary (including bonus). On this basis, I was able to rate and rank the shareholder value focus of each CEO.

*Before recent change of CEO

Overall, this analysis is very positive for US companies. Three-quarters of the CEOs analyzed own shares equivalent to more than five years’ worth of salary. Therefore, they are extremely incentived by the performance of their share price.

Among them, JP Morgan and UnitedHealth CEOs are the most incentivized. Their stock ownership represents more than 80 years of salary. In part, this can be explained by their seniority as CEOs (for almost 10 years they have cumulated shares and stock options), and in the case of JP Morgan’s CEO by his relative low annual salary (he did not receive a bonus in 2014). Yet, this shows above all the boards willingness to align CEO interest with that of shareholders.

On the contrary, McDonald’s and IBM’s CEOs owned relatively few shares compared to their salaries. This is due partly to their relatively limited seniority in their positions but also because they have sold many shares over the last years. Whatever the reason, at the end, their wealth is not linked to share performance and this may worry investors.

Investor Relations intensity  

Investor Relations activity is the last thing to analyze in order to measure shareholder value focus. Even without board pressure and without financial incentives, management can involve itself in an active IR program. To measure these actions, the best approach is to measure the time dedicated by management (CEO and CFO) to investors (results, roadshows, conferences, investor days…). It is unfortunately difficult to obtain precise information on the management timetable from outside of the company. Also, to get an idea of management involvement in IR activities, I listed the number of investor’s events to which the company participated (excluding the mandatory ones such as quarterly results and AGM). This allowed me to rate IR intensity.

On average, Dow Jones’ companies participated in six events per year. However, some are much more active than that. For example, General Electric and Cisco have participated in more than 20 events per year. Alternatively, Nike seems to have participated in a limited number of events.

Conclusion

By adding the results on these three criteria, it was possible to rate the shareholder value focus for each company.

Microsoft and Wal-Mart obtained the best rating due to the presence of important shareholders on their boards, the separation of the CEO and Chairman roles and an significant share ownership of their CEOs. To the contrary, Chevron was at the bottom of the ranking as its CEO was also Chairman and owned very few shares on its company.

More broadly, these American companies have relatively good ratings as regard to their shareholder value focus. On the negative side, CEOs are often Chairmen and there is not much threat in theory from their boards. On the positive side, they are highly incentivized by their share price performance. This is not often the case in Europe or Asia.

Measuring share price behavior: the CAC40 case study

As I mentioned last week in my article, “How to measure stock reputation”, the first thing that is required is to analyze the share price behavior of company on its stock market. For this case study, I have decided to look at companies of the CAC40, the largest French stock index.

Erratic share price movements

Erratic daily share price movements represent a risk for investors and are an important factor of stock reputation. To measure these movements, I looked at the last three years and determined the number of days when the share price materially deviated (more than 3.5%) from the CAC40 index. I found that, on average, a company’s share price has erratic movements six times a year. That corresponds to a 2.4% probability on average. That being said, without surprise, the portion of erratic daily share price movements varies greatly from one company to another.

Air Liquide appears with the lowest rate of erratic share price movements.  In three years, the industrial gas world leader only had one erratic share price movement. Following a disappointing annual results announcement on February 17^th, 2012, its share price fell by 2.8%, whereas the CAC40 was up 1.4%. There have been no surprises since.

On the contrary, Alcatel-Lucent, the telecom equipment company, has had an exceptionally volatile and unpredictable stock market performance. Approximately every seven days, its share price performance deviates significantly from the market. Almost all announcements from the company or third party lead to a strong share price reaction. For example, at end October last year, Q3 results led to an increase of 16.1% of the share. Two weeks before that, its share price went down 6.2% following an estimate downgrade from Morgan Stanley.

Share price deviation from its trend

The share price deviation from its trend is the second biggest risk for an investor and a shareholder. The less it deviates, the highest the stock reputation and vice-versa. To measure this deviation, I calculated the standard deviation of share price variations compared to its 200-day moving average. Once again, I did this calculation over the last three years. Results are once again very different from one company to another but give similar conclusions to the ones concerning erratic share price movements.

