Why do the biggest companies disappoint on governance?

Tesco’s high profile failure reveals the interaction between incentives, failed strategy and governance. Unfortunately, despite hiring what should be the best non-executives, the record shows the biggest companies have more governance blow-ups. What is it about the way that big businesses operate that makes them more accident-prone, not less?

Even the investors lucky enough not to own Tesco shares can learn something from it. Its strategic and accounting nightmare offers lessons for all. As the crisis unfolds, investors have a rare opportunity to lift the lid on a major FTSE company, and examine the psychology involved. Disappointingly, it follows a familiar pattern of setbacks in big companies.

The Tesco crisis may not match the BP and RBS disasters for impact, but there are some parallels. The story involves corporate hubris, poor governance, private jets, perverse incentives and excessive rewards despite strategic failure. There are even some similarities in aspects of the management culture, excessive attention to make flattering adjustments to earnings per share, and in routine deflection of public criticism. It seems that being out of touch with society is a characteristic of big global groups, irrespective of sector.

That Tesco is not unique as a problem company, is not the issue. Investors need to question this pattern of corporate failure. Why do most of the biggest FTSE companies have such a poor record on strategy, risk management and governance? Of the top 15 companies over the past 10 years, consistent well-managed businesses such as AstraZeneca, BATs and Unilever, are very much in the minority. The hit rate on management or governance failure in mega-cap companies is much higher than the average FTSE or Mid 250 business. With the top 15 representing 44% of the FTSE All-Share Index, underweighting exposure to the biggest shares is often an easy boost to relative performance.

The high profile and global reach of many of these businesses may invite more investigation and complaint. However, management and governance in the top companies should be streets ahead of the average. Indeed, they are paid to be. Most also pay millions to get the best legal, remuneration and non-audit consultancy advice.

In the case of Tesco, this question still puzzles investors. Many of the concerns were well aired by analysts and respected fund managers. These should have been red flags for an active board. How much retail experience is needed in a non-executive director to question whether a 5.2% profit margin is really credible for a challenged food retailer that is losing share? Were directors just too high-powered to ask such simple questions? A casual walk round the stores, or check on blog sites, would have revealed under-investment and low morale. It seems that directors of small and mid cap companies are a little nearer the coalface.

In big companies, remuneration systems are designed with expensive advice, yet bonuses have short term focus and executives can readily game them. Remuneration committees seem to miss flaws that are evident to all. As long as executives can adjust earnings or change definitions of capital employed, winning rewards from ailing businesses will be all too easy. In Tesco for example, a potential bonus of 4x base salary includes elements such as “group colleague engagement”. In a shrinking business, managing CO2 reduction might not be so hard, either. Investors get what they pay for, and the result has been a continued redefining of earnings per share adjustments and capital employed.

Tesco’s references in its annual reports to “strategy” or “strategic” have grown tenfold in a decade. Over the same period, there has been a doubling of references to “underlying” and “adjusted”. These trends point to the increased attention on moving the goal posts.
Many active managers have cynically concluded that governance at Britain’s biggest companies will continue to disappoint. Betting against the FTSE’s top 15 by looking further down the FTSE 100 Index, or into the Mid 250, is the core of stockpicking for many. Despite the much greater analyst coverage of big companies, earnings forecasts remain risky. It is counter-intuitive, but big companies are more accident prone.

It is salutary to dust-off a list of Britain’s top 15 from 10 years ago. Most are still with us, though some – such as RBS, HBOS and BP – are shadows of their former selves. Investors need to join the dots to see the problem patterns. Not all the evidence is in the superficial metrics offered to evidence “success” each year. Behavioural finance tells us that incentives drive behaviour. Investors might spend more time reading remuneration reports.

A version of this article was published in the Behavioural Finance series in Citywire Wealth Manager on October 17 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. At the date of publication clients and other related parties had positions in BP, RBS, and AstraZeneca

Image credit; Wikimedia Commons some rights reserved. By mankind 2k http://en.wikipedia.org/wiki/File:Tesco_Kingston_Park.jpg