Moneyball Corporate Governance: making the best use of what limited capital is available – just like what the Oakland A’s had to do with their limited payroll.
In the mid-1980s, New York Mets manager Davey Johnson was among the first in professional baseball to realize the advantage that could be gained by using computers and statistics to help select the team members for any given game, the order in which he played them, and even which specific pinch-hitter to use in a given situation. Under his leadership, the New York Mets won the 1986 World Series, Major League Baseball’s championship series.
The more widely known Moneyball story, made famous by Michael Lewis’ book and a movie starring Brad Pitt, takes place nearly 15 years later. It tells a similar story – of using analytics and probability-based decision-making to successfully discover hidden value in both players and collections of players. In that story, the focus of the analytics is on maximizing player and team performance relative to the constraints of the Oakland Athletics’ very limited payroll.
In essence, Davey Johnson and the heroes of Moneyball, Billy Beane and Peter Brand, used their analysis to try to re-shape the distribution of possible outcomes from the individual decisions that they made. They were seeking a better overall result — exactly what every organization does. But, rather than more typical seat-of-the-pants analysis, Johnson, Beane, and Brand used mathematical probabilities to supplement their innate talents. And, a better-than-expected outcome is exactly what their organizations realized.
What relevance does this have for investment managers? The concept of my company’s work was recently described to me as “Moneyball for Corporate Governance.” (Credit for this expression goes to James McRitchie during a conversation he and I had in February 2017 and which prompted this article.) I think that captures the spirit of it quite well. In the book that I wrote back in 2012, Governance Reimagined: Organizational Design, Risk, and Value Creation, I describe in detail how organizations take risk and inter-relate with the members of their “social network.” Governed well, organizations can consistently be on a path towards better-than-expected outcomes. The concept that runs through the book and my work is one of making the best use of what limited capital is available – just like what the Oakland A’s had to do with their limited payroll. But, in the case of the companies on which I focus, the constraint they face is on something called risk capital – the limited and sometimes costly fuel that gives a company the ability to pursue its goals.
Risk capital is a term that is perhaps more familiar to risk managers than to corporate or investment managers. It’s the limit on one’s capacity to make investments while not threatening an organization’s or a portfolio’s existence. The traditional notion of diversification among investments is all about making better use of risk capital through the insulation that diversification theoretically provides.
For the sake of brevity here, I’ll reference two other pieces that I have written on re-shaping the distribution of outcomes from any organization’s work to be more to their liking. [Risk Management — Reshaping the Distribution of Outcomes, Not Just Modeing Them, Intelligent Risk, May 2012 and The Human Reaction to Risk and Opportunity, Chapter 2 in New Frontiers in Risk Management, Olson and Wu, Springer, 2008.] But, for publicly traded companies, the notion of reimagining governance towards better probabilistic outcomes comes through the better governance of risk-taking — better risk governance – which leads to higher returns for their owners and other members of their social network.
Most publicly traded companies are reasonably good at what they do. If they weren’t, they’d never have reached the stage of success to be able to raise capital from the public. Their efforts do not result in random outcomes; they tend to be better than the flip-of-a-coin gamble. Statistically, we’d describe most companies as generally having a positive mean expected outcome and a positive skew to the distribution of expected outcomes. This is the source of advocacy for both the buy-and-hold and index investing strategies.
But, we know that such a statement does not apply to all companies in which one can invest. Some have much more positively skewed distributions that bring home, from time to time, “World Series” trophies. Think Google. Remember when it used to be just a search engine? Soon you’ll legally and responsibly be able to use that search engine — or, more correctly, the products of Google’s parent company, Alphabet — while your car drives you to work. And, Alphabet currently has a market value of over $500 billion.
In comparison to a random, coin-toss-bet, the distribution of possible outcomes of your investment in well-governed companies looks like the graphs below. We refer to these kinds of companies as being resilient, as they are adept at managing change, both expected and unexpected.
Their expected value is higher — they are worth more and they require less of your portfolio risk capital to own. They are the Oakland A’s of Moneyball fame.
But, there is also the flipside: the companies that poorly govern their risks are subject to more problems that emerge unchecked. They are subject to more negative surprises. These organizations are more likely to alienate key members of their social network who determine their success. They are brittle; hence, their distributions are negatively skewed and have longer tails in terms of potential losses. They have lower expected values and make poor use of risk capital. As a result, a portfolio requires more risk capital (for the same probability of loss) to be assigned to them, limiting that portfolio manager’s ability to further diversify or invest in better entities. These investments destroy portfolio performance – unless you are short such companies.
