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The Importance of Corporate Governance for Successful Income Investing

July 23, 2013 | About:
Everyone’s actions are typically driven by self-interest. That is what has generated strong growth in the world economy over the past two centuries. Sometimes however, different individuals might have actions which might not be in the best self-interest of the people they work for. I am referring to the issue of corporate governance in many of today’s corporations.

The issue is that the goals of managers and shareholders might differ. Managers for example might be compensated based on total profits or total sales. As a result, they might end up pushing for acquisitions of businesses that might deliver short term boosts in these key metrics, but might end up being disastrous for shareholders wealth. Other managers might prefer to allocate excess cash to repurchase stock rather than pay a dividend, in order to increase share prices that would make their incentive stock options more valuable. A third group of managers might even attempt to manipulate accounting records in order to inflate profits and collect their fat performance bonuses.

One thing that could reduce the incentive by managers to do the above mentioned actions is to closely align their performance compensation structure with the actual performance of the business. This is an extremely difficult task to do, and there are countless studies by researchers and highly paid consultants that have spent hours upon hours studying the issue. The answer however could sometimes be very simple.

In my studies of successful businesses, I have noticed one very interesting phenomenon when it comes to corporate governance. This corporate governance situation closely aligns the compensation of managers with the well-being of the enterprise. The situation occurs when a majority shareholder in a company is also in charge of steering the business in the right direction because they are the CEO. Some great examples include Warren Buffett, who took over management of then struggling Berkshire Hathaway (BRK.A) in the 1960s, and then transforming it into a highly successful diversified conglomerate fifty years later. His initial investment of several million dollars has been compounded by the Oracle of Omaha’s investment genius into roughly a fortune worth $40 billion dollars today.

Another example of successful corporate governance by the founder/CEO is Microsoft (MSFT). He had been able to grow the company from a small software start-up in the 1970s, to one of the largest companies in the world by the time Bill Gates retired in 2000. He is a prominent philanthropist these days, but I am not overly bullish on Microsoft's stock.

My favorite CEO currently includes Richard Kinder, who is in charge of managing Kinder Morgan Inc (KMI). All of his wealth is invested and derived from his ownership of Kinder Morgan shares, which own the general partner and some limited partner units in the Kinder Morgan (KMP) and El Paso (EPB) pipelines. Richard Kinder founded Kinder Morgan with assets from Enron in the 1990s, after having a falling out with then managers of the high-flying energy trading company that later went bust. His salary is $1/year. He does however collect millions in dollars in dividends from his investment in Kinder Morgan however.

My other favorite CEO was John D Rockefeller, one of the original robber barons, who founded Standard Oil in 1870. His company was split into several companies in 1911. Many of today’s largest oil companies in the world such as Exxon Mobil (XOM), Chevron (CVX) are descended from these companies. John Rockefeller was famous for saying: “Do you know the only thing thay gives me pleasure? It’s to see my dividends coming in

My third favorite CEO was the founder of Wal-Mart Stores (WMT), Sam Walton. Starting the company in 1962, he revolutionized retail in America. His company managed to beat out larger rivals at their own game, through constant focus on cost containment and trying to become the lowest cost provider in the industry. By keeping costs low, the company is appealing to customers to the tune of 100 million visits every single week. This repeat business translates into dividend growth for more than 35 years, The company focuses on turnover, and usually sells most of the merchandise it ordered by the time it has to pay suppliers. Sam Walton thought like an owner however, as he not only expanded at a furious pace, but he also paid an ever increasing dividend only a few years after taking the company public. Check my analysis of Wal-Mart Stores.

To summarize, I have learned that there is often a strong link between having a strong visionary leader at a company, who is also a majority shareholder. This leader usually sees this business as their legacy, and they are very passionate about growing and preserving that legacy. This aligns their goals with the goals of ordinary shareholders to a certain extent. In the cases of the visionary founders listed in this article, shareholders benefited handsomely by the arrangement. By identifying someone who is passionate about their work, and has a majority ownership interest in that enterprise, investors would be wise to buy that stock.

Full Disclosure: Long KMI, CVX, WMT

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