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How are companies governed?
By Nadia Van Der Merwe
When you invest in equities – either directly or through a unit trust – you become the part-owner of the business. Nadia van der Merwe explains the role of a business owner in public companies.
A company is an institution that consumes various types of resources, including skills, time and money (capital), to produce various outputs, including the profits made from providing a service or selling goods. When they need extra capital, for example to build a new factory or buy another firm or even just to expand their business, some companies choose to offer shares to the public as a way to raise money. Companies that have many shareholders usually list their shares for trading on a stock exchange like the Johannesburg Stock Exchange (JSE) and are referred to as public companies. This helps their shareholders to buy and sell shares more conveniently and safely.
The mechanics of a company
In exchange for providing capital to fund the business, shareholders require an acceptable return on their investment and to have confidence that the business is being managed with their interests in mind. Just as a passenger in a car needs to know the direction it is headed in and how well the journey is progressing, shareholders need regular information from companies in order to make good decisions about whether to stay on board. When things are going wrong, or when it looks like the car may cause some damage to others, shareholders can jump out or they may try to replace the driver. If the company needs to be fixed, the shareholders may need to contribute insight or additional capital. An investor who is simply a passive and unskilled passenger is not in a good position to exercise their rights and fulfil their responsibilities as a shareholder.
Most public companies have thousands of shareholders. Running a company with a committee of thousands would be impractical, so the ultimate responsibility for the strategic direction of a company is vested in a board of directors – with the biggest shareholders stepping in if a situation warrants it. Shareholders are responsible for electing directors to the board by voting them in at the company’s annual general meeting (AGM). The board is generally made up of non-executive directors (people who are not employees of the company) and a few executive directors. Usually about a third of the board is required to stand for re-election at any given AGM. Executive management’s task is to execute the strategy set out by the board, which means managing the company on a day-to-day basis, providing regular updates and reporting to the board as well as the shareholders.
To extend the analogy: The board picks the destination of the car, which route it wants to take to get there, and whether it wants to get there in a hurry or not (i.e. how much risk it wants to take). It is then up to the executives to implement this plan – that is, to do the day-to-day driving and maintenance to ensure the car gets to where it needs to go.
Importantly, the board decides how best to incentivise executives to do their job and also monitors their performance. Each year, shareholders are allowed to vote on the company’s executive remuneration policy and remuneration report at the AGM, but these votes are not binding. Nevertheless, most boards make changes to improve the policy if less than 75% of the votes are in favour.
What is our role?
As investment managers, we search for companies for our clients’ investments whose share price is below what we consider to be the true value that the business will realise over time (the intrinsic value). The company could be undervalued for many reasons, such as market sentiment, a downturn that is unrelated to its operational strength, or perhaps that it has temporarily lost its way. To really stretch the analogy, this is a bit like looking for a car that has a reliable or powerful engine but may have some scratches on the paintwork, an unfashionable look, or taken a small detour from the main road.
Sometimes a company may be suffering from institutional problems, whether it is a board that is misdirecting the company or a management team that is not managing risks effectively. On occasion, these problems may require intervention from shareholders, like us, to ensure that the company is creating value as it should.
Our role as shareholders on your behalf is to help appoint the board to steer the company towards better returns and sometimes to suggest mechanical changes that may help improve its running. This may involve helping with remuneration policies that align management’s interests with that of the investors, engagements with the executive team, voting according to our recommendations at AGMs or written communication.
How does this affect you?
If things go well, the company may be able to pay some of its profits back to shareholders as dividends. Dividends are usually only paid if the company has sufficiently invested for the future. The other way you get returns is if the share price rises to a point where we can sell it for a higher price than you paid for it, thereby making a profit. Both of these ultimately rely on the mechanics of a company being sound: The board needs to provide a plan, the executives need to execute it, and shareholders must hold them to account.
It is important to remember that the ultimate owner of the investments we make is you. When engaging with management or the board on your behalf, or making voting recommendations for resolutions at company AGMs, we do so in the best interest of our clients with the ultimate aim being to maximise long-term shareholder value.
Our annual Stewardship Report, which is available on our website, provides an overview of our engagements with companies.