Our overall goal in creating the Stewardship Grade was to measure the demonstrated commitment to shareholders of companies' boards and management teams. Companies that have strong records of putting shareholders first will score well, while those that have not treated shareholders with respect--for example, by having overpaid executives, strong takeover defenses, or opaque financial disclosure--will score poorly. We've divided our assessment into three broad areas: transparency, shareholder friendliness, and incentives, ownership, and overall stewardship.
In this area, we examine accounting practices and overall financial disclosure, aiming to identify firms that provide investors with either insufficient or potentially misleading data. We take a dim view of firms with repeated "one time" charges, aggressive accounting practices, and nonroutine earnings restatements, as well as those that grant options without expensing them. On the other hand, we reward firms that have excellent disclosure that goes above and beyond what is required by law.
Here, we seek to gauge the power of shareholders relative to management. Insider-controlled share classes, takeover defenses, and related-party transactions would detract from a firm's Stewardship Grade, as would the holding of the CEO and chairman of the board roles by the same individual.
Incentives, Ownership, and Overall Stewardship:
In this section, we're concerned with whether management's incentives are aligned with shareholders' interests. We look poorly on firms that issue too many options, move goalposts for executives by redefining management goals midstream, have low levels of equity ownership by the CEO or directors, or create compensation packages that reward managers for being employed, rather than for making value-enhancing decisions. We reward firms that have consistently treated shareholders with respect, and which we think will continue to do so.
Our Stewardship Grades are a bit different from some of the corporate governance grades and scores that have been introduced by other firms over the past couple of years. For one thing, they're absolute, rather than relative. So, if a company engages in practices that we think do not reflect good stewardship of investors' capital, it will receive a poor grade regardless of how other firms may have scored. We're doing this because we want to award grades based on how firms are actually treating shareholders, rather than giving credit to firms with poor stewardship that happen to be the best of a bad bunch.
The Stewardship Grades also incorporate a firm's historical record of treating shareholders respectfully. We're doing this because we think actions speak louder than words--changing a few bylaws and appointing some independent board members is nice, but if these things are done by a company with a poor record of corporate stewardship, it may just be window dressing. All else equal, we prefer companies that were doing right by shareholders before it became fashionable in recent years.
Not all aspects of corporate stewardship are created equal, and the weightings that we assign to different questions reflect this. For example, we look poorly on firms that do not issue a balance sheet with their quarterly earnings releases, because it obscures their cash earnings relative to their accounting earnings. However, we place less weight on this question than, say, whether a company has a separate share class controlled by insiders. The former is a relatively small, though relevant, issue, while the latter has the potential to allow a firm to take actions contrary to the best interests of minority shareholders.
In our view, investing in a stock means becoming a business partner with the folks running the firm. Over the long haul, we think that management teams that align their interests closely with shareholders, compensate themselves reasonably, and communicate their results candidly are likely to be better business partners than those that don't. At a cheap enough price, even a firm with a poor Stewardship Grade can be a decent investment--but for long-term holdings, firms that consistently treat shareholders with respect will likely help you sleep better at night.