BI > JANUARY 2003

Finding Companies That Walk The Talk

Does Corporate Governance Matter?

One of his favorite quotations is from Edmund Burke: "The only thing necessary for the triumph of evil in this world is that enough good men do nothing." Substitute poor or undisciplined investing for evil and that is a pretty good description of what energizes Philip J. Keating, CFA. In the world of individual investing, he's a good man doing something.

For more than two decades he's been empowering individuals to become successful investors, helping them avoid the errors that thwart wealthbuilding and focus on principles and techniques that support it. From his home and office in Boynton Beach, Fla., he approaches each day as an opportunity to do something of value to help create value for others. "Isn't that what we all want to do with our lives, to add something of value to this world?" he asks. "The truly great corporations want to do that, too."

When it comes to investing and investment education, he walks that talk. Just ask directors of NAIC's Southeast Florida Chapter, or the National Computer Group, or any of the thousands who have attended his investment seminars at the annual CompuFest or National Congress. Head and heart, he's committed to helping Americans learn more about successful investing.

As we look to the new year, it's a privilege to put this month's editorial spotlight on Phil Keating's perspective on one of the key subjects catching the interest of investors in today's market -- corporate governance. He shared his thoughts in a telephone interview with BI editors in late October. The conversation started with corporate governance but quickly moved to the importance of knowing about all the people who are responsible for the numbers on a Stock Selection Guide. Who are the people responsible for this performance? What's their corporate culture? What does the corporate team value most? Is it more than dollars? More than just words? The interview ended with his outlook for 2003 and beyond -- "This is the best time to be an investor in 15 years."

Q. Does corporate governance really matter? Is it relevant to long-term investing?

A. Yes, I think it's terribly important. As George Nicholson put it decades ago when he formulated NAIC's investment principles, successful investing comes down to management, management, management. And that can be expanded to include the whole corporate culture and the values that produce the numbers we look at in our Stock Selection Guide.

If we're going to own stocks for the long term, we want companies where we have a high level of confidence that the books aren't being cooked and that the numbers represent what's being done to increase shareholder value on a sustainable basis, not just to meet this quarter's or this year's earnings target or to produce a short-term bonus or stock options for management.

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Corporate Culture. "When I first looked at Home Depot more than a decade ago," Keating says, "I was aghast that it was paying employees 50 percent more than its competitors. Then I realized how valuable its employees and service were."

Q. How does an investor begin to get a handle on that?

A. We can never have certainty.

That's what we must accept in life as well as in investing, so we want to increase the probabilities in our favor. The better we know our companies, their managements, and their products and services, the better our chances of success. For the core of their portfolios, beginners particularly should stick to companies with products and services that they have some knowledge of or can personally experience in the marketplace. For example, how does the average company employee present himself or herself to customers? How do they feel about the company they work for?

Last month's Undervalued Stock, Home Depot, is a good example. One of the things that has impressed investors and has certainly impressed me is that when you walk into a Home Depot store, those orange aprons mean something. The people wearing them are helpful, they're knowledgeable, they're enthused. They approach customers with, "Can I help?" rather than being defensive or avoiding them as we so often see in retail stores where customers are viewed as a pain.

Costco Wholesale is another company that has impressed me with its execution and the total value proposition they provide customers. Even the lowliest of employees seem to be positive and above-average in their dealings with customers. I also like the fact that managers wear blue jeans and knit shirts -- it's execution that matters, not how fancy they're dressed.

The orange aprons at Home Depot say something else that's important. They say, "I'm a shareholder," and in chatting with them I find that even the youngest first-time employee is enabled to become a stakeholder and given the promise of more equity interest in the future.

When I first looked at Home Depot more than a decade ago, I was aghast that it was paying employees 50 percent more than its competitors. Then I realized how valuable its employees and service were. That's its key competitive advantage -- above-average employees who are motivated and who give great customer service -- well worth a premium in pay.

The stores were not the most impressive in terms of being the cleanest or having the neatest displays, nor did they always have the lowest prices; but in terms of giving service and saving time, they were impressive. We focus a lot on wealth, but certainly time and health are important, too, not just money. So quality of service is important. At its competitors, we may pick up what we think we need for the special weekend project; but so many times I've been to Home Depot and employees tell me what else I need for the project, which reduces frustration and saves additional trips.

