A Governance Watchlist For Asset Managers And Activists

The Big Three’s engagement practices are arguably ineffective. I suggest that asset managers focus their engagement on the 245 firms in the S&P 1500 that have not beaten US treasuries over the last 10 years.

Three threads

In this piece, I want to integrate three threads that I have been working on. One thread argues that investor engagement at the Big Three looks ineffective, at least to an outside investigator. In a paper co-authored with Dhruv Aggarwal and Lubo Litov, we look at the engagement reports that the Big Three indexers (BlackRock, Vanguard, and State Street) put out. In general, we were unable to document meaningful firm characteristics that explain which firms the Big Three choose to engage with. Such engagement events lead to a tiny insignificant stock price reaction and the governance outcomes after these interventions look relatively insignificant. In essence, engagement by the Big Three does not seem to move the needle all at much.

The second thread relates to a piece where I had identified 37 firms in the S&P 500 that have not beaten US treasuries return of roughly 8.25% overall (not per annum) over the last 10 years. That piece got a fair amount of attention, and a few friends asked me to extend that analysis to the entire stock market.

The third thread relates to making the proxy proposal process more meaningful. I had argued that the SEC, by effectively excluding shareholder proposals on the firms’ operations, has rendered the proxy proposal process a relatively ineffective way for shareholders to engage with management on the future course of the company.

To bring these three threads together, I focus on laggards in the S&P 1500 universe this time. The S&P 1500 is meant to cover 90% of the market capitalization of the US stock markets and is a combination of the S&P 500, S&P MidCap 400, and S&P SmallCap 600. I deliberately stayed away from the whole stock market. The lower you go in terms of size and liquidity, the smaller the payoff from fixing governance problems at such firms. The S&P 1500 sounded like a nice compromise between liquidity, size, and payoff from fixing governance issues to release shareholder value.

S&P 1500

A bit more about the institutional details behind the S&P 1500 index. The S&P committee uses a combination of algorithmic and discretionary rules to decide which stocks enter these indices: (i) only US companies are eligible; (ii) they have to trade on a US exchange; (iii) total company level market capitalizations of US$ 14.5 billion or more are required for the S&P 500, US$ 5.2 billion to US$ 14.5 billion for the S&P MidCap 400, and US$ 850 million to US$ 5.2 billion for the S&P SmallCap 600; (iv) certain minimum float requirements have to be met; and (v) the sum of the past four quarters GAAP profit must be positive as should the most recent quarter.

Deletions from the index usually occur when the firm gets merged or delisted or the S&P Committee boots out a company from the index. When I pointed out that 37 laggards still seem to lurk in the S&P 500, critics rightly pushed back saying that I had overlooked the hundreds of laggards who the committee had kicked out in the last 10 years.

To investigate a sample of these deletions, I looked at the 12 companies that have been booted off the S&P 500 in 2023: (i) Organon & Co; (ii) Activision Blizzard; (iii) DXC Technology; (iv) Lincoln National Corp; (v) Newell Brands Inc; (vi) Advance Auto Parts; (vii) Dish Network; (viii) First Republic Bank; (ix) Lumen Technologies; (x) Signature Bank; (xi) SVB Financial Group; and (xii) Vornado Realty Trust.

The three banks (SVB, Signature and First Republic) were placed under FDIC receivership and have hence ceased trading. Activision was bought by Microsoft. The remaining seven firms were booted out because their market capitalization fell below the $14.5 billion threshold required to stay in the S&P 500. Somewhat oddly, except for Vornado which was added to the S&P MidCap 400, each of the deleted firms were demoted to the bottom of the class or to S&P SmallCap 600 index. This implies that the eventually deleted firms hung around in the S&P 500 for long enough to lose as much market capitalization as to only qualify for the S&P SmallCap Index. Odd! I wonder whether and how shareholders expressed their frustration with these laggards when they were in the S&P 500.

Anyway, here is the updated list of the 245 laggards in the S&P 1500. I have not investigated board composition, CEO turnover, proxy proposals or say on pay support at these 245 firms. My plan for now was to simply surface the list and have the community debate what, if anything, can be done to nudge management into delivering value for shareholders.

Potential ideas:

· The Big Three indexers might want to target these 245 firms for private engagement.

· Activist investors might want to look through the list to identify firms that they might be interested in going after.

· Consulting firms or investment bankers might want to pitch turnaround strategies to these firms to try and release value.

· Asset managers could potentially trade ideas on how to engage with these firms on a private wiki. And, before someone says this is collusion, I hope common sense will prevail. We are trying to release value for everyone who is stuck with holding these 245 firms as they might be part of an index held by that asset manager.

· Shareholders might want to introduce proxy proposals on board composition or withhold their support for say on pay.

· More experimental, lawyers might consider ways for shareholders to introduce proxy proposals suggesting concrete strategies for these firms to restructure themselves. The trick is to write the proposal such that the SEC does not reject the it claiming that shareholders are trying to micromanage the board and the C-suite.

As always, constructive comments and suggestions are welcome.