Poorly governed companies can experience single risk events, such as earnings disappointments or loss of key clients. Or, they can be harmed by more slowly accumulating exposures like accounting frauds, unremedied environmental issues, or the exposures of the sub-prime crisis. Whatever the case, these surprise negative events are reflected in large negative price shocks to their publicly traded stocks and losses in the portfolios of investment managers who were their owners or proxy owners.
Differentiating poorly governed companies from well-governed ones is the crux of good portfolio management. Adopting a model for governing companies that makes better use of risk capital makes those companies into good investments. There is a very virtuous circle here: better performance leads to reduced costs of capital, both on debt and equity, and better outcomes for owners and proxy owners. A lower cost of capital yields greater profitability and more ability to pursue corporate goals. Investing to govern risk well is a win-win proposition. It’s Moneyball Corporate Governance.
Surprisingly, the analysis of risk governance at publicly traded companies is not widely adopted by either portfolio managers or corporate managers. Further, boards sometimes have innate skepticism that “improving corporate governance” is just an activist’s euphemism for a raid on their status. But, better risk governance leads to discovered value at both well and poorly governed companies.
In 2016, the internal portfolio that I run using our good/poor risk governance differentiating methods, along with active portfolio risk governance, produced a risk-adjusted return that exceeded 99% of the 125 funds against which we benchmark. Those funds included Large Blend, Balanced, Low Volatility, and Socially Responsible funds. It also bested long/short hedge fund indices from Credit Suisse, HFR, and Barclay, along with a theoretical “moderate risk” portfolio of stocks, bonds, and T-bills.
We don’t presently offer outside management of investments. In lieu, my company’s work now includes Director Search and Education – services for boards that are designed to foster the better use of risk capital by both publicly traded companies and investment managers. We work with activist investors and companies looking specifically to enhance the governance of risk at the board level by finding and placing Qualified Risk Directors on their boards. We work with portfolio managers looking to better understand the difference between what the market might think of a company’s prospects and what we believe the distribution of possible future outcomes to be. Sometimes there is a surprising dissonance and their portfolios can be improved by incorporating that knowledge.
When looking for a baseball player, Billy Beane might ask, “Who can hit a curveball?” In portfolio candidate review, we look for companies that are more likely to be able to adapt to unforeseen opportunities and events – economic curveballs. They will have demonstrated the ability to avoid tail events and will have clearly articulated their risk governance culture through infrastructure and board committee charters. The oversight of corporate risk will feature prominently in key charters, rather than far down the list of responsibilities for an over-worked Audit Committee. Taking this further, we’d give more value to companies that have separate risk committees of the board or even a Qualified Risk Director as a member of that board. [Are Board Risk Committees Becoming a Fiduciary Expectation?, Risk Watch, Conference Board of Canada, December 2010.] MSCI and Sustainalytics, both governance-rating agencies, now include an adjustment to the scores they give to companies based on whether there is risk governance expertise among directors.
Billy Beane might also ask, “Who’s a franchise prospect?” In other words, who is a player to add to the team that is going to generate value for a long time? In portfolio candidate review, we’d look for sustainable and ongoing Economic Profit, among other factors, particularly looking for situations where a company’s prospects have not yet been fully priced-in, or, where their risk is perceived as being higher than we believe is warranted.
And, we’d be very wary (read: short) of a company with these characteristics:
The chart above shows a growing divergence between the company’s actual Economic Profit and its market valuation. The chart on the right demonstrates both our internal market-implied governance metric (MIGM) – what the market has priced-in in terms of risk governance — and our overall assessment of the company’s financial, environmental, social, and structural governance practices. In this illustration, the cumulative assessment by the market is very positive in relation to the distribution of governance assessments at nearly 1,200 other publicly traded companies. Our assessment is bleaker. As a result, this particular company ranks among the worst in terms of risk to a loss in value. If this were a long position in your portfolio, the amount of risk capital we’d suggest you assign to it would dwarf its upside potential. Trade it for another player, or, in the very least, buy some performance insurance.