Q. Is personal experience the best way for people to learn about a company and the people behind their investment?

A. Yes, I think that's the extra dimension. Certainly they should always do an SSG before considering an investment. Stock screens can identify candidates for SSG study, too, but if someone experiences a company that has impressive products or service, it makes good sense to follow that up by doing an SSG. If the numbers and the experiences confirm each other, then it's probably going to be a good investment.

We want the numbers to look good, but we also want to be sure there are corporate values and processes in place that are producing the numbers on a sustainable basis, not just from having one lucky product, one great manager, or being first in a particular category. We want to invest in something that's sustainable so that it becomes a 5- or 10-year investment opportunity. This is something Wall Street doesn't talk about much, but Main Street should.

Walking the Talk. "Goodness is not a state of being," Keating says. "It must be defined and created by one's actions each day." Individuals fortunate enough to spend time with him know his actions do just that.

I'm often amazed in meeting with clients or prospective clients to see what products and services have impressed them -- and how often they don't invest in products or services that they clearly feel are the best. It just hasn't occurred to them to do SSGs on such companies or to be on the lookout for them. A few days ago I invested for the first time in a company that I've been following for years because I feel it is clearly the best in general merchandise retailing, and that company is Target. It finally reached my target.

Q. What were the corporate culture aspects of your decision to invest in Target?

A. Well, you know the SSG had to look good. I was waiting for a certain price target and it came in a selloff in July and October. That's when Wall Street downgraded the company after a couple of firms said its sales had been below plan in late August and September and they were looking at Wal-Mart instead. But the short term didn't matter to me. I was looking for a 5- and 10-year investment in a company that has a competitive advantage, and I've noted over the years that Target had key differentiators. Again, just the personal experience showed me that -- like never having to wait in a checkout line, versus the Wal-Mart checkout, which can be a hassle. Or no questions asked on returns, like at Costco, whereas at Wal-Mart it's an ordeal.

Wal-Mart's prices are great. Target has good prices -- not always the lowest but often quite competitive with a Wal-Mart -- but it will have products and quality of merchandise that you don't see at a Kmart or a Wal-Mart. They've also been very smart in differentiating themselves by using designers like Mossimo and Michael Graves for apparel, kitchenware and bathware and by paying attention to who does most of the shopping in households -- the women. Lowe's has done the same in its home improvement area, and now Home Depot is having to counter that.

Every Target employee I have encountered over the last 10 years seems to want to give good service. That impresses me. So does their commitment to the communities, which I notice at the store level and also in the annual report. The company devotes 5 percent of its taxable earnings each year to nonprofit organizations and schools in communities where it has stores, and it has done that for over 50 years -- some $1.5 million per week in 2001.

That's what I refer to from Jim Collins' book Built to Last -- having values that go beyond just making the most money in the shortest period. Those are things that I think give a spirit, a focus, a team feeling to companies that are doing things besides just trying to save money or make the most money. If you work at a Target, I'm sure you feel that if you do a better job -- if you reduce costs or improve productivity or profitability -- you're not only helping yourself and your co-workers, but you're also helping your community. Putting values into action results in pride and enthusiasm.

Q. Are companies that are doing that sort of thing talking about it?

A. Yes, but the problem is that you get many wolves in sheep's clothing, rather than companies like those referred to in Built to Last, a book that has become one of my touchstones. Corporate managers can go to seminars, and they can easily adopt the jargon, but it's walking the talk, not just talking the talk, that makes the difference. So many companies will have the right buzz words in their annual reports, in their public relations releases and in the blurbs at the bottom of their earnings releases, but it's important that the average employee is imbued with these values, not just top management or the public relations staff.

Q. Besides personal experience, how can an investor tell whether a company is walking the talk?

A. Certainly by seeing whether the company produces the numbers on a consistent basis over time. Another thing I look for is companies that have high-quality earnings -- companies that, when they could make themselves look better than they are, don't do it. They don't do things "just because others are." They may often have earnings that are understated. Many top research-based pharmaceutical companies expense a lot of R&D that in other industries is amortized over the potential useful life of the investment or expenditure. So most pharmaceutical companies sell at a premium multiple to the market. But if you normalize their earnings, they're not much different than the market multiple, and in some cases even below it.

