I think investors often overlook the role of directors in company management. It's very easy for us to willingly believe that directors have the best interests of both the company and its investors in mind, but most of the time, that is just not the case. Even if experienced individuals manage the company, these managers and directors may not see eye to eye, which might cause problems.
Company directors and company managers have two different roles. The directors are supposed to represent the interests of shareholders, while the executive managers, such as the CEO and chief financial officer, are responsible for running the business on a day-to-day basis.
Both of these parties really need to have shareholders' best interests in mind because, more often than not, directors do not act against managers if they believe they are making the wrong decisions for the business. As for shareholders, we often get bulldozed over for the profit of both directors and executive managers.
There are two main reasons why directors need to have shareholders' interests in mind, as the Oracle of Omaha, Warren Buffett (Trades, Portfolio), explained in 2006 at the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting.
As the CEO of Berkshire said at the time, boardrooms are partly business-focused and partly social-focused. More often than not, directors are more interested in social climbing than the correct management of the company, which means they are not inclined to act against managers who may not be following the right path.
This can be a disaster for investors who end up investing alongside a board of directors that are more interested in social climbing than sensible business management. Directors need to be able to hold managers to account if they make poor acquisitions or misuse shareholder funds.
Buffett's advice for finding those businesses that have directors with shareholders' best interests at heart was to focus on finding boards that think like owners. Specifically, he said:
"The question is to what extent do the people that are participating there think like owners, and whether they know enough about business so that even if they're trying to think like owners, that their decisions will be any good."
One of the easiest ways to determine if boards are working in the best interests of shareholders is to analyze how many shares directors actually own and if they have been purchasing shares in the market in addition to option awards.
Most of the time, the majority of directors' interests come via option awards, which doesn't really indicate any belief in the business as these have been acquired with little or no personal cost to the director.
Buffett went on to say in 2006 that:
"The only cure to better corporate governance, in my view, is that the very large shareholders start really zeroing in on whether those questions I just mentioned are being addressed properly. If they go on to all these peripheral issues, you know, they have a lot of fun and they get in the papers. You know, they have little checklists and they can issue grades and all that. It isn't going to do anything in terms of making American business work any better."
An engaged shareholder base is the most important factor that can influence directors' decisions. There are many ways a shareholder base can become engaged with company management.
Activist investing is possibly the most common, but there have also been plenty of examples where former founders, who have stepped back from running the company on a day-to-day basis but still own a large stake, are willing to use their influence to drive better outcomes.
And of course, the easiest way to see how much of an impact shareholder ownership will have on director outcomes is to analyze how much of the business the directors own in the first place. It could be something to keep in mind when looking for potential investments.
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