On Monday, corporate governance adviser RiskMetrics listed its Top 10 company directors, dubbed the “dream team.” It generated considerable market mirth.
The typical response was: “How on Earth did he/she get (or not get) there?” No offence, but most dream team nominations reflect methodology problems rather than superior performance.
Only one of the 10 nominations would raise few objections: the three-decade track record of shareholder value-creation by QBE chairman (and former chief executive) John Cloney.
Governance advisers can add significant value. But those overly attached to rigid rules about board structures and processes don't.
RiskMetrics has good intentions -- to give shareholders some empirical guidance on director selection/re-election decisions, but it displays over-attachment to numeric analysis and under-attachment to sanity-checking results.
RiskMetrics started with the best measure of company performance, excess TSR (total shareholder returns of dividends plus capital gains) in excess of those earned by comparable companies.
They calculated this for the 49 Top 100 companies that were ASX-listed at their chosen start date of September 2000 and end date of July 2007. They allocated the companies' excess TSR between their non-executive directors (NEDs) in proportion to their remuneration.
This generates an artificial and dangerous sense of precision; for example, Elizabeth Bryan's excess TSR was 81.7 per cent. Many methodological biases can swamp differences in director performances.
Not coincidentally, the two highest-ranked dream team members, Elizabeth Bryan and Dick Warburton, were Caltex directors. There are no ASX-listed companies that are really comparable to Caltex. Within the oil and gas sector, Caltex is the only petroleum refiner/marketer. Its TSR is much more sensitive to crude oil prices and refiner margins than any other company.
RiskMetrics' end date coincided with extremely high oil prices and rising refiner margins, making its excess TSR look good. But Caltex's share price subsequently plummeted more than 60 per cent as the oil price fell.
A bigger problem is “non-survivor” bias. RiskMetrics doesn't penalise directors whose companies do badly following the start date if they are delisted before the end date.
Examples of start-date Top 100 companies that followed this path include Southcorp (taken over) and One-Tel and Pasminco (went broke).
Soon after RiskMetrics' start date, Southcorp launched the Rosemount takeover, which destroyed billions in shareholder value. Warburton resigned in 2003, but Foster's 2005 acquisition of Southcorp causes RiskMetrics to ignore Southcorp.
Recognised for excellence: QBE Insurance chairman John Cloney is high on the list.
Likewise, RiskMetrics gives no credit to directors who create value by breaking up their companies or by seeking out/encouraging buyers if this causes delisting before the end date. Western Mining Corporation (WMC) was a prime example of this value creation.
Whether key events straddle arbitrarily set end dates or not can unduly distort relative director assessments. Coles Group and Howard Smith were both Top 100 companies at RiskMetrics' start date.
Within a year, Wesfarmers had taken over Howard Smith, paying 70 per cent over the start-date price. Because Howard Smith was delisted before the end date, Howard Smith's value gain is ignored.
In contrast, Coles was facing a takeover bid, which boosted its share price, but the takeover had not been completed at RiskMetrics' end date. Coles’ directors therefore got points (although this still wasn't enough for any of them to crack the dream team).
RiskMetrics' rankings also favour directors of companies (such as Macquarie Group and Mirvac) that tanked after the end date, even though that end date was almost two years ago.
Insurance Australia Group (IAG) chairman James Strong made the dream team, but was heavily criticised for rejecting QBE's $8.7 billion ($4.65 a share) takeover offer last May. Leading fund manager Peter Morgan said the “board should hang its head in shame.” IAG's share price is now only $3.45.
RiskMetrics also ignores value destruction before the start date. Warburton was David Jones' chairman from 1995 to mid-2003. Its 1995 float at $1.99 a share gave it a $746.3million market capitalisation, placing it well within the Top 100.
By RiskMetrics' start date, five years later, the share price had plummeted to $1.20 (although 20c reflected a capital return) and David Jones was well outside the Top 100. Continued disasters such as the Foodchain fiasco depressed the share price further.
On the day Warburton eventually resigned, the share price rose 2.7 per cent, making shareholders $12.5 million better off. The share price reached $1.60 within a year and $5.75 in mid-2007. David Jones entered the ASX 100 index in October 2007.
But because David Jones had fallen outside the Top 100 before the start date and remained outside until after the end date, RiskMetrics ignored it.
Ignoring companies outside the Top 100 can disregard useful information on directors. Consider the following four dream team member experiences.
Elizabeth Bryan became a director of Western Metals just after RiskMetrics' start date. Within two years, the share price had crashed 90 per cent and Western Metals was forced to restructure; this included giving creditors 48 per cent of the company’s equity to forgive debt and directors (including Bryan) resigning.
Roland Williams became Australian Magnesium Corp's (now Advanced Magnesium Limited (ANM)) chairman just prior to RiskMetrics' start date; AMC's / ANM market capitalisation was then about $270 million. Even though it realised $500 million through further share issues (which should have made AMC/ANM a Top 100 company), it was worth less than $200 million by mid-2003.
Huge cost overruns on a major magnesium development destroyed $570 million of shareholder value and the share price had fallen by 78 per cent. AMC/ANM reported an $813 million loss in 2002-03.
Williams resigned as part of a restructuring plan agreed with stakeholders, including creditors and the Federal and Queensland Governments, who chipped in $300 million of taxpayer funds. Williamson admitted that without these stakeholders' support, AMC/ANM would have had to enter administration.
Penny Morris was a Strathfield director for only three months before resigning, citing concerns about corporate governance. During that time, Strathfield's share price more than halved. This example highlights the need for careful judgment.
Should Morris be penalised for value losses that may have been beyond her control? Maybe she should be congratulated for quitting a board which she felt was not conducive to maximising shareholder value.
When Ian Blackburne joined Australian Plantation Timber (now Integrated Tree Cropping (ITC)) as chairman in February 2001, it was a Top 200 company with a market cap of around $200 million. Within five months, Blackburne had resigned for personal reasons.
One month later, APT/ITC entered administration, owing $80 million. Unsecured creditors eventually got 43c in the dollar.
RiskMetrics' approach also favours chairmen of small boards that set a high chairman remuneration premium over non executive directors (NEDs). For example, in 2006-07, Warburton's $390,200 remuneration represented 31.5 per cent of all NED remuneration, so he was allocated a substantial proportion of any Caltex excess TSR.
These are just a few of the biases embedded in RiskMetrics' approach. Of course, we could invent more complex methods to mitigate biases. But it is more valuable to take a step back to see the wood from the trees; employ simple company-level numbers as useful inputs to director assessments, while recognising that good judgment is far more crucial.
It is just like judging a painting's quality: scientific tools such as good lighting can help, but no amount of science can substitute for your considered judgment.
BEST IN SHOW
Dream team of company directors
Elizabeth Bryan (Caltex, Westpac)
Dick Warburton (Caltex, Tabcorp)
David Simpson (Commonwealth Serum Laboratories (CSL), Aristocrat Leisure)
Kevin McCann (Macquarie Group, Origin Energy)
Ian Johnson (Leighton Holdings, Newcrest Mining)
Penelope Morris (Aristocrat Leisure, Mirvac)
John Cloney (Boral, Brambles, QBE)
Ian Blackburne (CSR Gyprock, Suncorp Metway)
James Strong (IAG, Qantas, Woolworths)
Roland Williams (Boral, Origin Energy)
Paul Kerin is Professorial Fellow, Strategy, at Melbourne Business School.
As published in The Australian on April 3, 2009.