Q. How does an investor get a handle on the quality of a company's earnings?

A. Start by staying with what you know, with products and services you understand, and with businesses where there aren't a lot of financial complexities, particularly in revenues and accounts receivable. As I noted in an article I wrote for BITS on Regina Vacuum Cleaner (Oct. 1989, available in the BITS Online archives), always look at the balance sheet, especially accounts receivable and inventories. Look at the percentage increases in these and compare with the prior year or prior period and with the percentage increase in sales. It's very simple. It tells you whether the company is becoming more liquid or less liquid, and whether revenues are real. There are other fancier ratios, but that one's simple enough for anyone to use, and it certainly would raise questions if it shows a substantially larger increase in the nonliquid parts of working capital.

So many earnings disappointments have come from companies booking revenues that really haven't been collected as cash, whether it's in the financial sector, the telecommunications industry or some other area.

Quality of Earnings. With Johnson & Johnson's long-term performance on his computer monitor, Keating explains why he judges the company's earnings to be high quality.

Q. Can you suggest a company you would consider premier in terms of quality of earnings?

A. I've cited Johnson & Johnson a lot in my seminars over the last few years as a company in which you'll find most of the characteristics that we're looking for. J&J has high-quality earnings, and it spends considerable amounts on research and development, close to $4 billion this year. The company has increased its percentage of sales spent on R&D in each of the last three or four years, and it's approaching 12 percent now. That tells me it could have reported even more earnings growth if it had kept R&D expense at the historic level of around 9.5 percent to 10 percent. Instead it invested money in its future through accelerating research and development.

The trend in R&D expense, whether it's up or down, is very important for pharmaceutical companies and probably also for companies in technology, whether they're under- or over-investing. Also, look for unusual drops or increases in capital spending.

A few years ago J&J had a huge increase in acquisition and restructuring charges, and that led to depressed earnings for that year. If you looked at its profit margins on a GAAP (Generally Accepted Accounting Principles) basis, it looked like the company had a drop that year, but it really was nonrecurring items that reduced margins. All of these were noncash charges that didn't affect cash flow and free cash flow. The acquisition was critical to successfully making J&J the second-largest biotech company in the world. The manufacturing restructuring lowered costs for several years into the future. Consider the difference such management decisions can make. That's why it's important to know if a company is making decisions for the long term or the short term.

The key is that a company can have one year that seems to be an outlier, and as potential investors in the company we should learn why and understand the business. J&J was doing the right things.

This illustrates why looking at cash flow can be very helpful. I use it regularly as a professional money manager. Look at the statement of cash flows in a company's annual report, and if possible in its quarterly report. Only about 15 percent of companies give you that information in their quarterly reports to shareowners. But it has to be in their quarterly report to the SEC, the 10-Q, and that is filed about 45 days after the end of the quarter. Look at the cash flow statements because they reveal where a company is getting cash from and how it's used. In particular, I pay attention to free cash flow -- operating cash flow less normal capital expenditures. Looking at that figure year by year is essential and, depending on the company, quarter by quarter may be of interest as well.

For example, J&J announced in its second-quarter report in July that it had bought back $5 billion worth of stock from free cash flow. I generally like companies that buy back shares. J&J is ideal in that it has also increased its dividend at least as fast as earnings over the years.

One trend I anticipate is for dividends to return to greater importance in investor decisions. Historically, dividends and the reinvestment of those dividends represent about 47 percent of the total return on stocks over the past 75 years. In the 1950s and 1960s companies typically paid out 50 percent to 55 percent of earnings as dividends. As taxation on capital gains came down, companies retained more. They explained that it was best for shareholders if they could reinvest the funds for future growth rather than pay them out and see them taxed a second time at high personal rates, versus the lower capital gains rates investors would pay on realizing higher prices from growth in the value of the company.

The most recent S&P 500 dividend payout figure is 33 percent. If there's a reduction in the tax on dividends, I think we could see the payout increase back to the 40 percent to 45 percent range. I think dividend growth could be higher than earnings growth over the next 5 years or longer, and I think this will be a plus for shareholders in quality companies that can pay growing dividends. Dividends, unlike earnings, usually don't lie! One of the tip-offs to Enron, WorldCom, et al. was no or low dividends.

