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Digging deep It’s not just about the numbers...
Jeremy Bolland Supervisory Analyst and Securities Research Consultant Author of “Writing Securities Research” (John Wiley & Sons) Tel: Hong Kong (852) 9176-0389 / E-mail: [email protected]
July/August 2012 © Jeremy Bolland
13 August 2012
13 August 2012 2
Content: Reasonable basis for opinions
Why should I buy (or sell) this security?
Clear and consistent investment case
Based on verifiable facts and reasonable assumptions
Difference from consensus
Changes to views
What are my risks?
The greater upside/downside to TP the greater the need to balance with risks
What catalysts/events would prove analyst right/wrong?
Sensitivity tables, scenario analyses
Corporate Governance and Sustainability issues gaining importance
13 August 2012 3
Benefits to analysts of highlighting risks
Avoid regulatory action
Avoid fines; suspension of business
consequent reputational risk; loss of client trust
Use as research reference
By including sensitivity tables, scenario analyses, risks in published research, analysts can refer back as events unfold rather than having to produce new research
Attract media attention and gain trust of clients
Clients burned, eg Chinese IPOs, RTOs in US
Nouriel Roubini’s “perfect storm”, 2011
13 August 2012 4
Case: Drawing attention to risks
Global Research Analyst Settlements, 2003-2007
Insufficient risk disclosure
Bear Stearns
US: Fined US$1.5m by NYSE for offences, Feb 2006
Charges included improper communications during IPO roadshow: “Neither the analyst’s introduction nor any of his comments during the question and answer period included any discussions of the risks associated with an investment in the company” (NYSE)
Credit crisis, 2007/8
US: HSBC agrees to FINRA fine of US$375,000 and pay restitution of US$320,000 for not explaining CMO risks to investors, Aug 2010
US: Global investment banks settled with SEC regarding miss-selling of auction-rate securities as safe cash-equivalents, 2008
Global: Cases stretch from Japan (Higashimatsuyama) to Australia (Wingecarribee Shire Council et al) to Norway (Narvik in Arctic Circle) to Hong Kong and Singapore (minibonds)
13 August 2012 5
Relevance of CG for research analysts
Correlation between CG and stock market performance
Strategy that bought firms in lowest decile of “Governance Index” of 1,500 firms (where shareholder rights were strongest) and sold firms in the highest decile would have earned abnormal returns
Firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capex, and made fewer corporate acquisitions Corporate Governance and Equity Prices, Feb 2003 Paul Gompers of Harvard, Joy Ishii of Stanford, Andrew Metrick of Yale
Growing interest among institutional investors
United Nations Principles for Responsible Investment, 2005/06
UK Corporate Governance Code, Jun 2010: comply or explain UK Stewardship Code, Jul 2010: “aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities” Expanding list of signatories: Fidelity, Templeton, Capital, BlackRock, hedge funds etc
13 August 2012 6
Relevance of CG for research analysts
FTSE4Good rating system, FT Apr 6, 2011
"The key innovation is identifying companies at risk that aren't managing that risk" Craig Mackenzie, head of sustainability, Scottish Widows Investment Partnership
“It’s about identifying torpedo stocks – stocks that, if they blow up, will do great damage to your portfolio" Helen Wildsmith, head of ethical and responsible investment, CCLA IM
13 August 2012 7
Company perspective – CG a matter of self-interest
Twin aspects of good CG
Avoiding negative “goodwill”, eg through risk management, quality control
Creating positive “goodwill”, eg among employees, customers, business partners
Upward spiral
Increased brand awareness
Increased sales turnover, repeat business
Reduction in staff turnover, increase in motivation/productivity
Lower cost of capital
Avoidance of fines, penalties
Increased profits
Creation of shareholder value
Higher share price
…or downward spiral
13 August 2012 8
Public perception of analysts’ CG coverage
Way to assess the future of a company
Know its controlling shareholder
Questions to ask
Who is the boss?
How did he/she make the first bucket of gold?
Is the boss strapped for cash?
How well has he/she treated the minority shareholders?
