Tuesday, July 07, 2009

Best in Class: America's Top Boards

07/07/09 - 09:11 AM EDT


Eric Jackson

It seemed an easy-enough question last week when someone asked me: What's the company in America with the best corporate governance? Yet, in trying to answer it, I was sent on a frustrating journey and a disappointing conclusion that there's no obvious winner. However, I'll name three good companies and look to address why it's so tough to answer the question.

In preparing this article, I reached out to some of the people I most respect in the world of corporate governance today: consultants, writers, bloggers, corporate secretaries and academics. Most of them were stumped by the question of what company is the best when it comes to corporate governance. It's certainly much easier to list 20 companies with bad governance for every company with good governance, which says a lot.

But three really good ones are Berkshire Hathaway(BRK.A Quote), Amazon.com (AMZN Quote) and Johnson & Johnson(JNJ Quote).

I'll revisit them later after I explain how I arrived at my conclusion.

To help spark my thinking, I searched the Web for recent corporate rankings of the best boards in corporate America. I came across a list from BusinessWeek from 2000. The top board on the list was General Electric (GE Quote), which unseated Campbell Soup(CPB Quote). Others near the top were IBM(IBM Quote), Home Depot(HD Quote), Intel (INTC Quote) and Cisco(CSCO Quote).

Since this ranking was issued, the combined stock returns of this group has been down 60% vs. negative 37% for the S&P 500. Three of the worst boards in 2000 in the rankings -- Walt Disney(DIS Quote), Rite Aid (RAD Quote) and Waste Management (WMI Quote) -- actually have slightly outperformed the best boards in the nine years since, but still returning on average negative 54% .

Ten years ago, GE's board was lauded for having a high number of outside directors who owned large amounts of stock in the company, which is worth 77% less today than it was back then. The board's largest move since 2000 was appointing Jeff Immelt as Jack Welch's successor rather than Bob Nardelli. It's hard to fault the board for that pick, given Nardelli's travails since then, but GE's shareholder base was frustrated with the stock's flat performance for the majority of this decade -- and that was before the wheels fell off last year with the concerns about GE Finance and its commercial real estate holdings.

Campbell Soup, the No. 1 corporate board of 1999 according to BusinessWeek, has lagged its peers like General Mills (GIS Quote) and Heinz(HNZ Quote) for a decade and barely treaded water with the S&P 500 over that time. Its stock is down 30% from 1999.

Finding the link between governance and performance has often vexed academics researching the link. At larger firms, with so many moving parts, it's often difficult to find the long-term performance effects of, say, separating the chairman and CEO roles.

''You are never going to be guaranteed total success,'' says Charles Elson, head of the Weinberg Governance Center at the University of Delaware. ''But good governance gives you protection when things go wrong. In the long run, that will play out.''

I spoke to Elson last week about the problem which many governance ratings have had in subsequently predicting company performance. He told me, in his view, that there were two critical governance factors which clearly showed a relationship to performance: (1) equity ownership of directors and (2) independence of directors.

I think he's right. Back in 2000, I was involved in a major research project which sought to link governance-related factors to subsequent company performance. The one factor which stood head-and-shoulders above any other was director stock ownership. And, by the way, owning stock through stock options or stock grants (the equivalent of "found money") didn't predict future company performance compared to when directors actually dug into their own pockets and purchased stock.

Board "independence" has been talked about often since the Enron and Worldcom scandals. We take it for granted that having a board stacked with family members or lawyers, accountants, and consultants who are paid by the company as directors is likely to produce more rubber-stamping boards than ones with more independent-minded people. However, there's still a lot of work to do in linking specific types of independent directors and company performance.

For example, I strongly believe having an independent director with industry experience is going to be more valuable in the long run compared with an independent director without that experience who doesn't want to speak up for fear of looking like a fool in front of the group. I also think too many boards lack diversity, in terms or ages, backgrounds or tenure on the board, which makes them collectively less independent thinkers than boards with such diversity. (However, adding a director for diversity's sake, without required business or industry experience, won't result in any new benefits for the group because such directors, again, will likely be too afraid to speak up.)

There's one more dimension I would add to the mix as being critical to finding a clear link between board governance and future company performance, and that's time to serve. If you go back and review the boards of the big failures from last year -- Lehman, AIG(AIG Quote) and Citigroup(C Quote) - all had a large number of directors who were too busy with other commitments to effectively serve as directors.