I think shareholders should especially question companies that have not paid dividends and that have had declining returns on capital (see Section 2B on the SSG, earnings divided by book value). If that's declining and a company is paying out a below-average amount as dividends, or a declining amount, questions should be asked. The holding should also be challenged with another company where the trends are more in the shareholder's favor. In the case of J&J, the payout has been about 35 percent. That's been amazingly constant over the past 15 years.

Q. Any comments on the importance of a strong board of directors or audit committee?

A. I think this is a very important subject. The spotlight has been on it, and a lot of companies are reacting. Disney, for example, historically did not have a strong board of directors, but it has recently made pledges to improve this. The company has a unique position with its brands and franchises, but there were some problems with management giving themselves a bonus of about $300 million a few years back and concerns over cronyism in the board of directors. In late June, early July, the company vowed it would have a majority of outside directors and that the audit committee and the compensation committee would be made up of outside directors. They pledged to expense stock options.

Another positive trend that many companies are going to is to select a lead director, someone with management experience in industry, but not an insider. On the audit committee, on issues of corporate governance, on matters of compensation and stock options, the lead director would be someone of standing from outside the company so that it isn't the chairman or CEO who's dictating decisions. General Electric has just announced the implementation of the lead director process and that a majority of board meetings will be run by the lead director with the CEO not even present.

Q. How does an investor know whether a company's board of directors is effective?

A. If someone like Warren Buffett is on the board of directors of the company, it's not a guarantee -- but it's a pretty good sign. One thing that investors don't pay enough attention to is the annual report and the proxy statement. I can understand not going through all the numbers, but often a cursory examination of the reports is revealing. I do some seminars on this called "The Good, the Bad and the Ugly." If the annual report contains lots of pictures of top management taken from angles designed to make them look colossal like Superman, plus color pictures of glamorous new headquarters buildings, I consider those negatives. On the positive side, the annual report can give good insight into how management and its board of directors operate.

The proxy statement is an extremely valuable report that people don't pay enough attention to. In the proxy statements, a company and its directors have to tell you their ownership, their interest in the company, their business background and also what salary, bonuses and stock options they receive. The first thing I have people look at in the proxy statement is the graph that shows how the company has done versus the S&P 500 index and its particular industry group over the last 5 to 10 years. The SEC requires a 5-year comparison, and some companies do an even longer comparison. I think that's a good thumbnail measure of how your company is doing versus its competition, and how the stock market is assessing it.

Who are the outside directors? If they're chief executives at other companies, that's probably a positive as long as there isn't a back-scratching relationship between them. I think it's also a positive for companies to have no more than one or two members of its management on the board. Anything beyond two management members is a warning sign. I'd prefer one, but there may be cases where a chairman or CEO is going to retire in a couple of years and they want the next person in line to get some board experience. But I think going beyond two raises some questions of cronyism or a board's effectiveness as an independent force.

Q. Is there a company that has had a strong board for a long time?

A. There are famous companies such as Target as well as some that aren't as well-known that have exemplary corporate governance. One in the latter group is Technitrol in Philadelphia. The company makes components that go into a lot of electronics and technology. It's been hurting the last couple of years after the collapse of the Internet and Y2K bubbles and subsequent tech problems. But the corporate governance there has been excellent, with directors who make a difference, including their longtime secretary and counsel who is now retired but still is on the board representing the founding family and the long-term interests of shareholders. He was instrumental in getting the company involved with NAIC. When the requirement to certify financial statements by Aug. 14 was announced, Technitrol said in its quarterly report that it applauded the measure and would conform even though it wasn't required to because of its small size. The company also reported that it has always had standards that both encompass the SEC guidelines and go beyond them.

Target is exemplary in most respects: It has only one member of management on its board; all the committees are chaired by outside directors who are all in their 50s and include the CEOs of Wells Fargo, Medtronic, PepsiCo, Xerox, Cargill and General Mills.

Also important is a company's corporate code of ethics or statement of values and principles. I think it's a positive if a company has a code and has both publicized it and lived up to it. J&J is one of the best examples. It has published its credo since 1940 in its annual report. It is on the back cover of the 2001 Annual Report. And J&J has lived up to its code demonstrably many times in periods of crisis.

A code of ethics helps define what a company's values are and how it will react in a crisis, particularly if it's a code that's on the office wall of every management employee. When a maniac put cyanide in Tylenol capsules, J&J didn't hesitate to take the product off the market -- not just in Chicago and northern Illinois, but throughout the whole world at great cost that blew away earnings.

