5 Ways Corporate Governance Affects Investors and Stock Valuations

Thanks everyone for joining our webinar today on 5 ways corporate governance affects investors and stock valuations. I'm David Trainer, the CEO of New Constructs, and I'm going to get right to the point. Look, corporate governance really comes down to 5 really important things. I call it the 5 C's: CEO or leadership, capital budgeting, Compensation, communication, competition. If the CEO doesn't believe in caring about creating shareholder value, then no one's going to believe in it. If you don't have top-down influence to focus on doing what's right for investors, then you're probably not going to really be a good organization. You're definitely not going to be a good investment. Look no farther than Valeant for an example Of bad leadership. Capital budgeting. If you're not making decisions about how you allocate capital based on returns on invested capital, based on cash-on-cash returns, based on the NPV analysis of investment— of investing, if you're not thinking like that, then, then you're, you know, that's bad corporate governance and investors want to avoid that. Great example. If you are looking at acquisitions or investments solely based on what kind of revenue you think they're going to generate, that's not good capital budgeting. That's not capital budgeting. There's no capital in the budget there. You're not even taking into account the cost of the capital. That's a bad thing. And really, the only way you know whether or not someone's doing capital budgeting the right way is if they're talking about cash-on-cash returns. It doesn't have to be called return on invested capital. It just has to be called something that's true to the meaning of understanding how much cash flow you're getting relative to how much capital you've put into the business. Compensation. Let's face it, executives and leaders will do what gets them the most money. It's called human nature. It's called self-interest. If you're paying people For performance that is not linked to creating shareholder value, but linked to— whatever it is it's linked to is what they're going to do. You're not going to get what you need your executives to be doing if you don't pay them based on those metrics. Communication. You've got to be able to talk about it. If you can't articulate the message, if you can't convince me that you understand return on capital and And that you're pushing it through the organization as a CEO in terms of leadership, as part of the capital budgeting and compensation of the company, I'm not going to believe you. It's not that hard to articulate. We'll do it for you. Watch the webinar on return on invested capital. See the white paper on return on invested capital and you'll understand It's not that hard to communicate. Lastly, competition. You really want to beat the competition? Then focus on return on invested capital. That's what drives valuation. You want to convince the market that you can outcompete your peers? Focus on return on invested capital. So really the kind of purpose of this webinar is in linking all the webinars we've done together. And the kind of the big picture message. And you can see all of our webinars in the education section of our website. The big kind of clear message here, or the full circle, is corporate governance. Corporate governance. At the end of the day, these are the people that set the business up to succeed or not to succeed. And when we talk about American Express, or we talk about Oracle, or we talk about GE, all of— all these companies we've done case studies on, it all comes back to return on invested capital. That's what drives valuation. And that's what executives need to be focused on. So the thesis again, Focus on companies with good leadership. How to define good leadership? Good leadership means good corporate governance, which means focusing on return on invested capital. What's the basis of our argument? It's predicated on the ideas that real cash flows matter and superior profitability is ultimately rewarded by the market. I find these things intuitive. I've been in the business for over 20 years. I've been through the tech bubble. I've seen markets get irrational. We've made many calls here at New Constructs about stocks with irrational valuations. They do come back to earth. We're imminently publishing a report on the power of quantifying expectations. It speaks to even though stocks may be overpriced for a long time, it won't last forever. Keep in mind that the market would cease to exist The stock market would cease to exist if it continually allocated capital to companies that lost money or destroyed value. If they didn't earn an adequate return on capital, they didn't earn an adequate ROIC compared to their weighted average cost of capital, the market would destroy itself because the money would go away. It's called pouring money down a hole. And on the other hand, the market rewards companies that create more value Well, then the market can sustain itself. So this is sort of a basic, sort of part of nature thing. Those organisms, those entities that create more than they take, they prosper. Those that just take eventually die unless they can find an infinite source of free resources. It's basic nature. It's also some basic math, right? When we look at return on invested capital, This isn't just for peer— for financial companies. It's for all companies. But in this situation, for American Express versus its peers, 72% correlation between return on invested capital and valuation. Looking at larger groups, the S&P, a 56% correlation. Large-cap financials, 69% correlation. Those of you who have seen my prior webinars, We do this regression analysis all the time. I've even done it on the fly in one of these presentations to show you how quickly it is to access our data. It's not sexy. It's not quite as much of a thrill, but you know what? The real thrill at the end of the day is long-term knowing that you made money, that you did the right thing. The real thrill is putting your head on your pillow at night Knowing you're not just gambling. It's betting on the right things. Try not to be distracted by the noise because it's all around you. This is not entertainment. Investing is not entertainment. It's about protecting and growing your wealth. And we're here to help you