article , video 11-10-2016

Why Investors Should Care About Corporate Governance

Portfolio Manager Charlie Dreifus outlines four key corporate governance issues he focuses on and why they are important for investors. 

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Why Investors Should Care About Corporate Governance

Steve Lipper: When you want to look more deeply into corporate governance, what are the things that you focus on?

Charlie Dreifus: I focus primarily on four issues. I look at the composition of the audit committee. I look at the accounting principles employed, are they aggressive or conservative? I look at incentive compensation, is it fair, is it biased? Finally, I focus on ownership. I am looking for management to have some skin in the game.

Why Accounting Practices Matter

I came to appreciate governance along with the cynical view I take of companies in general and the deep dive into accounting. It's intertwined clearly and companies that are accountable and transparent tend to reward investors.

What I've observed over my career and it came about, again through the deep dive into the accounting. Yes, it's a mosaic, but the colors in the mosaic for the good companies are complementary, whereas for the bad companies, they are stark and they're all the same. Because if a company has bad conduct in one regard they're probably taking liberties elsewhere.

Incentive Compensation: The Metrics Matter

Steve: So let's probe on that a little. So on incentive compensation, what do you regard as more favorable and less favorable?

Charlie: Perhaps the easiest way to understand this is, yes, it relates to salary and perks, but really where you get a very meaningful insight regarding this is most managements have incentive compensation beyond salary compensation– and what are the triggers, what are the metrics, and how distorted are they, how easily are they circumvented, and just even the choice of the metric itself gives an insight into the mind-set of the company.

What are they really trying to do? Are they just trying to pay the anointed group the most they can or are they really striving to, from our standpoint, show that they're good allocators of capital, that whatever they're doing is incremental, and it's not just moving the chips around the table.

Audit Committee Leadership Matters

Steve: You also look at the audit committee. What do you look for and, again, what do you think is more favorable and what is a red flag for you?

Charlie: The composition of the audit committee and who is chairing it. The chair should be someone with a great deal of practical experience.

People who have some financial background, and who know what to ask. You really have to have a cynical mind; you have to know what the options are for portraying results. The results should be the economic reality. Anything beyond that is puffery and the question is the levels of puffery.

Insider Ownership: What Matters?

Steve: Tell us your perspective on officer and director ownership.

Charlie: It is always interesting in ownership to see when management is buying shares in the open market with cash. People generally only do that if they're confident of the results. They can still be gimmicking the numbers, and think that that will make the stock go up, but it is better than them not buying stock.

The companies that I invest in, oft times there is a family. In the small-cap space, you still find companies where there is a dominant family, and certainly those families who are involved in the business have significant ownership. And actually, I found that comforting over time because they're fairly good stewards of capital and contrary to everyone's belief, they don't use a great deal of nepotism, they don't overpay themselves. This is the family crown jewel, and they want to preserve it, enhance it for, if nothing else, future generations of the family.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of July 12, 2016 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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