You can think about companies in your portfolio, or business lines at your company, much like the players on a baseball team. Billy Beane and Peter Brand felt that a metric called “on-base percentage” was a good predictor of success, as Economic Profit is viewed in our models. The pivotal player in the book Moneyball is arguably Scott Hatteberg, who was remarkable for his on-base percentage. Thought to be a washed-up player due to an injury, Beane recruited him and had him play first base, even though he’d never played the position before. If you’ve seen the movie or read the book, you’ll know that was a good decision: Hatteberg hit the memorable walk-off home that won the A’s major league record 20th game in a row. [Moneyball: What ever happened to Scott Hatteberg?, Jerry Garrett, September 26, 2011.]
Back in 1984, Davey Johnson of the Mets used on-base percentage when he decided to make a change in the batting order, moving a player named Mookie Wilson from the leadoff spot to a position later in the lineup. This change from the season before produced demonstrably profitable results in 1984 and, more memorably, just a couple of years later. [Davey Johnson, The Mets, and Sabermetrics, Misc. Baseball.]
Yes, that’s Mookie Wilson at bat in the 1986 World Series – in his spot later in the batting order. The other pivotal player in this clip is Bill Buckner of the opposing team, the Boston Red Sox. The Red Sox chose to have Buckner play first base despite his ankle problems, which were known to become more acute late in games. The video is of a moment in “extra innings” – overtime in baseball. In other words, it takes place very late in the game. Watch it and see the impact of Davey Johnson’s probability-based decision and Boston’s choice to ignore the odds. (My apologies to Red Sox fans.)
In the end, if your investment portfolio — whether consisting of products that your company offers or of stocks and/or debt – can make better use of risk capital, i.e., realize better risk adjusted returns through probabilistic supplements to your innate talents, then perhaps one day someone as famous as Brad Pitt might play you in a movie! Or, let’s simply say that you’ll do your job better. That should be reason enough to play some Moneyball Corporate Governance at your company and in the management of your portfolio.
You might even start to feel like Mets fans felt way back in 1986.
David R. Koenig is the Founding Principal of The Governance Fund and the author of Governance Reimagined: Organizational Design, Risk, and Value Creation (John Wiley & Sons, 2012). He has held key corporate leadership roles that included the creation and development of risk management programs at three different companies, the management of complex, multi-billion-dollar portfolios, the risk oversight of a complete suite of mutual funds for one of the world’s largest banks, the development of the first firmwide risk management program in the mortgage banking business (1993), and as a founder and chief executive of one of the world’s premier professional risk management associations. Though the work of The Governance Fund, he has also guided the successful development of an international group of directors and executives focused on board-level risk governance that now includes members in more than 125 countries.
David’s work has been recognized internationally. In 2010, his idea, “Risk Capital as Commons” was chosen as one of the winners of the first M-prize for management innovation. He was selected as the recipient of the PRMIA Higher Standard award in 2008 – that organization’s top honor. In 2007, his industry peers named him as one of the first 100 members of the Risk Who’s Who international honorary society.
David has been a featured speaker at more than 75 events on four continents.
Disclaimer: No securities or investment advisory services are being offered. This report is for information purposes only and is based on the performance of an internally owned and managed individual account. No representation or warranty, express or implied, is made or given by or on behalf of The Governance Fund Advisors, LLC, or any of its members, managers, directors, officers, employees, agents or advisers as to the accuracy, completeness, or fairness of any projections set forth herein. Past performance may not be indicative of future results. No representation or warranty is given as to the achievement or reasonableness of, and no reliance should be placed upon, any projections, targets, estimates or forecasts contained in this presentation or document and no such projections, targets, estimates or forecasts should be relied upon as a promise or representation as to the future performance. Therefore, you should not assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies contained herein), or product made reference to directly or indirectly in this report, or indirectly via link to any unaffiliated third-party website, will be profitable or equal to corresponding indicated performance levels. Any projections herein have been prepared by the company based on their reasonable belief and best estimates and judgments currently available to them. The projections are not predictions of fact and should not be relied upon as being necessarily indicative of future results. Investments involve the risk of loss. The variability of returns in the future may exceed those discussed herein. Pro-forma adjustments have been made for comparison purposes to equate the portfolio performance to that of a portfolio with an annualized expense rate (fees plus commissions paid on trades) of 150 basis points of the average account balance.