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Narrator:
Running a public company requires a million decisions, but how can you make sure those decisions benefit you as a shareholder? After all, it's not very easy to get the CEO on the phone.
Thankfully, a system of rules, policies, and practices referred to as corporate governance is used to help guide companies and aims to ensure that all stakeholder interests are protected. It provides checks and balances to promote successes and correct failures, with the ultimate goal of promoting shareholder returns.
Retail investors should consider a company's corporate governance practices when evaluating an investment because it can impact performance over time.
In the United States, there are three main groups of people that make up this governing structure: a board of directors, the company's management, and the shareholders of the company's stock. There are other groups like employees, customers, vendors, and more, but we'll focus on the three for now.
In short, shareholders vote on who's elected to the board, who help set the companies' strategic directions, which should serve shareholders' long-term interests. Then, management executes upon that guidance.
Let's start with the board of directors, whose members are elected by shareholders. The board oversees the way a company is managed, approves business plans, provides strategic direction, and hires and sets the pay of senior management.
Boards can be a mix of people who have ties to the company, like the CEO, and others who don't. Typically, most members have previous experience on a board of directors or as an executive at a large company in a similar industry or with overlapping demands.
There are many things investors should keep an eye on when it comes to the board of a public company. Three of the most important are: its independence; the depth of the board's overall skills and expertise; and members with different backgrounds, including those with institutional knowledge and others with new ideas.
Ideally, board members have an arm's-length relationship with the company's management team they're overseeing. That would theoretically allow them to make impartial and, if necessary, difficult decisions.
An overly friendly board was an issue for Disney during Michael Eisner's time as CEO in the 1980s and 1990s. Eisner was questioned for decisions some felt weren't sufficiently challenged by the board, including decisions about hiring and firing and his negotiations to make himself the highest compensated CEO at the time. Eisner's push for a theme park in Paris was costly and frequently criticized. In the company's 1993 annual report, he called the park's performance "dreadful," and Disney's stock fell almost 3% in the days after.
A board that lacks independence, or whose members have similar backgrounds or skill sets, can suffer from groupthink that encourages conformity and discourages evaluation. That may limit a company's ability to deliver on its full potential over time. Studies have shown a positive link between a company's financial performance and its board's diversity in terms of areas of expertise, skills, and personal experiences.
Occasional turnover can help bring in energy and new ideas, too.
Next, we'll touch on management. A leadership team is hired by the board to execute the company's strategy on a day-to-day basis. Investors want a group that can maximize their investment by navigating problems, mitigating risk, and who are transparent. One way management ensures transparency is through third-party audits, which the government mandates each public company receive annually.
The chief executive officer, or CEO, is the highest-ranking member of the management team. They're the top decision maker in the day to day and the liaison between management and the board. Others include the chief financial officer and the chief operating officer, but roles vary from company to company.
Ethics and transparency from a management team are two characteristics that every investor should look for. Enron is a good example of why it's so important. It was a hot energy stock in the early 2000s. Eventually, increased competition chipped away at its market share. Yet the stock continued to hum along due to its positive earnings reports. It turned out those financial statements were too good to be true. Management allegedly committed a series of financial fabrications, making it appear that unrealized theoretical future gains were current income.
An investigation showed the board failed to sufficiently audit financials and avoid conflicts of interest, among other issues. Enron's failure led to the Sarbanes-Oxley Act, a 2002 law that tightened requirements for corporate financial recordkeeping and reporting.
Private organizations monitor corporate governance too. For example, most mutual funds keep an eye on the operations of the companies included in their fund. For individual stocks, their exchanges perform a similar role.
Finally, shareholders technically sit at the top of the corporate governance structure because they vote on who is elected to the board of directors during the company's annual shareholder meeting. They also get a say on other big decisions, like executive compensation, issuing more shares, and mergers and acquisitions. Shareholders typically get one vote per share, so holding more shares can provide investors more influence.
While most common shares come with voting rights, keep in mind there are different types of shares, called share classes.
Different classes come with unique rights and privileges, like voting power or a lack of it, dividend payments, or a greater claim to assets if the company goes under.
For example, Google parent company Alphabet offers three share classes. Investors who buy GOOGL are getting voting rights. Meanwhile, GOOG is a nonvoting share typically offered at a discount compared to GOOGL.
Finally, Alphabet has a Class B share, which includes a vote worth 10 times that of a common share and is available only to the company's founders.
So where can investors go to learn more about a company's corporate governance before investing?
As an investor, you can monitor news reports about decisions made by a company's management or board. You can also find more information through quarterly earnings reports and other regulatory filings that summarize corporate leaders' decisions and discussions.
If you hold shares that permit voting, you may do so at the company's annual shareholder meeting. Look out for messages from the company in the weeks or months before the meeting about topics up for a vote.
There are also third-party evaluations like MSCI's Governance Pillar Score, which assesses companies risk level and management practices.
The score is a criterion you can screen for using the Stock Screener on Schwab.com. Select Analyst Ratings, and then Governance Pillar Score. For the top-rated companies, select Leader. You can further refine your search by selecting additional criteria under Company Performance and Financial Strength.
Understanding how shareholders can influence the board, which oversees how the company is managed day to day, can help you better evaluate potential investments.
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