Comment
“…in most cases, you are not going to find the answers in any research report” Shirley Yam, “Money Matters”, SCMP, Nov 6, 2010
13 August 2012 9
Analysts need to address CG
Securities Analysis
Not just analyzing numbers, but also assessing people and identifying risks
CG issues, dividend payment have become more important
Alignment of management and shareholders’ interests
Breadth of ownership
Performance-related remuneration, expenses
Management’s treatment of all stakeholders
Shareholders, creditors, employees, customers, trading partners, society
Fairness, integrity, transparency, accountability
History of CG issues, ethical culture and risk management resources?
Source of info, clues
Rankings: By country (World Bank); company (GMI, EIRIS-FTSE)
Press coverage, industry awards, customer loyalty, staff turnover
Accounts, disclosures, ROE, dividend payout, auditor/director turnover, proxies
Lawsuits, complaints, case studies…
13 August 2012 10
Note – All fines against co are CG fines
Fines against company are fines against shareholders for actions by directors
US: Bank of America
BoA agreed with SEC to pay fine for misleading shareholders over bonuses before its acquisition of Merrill Lynch, 2009
District judge rejected initial settlement querying why the company (ie the shareholders) should pay fine for acts that execs had committed – after all, it was the shareholders who were the victims to start with
“…half-baked justice at best”
HK: Citic Pacific
Raided by CCB April 2009 over unauthorised currency speculation; after delaying disclosure of loss for 6 weeks, chairman and MD resigned
“A co is its shareholders. The shareholders are the co. Yet the co is…using shareholders’ funds to defend a prima facie case of fraud” Richard Turnbull, DoJ prosecutor (SCMP, March 19, 2011)
13 August 2012 11
CG issues in practice
Case studies
Social responsibility
Fair disclosure
Executive insider trading
Accounting irregularities
Antitrust, cartels, price-fixing
Lying to shareholders
Executive compensation
Poison pills in M&A
Related-party transactions
Vote-rigging
Independent non-executive directors
Money laundering, terrorist-financing, bribery & corruption
13 August 2012 12
Case study: Social responsibility
First Consumers International World Congress, Sydney 2007
Most unethical “winner”: Takeda Pharmaceuticals, for advertising in US its “back-to-school” Rozerem sleeping pills for kids, without health warnings
Coca-Cola (Dasani tap water)
Kellogg’s (cartoons and product tie-ins for sugar-dense cereals for kids)
Mattel (shifting blame over lead-based paint in toys)
Other recent cases
News Corp, BP, Toyota, Chinese milk companies (melamine scandal)
GlaxoSmithKline pleaded guilty to illegally marketing drugs and withholding safety data; agreed to pay US$3 billion in “largest health-care fraud settlement in U.S. history”, July 2012
Note
General conclusions: reputational risk, regulatory & legal risks, management resources
13 August 2012 13
Case study: Fair disclosure
Singapore: “OCBC snubs Morgan Stanley over ratings” (FT, Oct 2007)
MS analyst had never rated OCBC “buy” since initiating in 2004
He had questioned the bank’s attitude to CG in a research report
OCBC decided not to invite him to briefings with senior executives
Other instances
CLSA analyst accuses Citi of shutting him out after he criticised the bank; CLSA and Oppenheimer analysts accuse Forest Labs (Reuters, Nov 2010)
Notes
Technically may be fine for OCBC if not disclosing PSI, but is it good CG?
OCBC’s actions proved the analyst’s point
Clients more inclined to trust analyst who sticks to his guns?