Air Liquide has also the best rating on those criteria. Over the last three years, on average, its share price has deviated by only 3.3% from its trend. On the contrary, Alcatel-Lucent is exceptionally volatile. Between February 2012 and August 2012, its share price has been divided by two.  The share took back 80% over the next six months and, then, has been multiplied by three during 2013. It was once again divided by two over the first nine months of 2014 and, recently took back more than 75% in three months.

Conclusion

By combining results concerning erratic share price movement and the ones concerning share price deviation from trend, it is possible to give a share price behavior rating to each company. This rating will give a first stock reputation measurement. In the current case study, without surprise, Air Liquide has the best rating and Alcatel-Lucent has the worst.

How to measure stock reputation

As I mentioned in a previous article, it is relatively simple to spot an issue with stock reputation. Quantifying it is much more difficult. Nevertheless, it is not impossible. By analyzing 5 specific criteria for a company over a long enough period of time, I believe stock reputation can be precisely measured. 

Share price behavior

The historical share price behavior of a company points to its reputation with its shareholders. Movements up and down reflect investors’ disappointments, surprises and fears. They show both their nervousness and confidence level. Also, by analyzing this behavior, stock reputation can be measured and rated. In order to accurately measure this, two analyses need to be performed.

First, erratic daily share price movements need to be identified and counted to determine their proportion over the period of time. An erratic movement can be spotted when, during a trading day, the share price materially deviates from the stock market. Ideally, each erratic movement should be analyzed and explained (announcement, market fact, etc), but in this case, the statistical measurement is what is important. The goal is to determine historic risks and the probability of facing an erratic share price movement for an investor.

Second, the maximum deviation magnitude of a share price compared to its average trend needs to be measured. A share price which deviates, one way or another, regularly and significantly from its trend (the 200-day moving average, for example) represents an important risk for investors. To the contrary, it is safer to invest in companies that do not deviate from their trend.

Shareholder value focus

Shareholder value and share price focus is the second criteria to measure stock reputation. It is largely related to Corporate Governance. Officially, this is the company’s management team’s first priority. In reality, however, this is not always the case. Many CEOs simply do the minimum asked by investors. The main reason for this is that they do not have to report to investors but rather to friendly and complacent board members who do not specifically represent shareholders. CEOs typically only take care of shareholders when their position depends directly on them and when they are strongly incentivized by share price performance. Also, this criteria needs to be measured at three levels.

First, the focus on shareholder value has to come from the board. To rate this, the best approach is to count the proportion of board members representing a major shareholder. As a matter of fact, a board member representing directly one key shareholder (a founding family or a reference shareholder) will always give priority to shareholder value and will pressure management in case of bad share price performance. A “professional“ board member may have other priorities. Similarly, a board structure, where the roles of chairman and CEO would be separate, will be positive to the rating. A CEO with an underperforming share price would be more at risk in this configuration. Note that this rating should be reduced in two cases. One is when the CEO is also the main shareholder of the company and cannot be fired following a poor share price performance. The other case is when the board member represents a public shareholder. Shareholder value is never governments’ first priority.

Second, shareholder value focus needs to be determined at the top management level. The way to do that is to measure the number and the proportion of shares (and stock options) owned by the CEO and management team. As a matter of fact, the first priority of a CEO is to keep its job and then generally to maximize revenue. A management team, which is highly incentivized by share price performance, is most likely to listen to investors.

Third, this issue needs to be analyzed at the level of Investor Relations. All things being equal, intensive IR work impacts stock reputation. To measure these actions, the best is to measure the time dedicated by management (CEO and CFO) to investors (results, roadshows, conferences, investor days…). The CEO’s dedicated time should be, of course, overweight compared to the CFO’s.