do that the right way. That's a big part of what we're doing. We believe the purpose of the capital market is to allocate capital to its most efficient use. I think the biggest reason that the United States is the greatest country in the world compared to 200-plus years ago when we were not on the world scene at all, what's the difference? It's our ability to allocate capital more effectively. It's the freedoms of speech, freedoms of religion, freedoms of ideas that have ultimately resulted in more efficient capital markets and a more effective way to get more out of the resources we have today. today than we did back then. Lakes aren't deeper, oil wells aren't fuller. We do more with less. That's what drives improvements in standards of living. That's what our investing principles are based on. And we stand up for those principles by specializing and investing lots of capital in technology, on gathering the data to identify The best measures of cash flows to show that the relationship between profitability and stock valuation is not just intuitive but empirically supported. That's what matters. So corporate governance, it's about leadership, capital budgeting, compensation, communication, competition that focuses on return on invested capital. At the end of the day, if you can earn more money on the small— on the amount of money you allocate than your peers, you win. If you can earn more money on every dollar of capital that you allocate than your peers, you win. If you can make $20 for every $100 you invest and your peers can only do $15, you win. If they can only do 19, you win. Feel free to send in some questions anytime. I've already got 2 or 3, but I'm happy to answer questions. This is a pretty simple takeaway. And one of the things I like to kind of, you know, to back up this message, just look at the, you know, the research we've done, the case study on American Express showing exactly how executives can drive value by focusing on return on capital. We've got models that provide scenarios on exactly, you know, how much value the company can create for its investors if it can focus on return on capital. Net shareholder value creation, gain over current market cap— all these are linked back to changes in return on invested capital. We did the same thing For Oracle. Case study. And by the way, in these case studies, there are links to models that will show you exactly how we calculate— do all these calculations. As you guys know, I'm super transparent. I want you to know how much work we do for you. We're here to help you. We're here to help you identify good ideas And avoid the worst ones. Valley's a perfect example where corporate governance is a disaster. They set up compensation plans that rewarded behavior that was bad for shareholders but good for executives. They got paid— executives got paid while losing money. That's why the stock is down a lot lower than when we wrote our Danger Zone report In late February. It was 84 then, it's in the 30s now. We don't think it's gonna get any better because we don't think the corporate governance has gotten better. You know, we started pointing out the issues with corporate governance because it was sort of so widespread and such a high-profile name, June 2014. Independent research is helpful. Wall Street doesn't help corporate governance. Find people who actually don't have a dog in the fight. Find people who don't get paid by the companies they're supposed to cover. Question on KMI. Listen, return on invested capital isn't something that has to be done or created tomorrow. So when a company like KMI is spending a lot of money, I can see how that's going to drive returns down in the short term, right? And look, we say this in our analysis of free cash flow. And in our training program, you know, one of my kind of trick questions is, is it better for free cash flow to be positive, negative, or zero? And the answer is you never know. You can't— there is no right answer to that question. Because if it's positive, well, that means you got so much— you got a lot of money left over. You don't have a lot of places to put that money. You don't have a place where you can get an adequate return on your investment, so you're just keeping it. Maybe you're giving it back to shareholders. If you're negative, well, then you're, you're investing more money than you're making. And maybe that's because you've got a lot of high-return opportunities. What it comes down to at the end of the day is expectations. All right, so If you're good at quantifying market expectations, then you can see how much the stock price has already baked in the amount of money they expect— the market expects Kinder Morgan to make on its investment. Return on invested capital does not have to be immediate. It just has to be more than the cost of that capital. That's why discounted cash flow models are around. Everyone bashes discounted cash flow models. Oh, I can't predict next quarter, much less 3 or 4 years. That's not the point. The point is quantify the market's expectations. Quantify the market's expectations. Because if you don't have different expectations from the market, you shouldn't be investing. Right? So if the market's expectations for KMI are super high for future returns on invested capital, Well, then maybe all the benefit of that investment is already priced in. If they're low, maybe it's not. So let's take a look. We'll open the model. You can see that the market implied growth appreciation for KMI is only 7 years, not that long, right? Let's take a look at what kind of future returns on capital are being baked in. When you look at more detail, Right? They've only got to grow at 5 or, you know, 6% with basically almost no improvement in return on capital for 7 years. Well, we can model different scenarios, right? Return on capital is a function of margins, pre-tax margins, tax rates, working capital, fixed asset needs. And in our models, you can forecast along all of those Metrics, which is critical. So if you believe that the margins will be steady, it's our neutral scenario. And they will— company will need less capital in the future because we've got a pretty heavy— Right? We can model that. Margins stay steady, need less capital because they're going to earn good returns. Save that. And you can look at returns historically, return on invested