13 August 2012 14
Case study: Executive insider trading
France: EADS
Criminal case that insiders sold shares ahead of disclosing about Airbus delay
Indonesia: Perusahaan Gas Negara (PGN)
Bapepam fined 9 former execs total of IDR3.2b in Dec 2007 for trading PGN’s shares prior to letting the market know about a delay in a pipeline project
Earlier some of these execs and the company itself were fined for not disclosing key info to shareholders
Singapore: China Aviation Oil (Singapore)
To raise funds CAOHK (holding co) placed CAO shares with Deutsche Bank while in possession of PSI about petroleum derivative trading losses of US$500m at CAO
CAOHK settled insider trading charges with MAS, Aug 2005
CEO jailed for 51 months, ex-head of finance for 2 years
Notes
Inexplicable stock price moves ahead of announcements might indicate how leak-proof the board is
13 August 2012 15
Case study: Accounting irregularities
Plenty of cases
WorldCom, Tyco, Enron, Mirror, BCCI, Ahold, Parmalat…
US-listed Chinese IPOs, RTOs, eg Sino Forestry, China Energy
US: WorldCom
“The news of WorldCom’s massive accounting fraud had shocked me to the core. How could I have missed it? …if I had been less analytical and more intuitive,…I might have better understood WorldCom’s addiction to acquisitions and, perhaps, aggressive accounting methods to fuel its continued growth” Daniel Reingold, “Confessions of a Wall Street Analyst”, 2007
US: Sino Forestry
“If changes in fair value of plantation assets less costs to sell were not taken into account, we would have had losses for the years to 31 Dec 2006, 2007 and 2008…” China Forestry offering doc footnote, Jake van der Kamp, SCMP, Feb 8, 2011
13 August 2012 16
Case study: Lying to shareholders
US: Vivendi in US’s largest securities class action going to verdict
Investors lost US$bs when share price fell from €84.70 to €9.30 (2000-2)
“We had 57 statements that we claimed were false, and the jury found that 57 statements were false” (Bloomberg, Jan 2010)
Potential claim could be up to US$9.3b
Vivendi had agreed in 2003 to pay US$50m to settle SEC fraud charges, and CEO agreed to US$1m fines
US: Citigroup
Fined US$75m by SEC for misleading disclosures about exposure to subprime assets, July 2010
Former CFO and former head of Investor Relations also fined
13 August 2012 17
Case study: Antitrust, price-fixing, cartels
Plenty of price-fixing cases
Air cargo fuel and security surcharges: Air France-KLM, British Airways, SAS, Cargolux, Cathay Pacific, Singapore Airlines, Air Canada, Lan, JAL, Qantas: €800m, Nov 2010 (Lufthansa – the whistleblower – not fined)
18 airlines fined US$1.6b by US authorities, with criminal charges against 14 execs for price-fixing (Bloomberg)
LCD: LG Display, Sharp, Chunghwa Picture Tubes: Epson Imaging Devices, unit of Hitachi, Chi Mei Optoelectronics: US$860m, 2008/9
SRAM chip: NEC, Renesas Tech, Micron Tech, Hynix Tech: US$25m, Jan 2010
Air France-KLM
€339.6m (following €330m in fines/class-action awards in US, Canada, Australia)
Intel
€1.06b by EU, May 2009; US$1.25b to AMD, Nov 2009
Notes
Affect on other securities, eg AMD’s share price
Class-action suits/damages
13 August 2012 18
Case study: Executive compensation
Global: Financial crisis, 2008
Shareholders in major banks lost while CEOs walked away with huge payouts
US: Lehman
£4.4b transferred from London to NY just before bankruptcy filing; US$2.5b set aside for bonuses for senior managers, while no guarantees for UK employees
US: Merrill Lynch
NY Attorney General Cuomo accused ML of secretly accelerating US$3.6b bonuses just before reporting loss for 4Q 2008. Four execs shared US$121m; nearly 700 had US$1m each
This was after ML had received TARP assistance
BoA, which acquired ML, agreed to pay US$150m as a penalty
Note
Shareholders shafted twice!
13 August 2012 19
Case study: Poison pills in M&A
Japan: Bull Dog Sauce (June/July 2007)
Activist hedge fund, Steel Partners, launches unsolicited takeover bid for remaining shares it didn’t own
BD board seeks to prevent takeover by issuing 3 warrants for every share, convertible into shares for all holders except SP, who would receive cash
SP seeks injunction - unfair
District Court denies injunction; High and Supreme Courts reject SP’s appeal
SP determined to be an “abusive” acquirer; cash deemed to be economic/fair
US: JC Penney (Oct 2010)
Poison pill after Pershing Square Cap Man and Vornado Realty Trust acquired stakes
Holdings would be diluted if they acquired more; other holders right to buy at half price
Notes
All shareholders are equal, but some are more equal than others? Discriminatory treatment in some markets, eg to protect company’s EV and/or stakeholders
13 August 2012 20
Case study: National interest
Strategic industries (resources, defence)
CNOOC failed to buy Unocal of US, 2005
Chinalco tried to increase stake in Rio Tinto of Oz, 2008; fear of Rio being taken over by BHP, which could force up prices of commodities?