You had people like Anne Mulcahy and Andrew Liveris (CEOs of Xerox(XRX Quote) and Dow Chemical(DOW Quote), respectively) on Citi's board, who also served on Citi's audit committee, which is the most time-intensive of any board committee). When their own companies were seeing their stocks drop like stones last year, both Mulcahy and Liveris participated in 25 Citi board meetings and 12 audit committee meetings. In my view, they were stretched too thin from their day jobs to flag Citi's problems early enough.

Directors also can serve on too many other boards. Roland Hernandez who, in addition to serving on the board of Lehman and its "risk" committee (which failed if ever a board committee did), also served on the boards of MGM Mirage(MGM Quote), Ryland(RYL Quote), Vail Resorts (MTN Quote)and Wal-Mart(WMT Quote). Maybe if Hernandez hadn't been so over-committed he might have asked more questions about Dick Fuld's assumptions about Lehman's real estate

So, if equity ownership, independence, and time are the criteria for "good governance," along with evidence of sustained outperformance relative to peers, what are America's best boards? Like I mentioned earlier, the standouts are Berkshire Hathaway, Amazon.com and Johnson & Johnson.

Even as Berkshire Hathaway has taken its hits from the fall in financials and insurance companies, the stock still has beaten the S&P 500 in the last one, five and 10 years by a greater margin as you go back further in time. Investments made in Goldman Sachs(GS Quote), GE, and Harley-Davidson (HOG Quote) in the dark days of six months ago, look shrewd today. From a governance perspective, Berkshire is the gold standard for shareholder openness through its two to three-hour question-and-answer sessions at the annual stockholders' meeting and in its annual letter to shareholders. In terms of stock ownership, with the exception of Sue Decker who joined the board last year, each director owns at least $6 million in stock, with the median holding being $106 million. I also smile every year when I read how much Berkshire directors are paid to serve on the board. The majority of them get $2,700 a year, with a couple of special folks taking home $6,700, which is far less than the $300,000 to $400,000 a year some bank and tech directors take home.

The biggest problem I have with the Berkshire board is its average age. A third of the board is above the age of 80. These directors will have to face board succession issues, as well as CEO succession issues, over the next few years. They seem to recognize that they could benefit from some new perspectives on the board, judging from the most recent appointment of Sue Decker, formerly president of Yahoo!(YHOO Quote) and in her 40s.

Amazon.com also has been a standout performer for the last one, five and 10 years. Although consistently criticized by some for its sky-high valuation, it continues to succeed operationally and in its moves into new categories (most recently with the introduction of the Kindle electronic book reader). CEO Jeff Bezos gets the lion's share of the credit, but the company's board also is deserving. The stock ownership among the directors is high, with the median around $4 million.
But what I love most about this board is that every director has relevant tech or consumer experience which they bring to the group. Bezos didn't waste a seat around the table with the former ambassador to Ireland, buddies from the Seattle business community with no consumer background, former bosses, or the general manager of the Oakland A's baseball team. There's also a good range of ages and length of time served on the board across its eight members. A couple of the directors serve on two other boards besides Amazon's, and three have been on the board more than 13 years, which is getting a little long in the tooth, but these are very minor infractions when compared with most boards.

Johnson & Johnson's long-term corporate performance also has stood out compared with other "Big Pharma" players, and its governance has stood out as well. Unlike many New York-area boards of S&P 500-listed companies, J&J doesn't boast a board replete with active CEOs. In fact, it doesn't have any current CEOs (although disgraced former Citi CEO Chuck Prince was appointed to the board before he was ousted).

The board is a blend of retired CEOs and people from academia or with a specific health care background. The median stockholdings of directors is good at just under $900,000. My concerns with this board are that a few of the ex-CEO directors hold several other directorships -- including chair of JNJ's audit committee, James Cullen, who serves on four other boards. It's also odd that the finance committee didn't hold any meetings in 2008.

If I had to pick one of these as the best corporate board, I would say it's the board of Amazon.com. It's done things right on the most important governance factors of equity ownership, independence and time. Given this, I expect the company's positive stock performance to continue in the next 10 years. More importantly, Amazon's good governance means it's far less likely to suffer a Lehman-like shock that could destabilize or kill the company.

At the time of publication, Jackson had no positions in the companies mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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