It was a crisis. Tylenol was and still is an important brand and franchise for the company. J&J did the right thing immediately without hesitation because that was what its code of ethics compelled it to do. Interest-ingly, that also turned out to be the best thing for the company and for its brand, which still dominates the pain relief market, having benefited from enormous public trust. In addition, J&J developed tamper-proof packaging as the answer to the crisis. That has benefited the entire consumer products industry, whether it's vitamins, pharmaceuticals or other products that we consume.

In periods of great crisis, what really makes a difference is people's values and their code of ethics. Ethics has to do with conduct. It doesn't necessarily have to do only with values that we might personally highly endorse; the fact that there are values guiding how people will act in a crisis is very important in investments that we plan to own for the long term.

Technitrol has its code. It's rather detailed, taking up two pages versus J&J's, which fits on one page. I think it's important that these things be stressed. How management acts, of course, often communicates it best.

Q. Any words for our readers looking to 2003 and beyond?

A. I think this is the best time to be an investor in 15 years. I think there are a lot of opportunities, a lot of investing gems that are in the backwash of the bear market, and this is a great time to be positive about the future. Corporate earnings quality and corporate governance should be much better for the next few years, at least.

This country has come through many crises, and the key is our values, our adaptability and how well American capitalism has been able to adapt and create jobs and wealth. I have a great belief in that. And when I look at young people, especially those I've met through the CompuFest and Congress youth programs, I think a great generation is coming along.

One of the glories of capitalism is that it's democratizing the investment process by bringing information and computer power to the desktop of every investor. It's sort of a Jeffersonian theme, but instead of a yeoman farmer, we have a person who with a computer can access research libraries and other resources anywhere in the world. This is incredible, and the results of all this knowledge are going to be momentous in the years ahead. Tremendous wealth is going to be created from research, innovation and entrepreneurship.

But I also think that capitalism has this creative destruction aspect to it, too. In his political writings, Thomas Jefferson said we should have a revolution every 18 to 20 years in which every new generation should overthrow the previous one. He was thinking in terms of the government or the ruling party, but I think we have that most of all in America in our capitalist system, which reinforces but is also driven by our democratic values. Bureaucratic, complacent companies and technologies are continually replaced by the new -- "For whom the Dell tolls; it tolls for thee." Most often this occurs in recessions and the recoveries that follow. As Andy Grove, chairman of Intel, puts it: "Only the paranoid [innovative] survive." Intel, by the way, has one of the very best Web sites and is exemplary in both the amount and quality of information it provides investors.

It's important to recognize and celebrate our core values and to put them into action, realizing that much of the distress in cleaning up market abuses after a 10-year expansion is quite normal and has happened many times before. We will soon enter a growth period (it may have already started) that, based on the precedent of the last two business cycles, will likely last another 9 or 10 years. There will be a lot of advances. Just look at the advances of the last 10 years with such things as the Internet, computing, medicine, artificial joints, the quality of people's lives and individual homeownership, which at 68 percent, up from 62 percent in 1995, is at an all-time high.

There are a lot of positives not recognized in the current "glass is half empty" atmosphere, and it's important to keep those in mind. Our economy has been a lot less volatile the past 20 years, but the stock market has been just as volatile as before. The answer to that paradox is that people's emotional cycles of fear and greed are just as prevalent as ever and have been fanned by the explosion of commercial media covering the stock market -- media that often overdramatize the trivial to keep viewers on the edge of their seats in order to sell more commercials. The importance has never been greater for an investment philosophy like NAIC's, the discipline of a tool like the Stock Selection Guide, and support groups like investment clubs, chapters, and the many seminars and educational programs put on by NAIC. My advice to investors is to turn off the TVs, "get a life" and give some extensive thought to the flesh and blood experiences behind their SSG stock analyses.

A lot of great companies are selling at very reasonable if not incredibly cheap prices. So people should be of good spirits and be building for the future. Even if you're fully invested, there's the opportunity to weed and feed, to harvest some tax losses and to move to higher-quality companies as George Nicholson stressed in his Challenge Tree process. Look at how many high-quality growth companies my screenings have turned up in the last few months. The very best companies are now selling at no P/E premium to the S&P 500 index. This is truly the time to be investing in the best.