Also food
Italian govt declared Parmalat strategic to fend off bid from Lactalis , Apr 2011
France declared yoghurt strategic when Pepsi wanted to buy Danone, 2005
China blocked Coca-Cola’s attempt to buy China Huiyan Juice
13 August 2012 21
Case study: Related-party transactions
India: Satyam Computer Services (Dec 2008)
Enraged shareholders by announcing it would spend US$1.6b to buy Maytas Props and Maytas Infra, both controlled by main shareholder; deal valued Maytas Props at US$1.3b, overvalued by US$1b
Chairman confessed to trying to fill US$1b hole in B/S
Co settled with SEC in US, US$10m; PWC affiliates settled, US$6m
China: Advanced Battery Technologies (Mar 2011)
2004 10K disclosure: “Related party transactions may occur on terms that are not favorable to Advanced Battery Technologies”
“The Chairman appears to have transferred ownership of ABAT’s key subsidiary to himself without explanation or compensation” Variant View Research website, Mar 2011
Notes
Extra scrutiny for transactions not at arms’ length
Behaviour may indicate underlying problems
13 August 2012 22
Case study: Vote-rigging
HK: PCCW’s privatization offer “clear manipulation” (Apr 2009)
Allegation that hundreds of Fortis insurance agents were being offered 1,000 shares each in PCCW in order to vote for privatization
(Fortis Insurance Asia formerly known as Pacific Century Insurance. PC Gp, controlled by PCCW’s chairman, sold its controlling stake in PCI to Fortis Insurance Asia)
SFC investigated, and three appeal court judges declared the offer “clear manipulation” that was against the interests of minority shareholders
13 August 2012 23
Case study: Independent non-executive directors
Singapore: Two Swissco INEDs resigned, Mar 2008
Exec chairman wanted all INEDs to serve one-year terms with renewal only at his discretion
Independence compromised
Notes
INEDs should be accountable to all shareholders, not management or majority shareholder
Analysts to look at reasons why directors resign
Not all compromised directors guided by their conscience
13 August 2012 24
Case study: Money-laundering, terrorist-financing, bribery, corruption
Plenty of cases, 2005-2012
HSBC investigated by US authorities, July 2012
IBM agrees to pay US$10m re Chinese and Korean contracts
Siemens fined €1.22b (US and Germany)
Aon fined £5.25m (incl payments made to 3rd parties in Indonesia)
Johnson & Johnson, Daimler, Credit Suisse, Lloyds TSB, ABN Amro, BoNY
Masawara prospectus to raise funds to invest in Zimbabwe (Citywire, Aug 2010)
“The group, and companies in which it invests, may in the future be the subject of government investigations and other accusations of corrupt practices or illegal activities, including improper payments to individuals.”
It advised that the fund cannot guarantee that rules designed to prevent this will be adhered to, and warned that crime could materially damage its finances
Notes
At least Masawara investors know where they stand!
Siemens rep said cost of addressing allegations was nearly as much as the fines
13 August 2012 25
Consequences and conclusions
Consequences
Management time – fire-fighting, management time/changes
Reputational risk – customer loyalty, staff loyalty
Legal/regulatory risk – fines and damages, not just locally but potentially globally
Conclusions
Fines against company are fines against shareholders for actions by management
Auditor’s job to follow the money, but analysts should still dig deep, ask questions, raise concerns, highlight risks
Ascertain whether company is devoting sufficient resources to risk management and spreading ethical culture
Not just about scandals/crises breaking, but how management deals with them
Caveat – be sure of facts to avoid defamation charges
13 August 2012 26
Investment implications
Research product
Apply premium or discount to valuations
Affect on other securities (competitors, suppliers, trading partners etc)
Highlight CG issues as risks (upside or downside)
Caveat: defamation risk
Research marketing
Basket of stocks with good CG to buy (Japan Pension Fund Association)
Basket of stocks with bad CG to sell (Tiger Asia Management)
Basket of stocks with bad CG to buy (activist funds, eg Lazard Korea CG Fund)
Basket of stocks for other SRI investors (eg green, Shariah etc), or others (eg CCBI’s China Policy Driven Fund)
© Jeremy Bolland
