PM Charlie Dreifus explains why investors should be wary of these four things in proxies.
Q1 hedge fund letters, conference, scoops etc
In proxies there’s a lot to be gleaned. There’s a lot to be gleaned, particularly post 2002, which was the era of Enron. We have Sarbanes-Oxley laws which require much more disclosure as to everything in the proxy. And it’s always baffled me, frankly, that the proxy doesn’t get more people reading it because it’s the kind of gossip people love to otherwise engage in, in terms of compensation and so forth, and ownership of the company.
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1. Distorted Compensation Metrics
So when I go through the proxy statement, the first thing I basically look for is the incentive compensation metric. Managements are incentivized based on a certain metric that is developed essentially by the Compensation Committee. I would also argue that the Compensation Committee should use the Audit Committee in helping them come up with that metric, but that metric over the years has morphed into something that we find very pernicious; the use of non-GAAP earnings. So that management can distort the metric such that they’re going to always win. Because the construction of the metric doesn’t really force them to attain what you really want them to do. So that has really escalated, along with the use of non-GAAP accounting.
2. Unqualified Audit Committees
The audit committee ideally should be comprised of people who have financial management experience. The audit chair ideally should be a person who has served as CFO of at least one, if not more, companies; or even better yet, was a partner at a major audit firm.
What you don’t want to see with all, you know, due deference to academics that are in history or literature, those people sitting on the Audit Committee. You want to see people who have had practical experience in accounting and financial matters. The Audit Committee also often serves as sort of the ethics committee, and so it’s very important.
3. Too Many-or Too Few-Audit Committee Meetings
The other thing that I look at is how often they meet. If they meet only once a year, that suggests then they’re probably not looking enough at the data. Conversely, if they meet 15 times a year, it suggests there are a lot of issues.
You tend to see, and a norm would be, something like four, which are the regularly scheduled quarterly board meetings. Plus perhaps, you know, one, two, three telephonic ones that are held because a specific issue comes up. So the sweet spot is, you know, four to seven. And anything much below that or above that is cause for concern.
4. Excessive Executive Perks
An item that I also look for as an indicator of the cultural landscape, the mentality of management, the aggressiveness of management, is perks. What kind of benefits does management enjoy? So I find enough times, it’s not pervasive, but you find it enough times that it’s disturbing managements living the high life at the expense of shareholders.
By that I mean they use a company aircraft for personal use, and at a very favorable rate. They may have very exotic and expensive automobiles that are leased and they have use of that, again, we as shareholders are paying. There may be company lodging, either in major cities or more often it actually occurs with things like hunting lodges, which are used at times to entertain clients; understand that, but are often also used by management.
We try to invest in companies that think of the shareholders. We don’t want the executives living the high life on our dollar.
Article By Charlie Dreifus, The Royce Funds