Shareholder structure quality

The quality of the shareholder register is the third criteria to rate stock reputation. Indeed, the more prestigious and the more loyal the shareholder base, the better it is for the company’s reputation on the stock market. Beyond share price performance, fund managers from large institutional asset managers have to justify their choices internally to their investment committees and externally to their clients. A long-term investment in a company with a good reputation will always be easier to justify compared to an investment in an unknown or risky one. To measure the quality of the shareholder structure, two analyses need to be performed.

First, the proportion of long term and large institutional funds managers within the free float need to be identified and measured. That should of course take into account pension funds and sovereign wealth funds that are particularly long-term shareholders. The greater percentage of these types of investor in the register, the better it will be for stock reputation.

Second, the shareholder loyalty needs to be measured. For that, over the reference period, the best is to determine the proportion of main shareholders that have remained in the register and those that have exited. Loyalty is always a great indicator of good stock reputation.

Equity story communication

Communication is, of course, important to stock reputation. It is qualitative but can be analyzed and measured with precision and rigor. Indeed, beyond valuation multiples and profitability prospects, fund managers invest in a company with a story and a promise of shareholder value creation: the equity story. This has to be explained in detail and communicated extensively in a fully transparency manner in order to create confidence. This communication is critical for stock reputation, and therefore, needs to be analyzed and rated. To do so, the quality and effectiveness of communication (website, annual reports, investor presentations…) needs to be measured based on the 5 key components of the equity story. 

First, the business model and the key profit drivers have to be explained and formerly disclosed. The quality and detail of those explanations, as well as the way in which they are communicated will determine the rating. Indeed, a lack of transparency or missing information will create doubt with investors and negatively impact stock reputation.

Second, the strategy – with targets – has to be properly explained and communicated. These also need to be rated. Often companies are hesitant to communicate on strategy because they fear they are providing confidential (or valuable) information to their competitors. This is a bad excuse. Companies are generally well aware of the strategies of their competitors, and good communication on strategy is not aimed at disclosing company secrets, but rather to explain main initiatives in order for investors to better understand the direction that the company is taking.

Third, the capital allocation– including the dividend policy – needs to be formerly disclosed and explained. A cash allocation policy and its communication are critical to investors as this explains investment priorities and returns that they could expect. That will determine the rating.

Fourth, results and performance have to be properly communicated and the quality of this communication needs to be rated. A company reporting detailed results every quarter, giving guidance, roadshowing extensively and taking conference calls to make sure that investors well understood results will be definitively more trusted than a company communicating limited information on its performance only twice a year.

Fifth, communication needs to be rated in its coherence. For example, a company that highlights specific profit drivers in its business model but communicates on other drivers in its quarterly results will lose credibility with investors. Equally, too much inconsequential information will alienate investors and will also negatively impact stock reputation. More broadly, the coherence should reflect on the equity story and permit to build the right financial model.

Consistency

It is critical to communicate on strategy and targets, but actually realizing this strategy and achieving targets is even more critical for stock reputation. Say what you do and do what you say. A profit warning or an M&A deal not in line with strategy will always be disastrous for credibility and stock reputation. Similarly, reporting changes and restatements will negatively impact visibility and investor confidence. Also, to be rated, consistency has to be analyzed at three levels.

Consistency in strategy is the first thing to rate. To determine this, it is necessary to review all press releases, transcripts and interviews to spot possible initiatives or announcements that are not in line with the strategy. Only one major inconsistency is enough to destroy stock reputation.

The achievement of targets and guidance represent the second level of consistency analysis. This can be also rated through a review of historical results announcements. A profit warning will of course strongly impact reputation but systematically better results than guidance is also not a positive. This raises investor expectations and increases disappointment risk for the day the company will only make its guidance.

Reporting consistency is the last factor to analyze and rate. To do so, once again, a detailed review of results publications needs to be done in order to spot presentation, reporting and accounting changes. Even when they are justified, reporting changes negatively impact visibility, the understanding of results and consequently, stock reputation.