capital. This is what we've seen historically. And our neutral scenario has return on capital going up compared to where it's been, right? When you run these models out way far, things get bigger and they get large, you know, all that stuff. Don't worry about that. We probably don't want to have a 20% revenue growth rate in our neutral scenario here. Let me knock that one down. Don't worry about how far out you have to forecast because look, the market is already looking into the future. Our job is to get a sense of what the market is saying about the future, right? So we'll just go with what consensus is here, is what we leave— usually leave in our models. Keep it simple. So return on capital is going to go up. Growth is going to be roughly in line with consensus, right? And as soon as this saves off, we can look at the results of the neutral scenario. And what we'll see is, you know what, the stock looks pretty cheap. Based on those forecasts, the company only needs 2 years of profit growth, right? If we think the stock's worth $30, what kind of expectations does that mean that we Are implying about the future performance of the company. 9 years growing at 5% with not that big an improvement over existing returns on capital. So the answer to this question is, if you believe in the business and they're making a good investment, then it's a good idea. The return on capital— it's a cheap stock, and the return on capital in the future doesn't have to be that much higher than what it's been in the past. If we were to divide— another question. If you were to develop a compensation plan that aligns interest with shareholders, where would you begin? Begin with return on capital. Make it a clawback too. Make them have to bank their compensation over several years. Is it bad to pay executives in company stock? It depends on what kind of executives they are. There's a lot of things you can do to pump the stock in the short term and leave shareholders holding the bag. Think about how much executives got paid for the Men's Warehouse acquisition. Right? We did a special case study on this one recently. Special offers. You know, the big story here was that Men's Warehouse executives turned down an offer when Joseph A. Banks wanted to buy them for $48 in cash, for $48 per share in cash, right? They turned that down. A month later, they put together a deal that's now resulted in the stock being at $18 a share. They cost shareholders over $1.5 billion. And guess what? The executives got a big bonus. CEO of Men's Warehouse? His pay increased by 167% to $9.7 million. Okay? He got paid a big bonus, made more money, investors lost money. That's an issue. Are the issues at companies like Valeant more widespread and common? Yes. Anytime you see a company trying to sell you on non-GAAP earnings, I would get out of the way. Why focus on numbers that don't represent, represent your real profitability if you don't care about real profitability? If you care about profitability, you should talk about it. If you want to hide from it, bad sign. How can a company like MNST High return on capital, false positive. Now, net income's still going up faster than economic earnings, so kind of a red flag. So even though they got a really great business model, net income is still going up faster than economic earnings, and we think that's a little bit shaky, a little bit fishy. And the valuation's gotten ahead of itself here a little bit too. So, you know, we see a lot in the markets these days is companies focusing on non-GAAP earnings Focusing on, on GAAP earnings too. They're just trying to do everything they can to focus you on something besides cash flows. And really, the biggest common denominator between GAAP earnings and non-GAAP earnings is that both overlook the balance sheet. They overlook CapEx, they overlook acquisitions, they overlook off-balance sheet debt, they overlook taking on debt to fund negative operations or unprofitable operations. They don't look at what you need to understand To get to the real cash flows. And companies take advantage of that to make themselves look more profitable, to pump their stock up, to get a good bonus. Why not focus on return on invested capital? We make it easy and available across over 3,000 companies. Part of the reason we're doing these case studies on things like American Express and GE and Oracle and more is to show how— where our model works for our consulting partners. Return on invested capital effectively provides a more transparent link between corporate performance and valuation. Simple as that. A link that should have always been transparent, but it's become cluttered over the years. Why? Because it's a whole lot easier to sell stock when people don't really need to know the real profitability. Know what I mean? Used car salesmen don't encourage you to look under the hood unless they're confident that it looks good. I'm not saying every Wall Street guy is a used car salesman. I'm just saying people aren't afraid to be transparent if they're not afraid to show you what's behind the superficial stuff. They're forthcoming with their numbers. It's intuitive. It makes sense. Thanks very much for joining me today. Appreciate your attendance. If you have any further questions, feel free to email us at research@newconstructs.com or support@newconstructs.com. We're publishing a ton of great stuff. We got a Danger Zone idea every week, long ideas not quite as often, but they're coming out as coming out well or very often as well. And then we've got great work on mutual funds and ETFs. We're actually looking at the underlying holdings. All this diligence I'm talking about. On individual companies, we do across 3,000. Well, we do it for 7,000 mutual funds and 400 ETFs because we have— we cover enough companies that we're able to cover all the holdings or the majority portion, large majority portion, 70% or more of the capital and the holdings of funds, and therefore give you a rating on funds that's just like a rating on a stock. It's an aggregation of our data on all the stocks that mutual fund holds. And the ratings that that mutual fund would get if it were just one big company that had aggregated all the financials of all the companies it holds. So super transparent, a much better perspective, not just on individual stocks, but also on mutual funds. Thank you again.