Honest investments: how do your stocks rate?

Yesterday, in the wake of the AIG bonuses scandal, I made an argument for the creation of a Corporate Honesty Index.  I continue that theme today by listing a few methods for judging the honesty of publicly traded companies.

My suggested inputs yesterday were:

  1. CEO compensation
  2. Number of SEC investigations in the past 10 years
  3. Tax rate?
  4. Number of lawsuits from employees, clients, or suppliers in past 10 years
  5. Spread between cash flow and earnings
  6. Corporate Honesty Index of other companies represented on the board

The spread between cash flow and earnings is the only factor that is easily quantifiable, and this number is useful because, if earnings are consistently above cash flow from operations, it’s possible that the company is claiming revenue on contracts that haven’t yet materialized (a la Enron).  If, on the other hand, cash flow is significantly above earnings, it’s possible that the company is cheating the government out of taxes.

Of course, there are legitimate ways to cut your tax bill, but at some point the government has to get its due.  And, increasingly, corporations are finding sneaky ways to shift the tax burden to the consumer.  Check out this quote from Berkshire Hathaway’s 2004 Annual Report:

Corporate income taxes in fiscal 2003 accounted for 7.4% of all federal tax receipts, down from a post-war peak of 32% in 1952. With one exception (1983), last year’s percentage is the lowest recorded since data was first published in 1934.

A corporation that shelters money from the government (and, in theory, saves more for shareholders), may not, ironically, be the kind of corporation that you want to entrust with your retirement.  That’s because cheating the government is a hard road.  Dropping a giant corporation’s tax rate by 1% could be the life’s work of a tax attorney or lobbyist.  If a company is willing to go to those measures, what kind of back flips will they do to squeeze shareholders?

The other factors on my list take a little more work, but thankfully there are a few resources available for investors:

Executive compensation database – The AFL-CIO’s CEO compensation database goes beyond SEC filings by estimating the value of additional perks, such as stock options and future bonuses.

SEC Litigation releases – The SEC does not make public its investigations until it decides to pursue a company in court, but once in court, those records are fairly easy to find on this page, and there’s even an xml feed.

2008 World’s Most Ethical Companies – Ethisphere collected this list of companies that were perceived to have the highest ethical standards in the following categories: “Corporate Citizenship and responsibility; Corporate governance; Innovation that Contributes to the Public Well Being; Industry leadership; Executive leadership and Tone from the Top; legal, regulatory and reputation Track record; and Internal Systems and Ethics/Compliance Program.”

The following companies also turned up in a more quantitative survey conducted by The Association for Investment Management and Research in 1994:

  • National Fuel Gas
  • Placer Dome
  • Cummins Engine
  • Southwest Airlines
  • Safeco Corp

Dated?  Yes.  But honesty is one of those things that age well.

4 Comments

  1. You make a good case for an ‘honesty index.’ Seeing that you are really interested in ethical business and investment behaviour, you should visit my globally popular ethical investing site. It also carries the latest global green-ethical investing news and research.

    It’s at http://investingforthesoul.com/

    Best wishes, Ron Robins

  2. http://www.fool.com/investing/mutual-funds/2009/03/20/its-time-to-reinvent-the-index-fund.aspx

    How does one reliably quantify honesty? Is honesty really what you’re trying to identify and measure here? Or are you in fact after something more broad like “transparent integrity” or “honorable stewardship”? Either way, standard definitions of moral terms and precise measures of same are hard to come by. Social sciences are considered “soft” (read: less-reliable) because they derive statistical data from fuzzy sources (like polls of individuals’ personal assessments) and then treat them as if they were culled from ruler & scale.
    You are in a way making a timely and timeless argument for buying companies that do good because their demonstrated moral virtue will result in them and us doing well.

    Jesus expelled the money changers from the temple – charging interest on money lent is damned as usury by most religions – Martin Sheen’s speech in the final scene of Wall Street chastised Bud
    Fox and us to “make something instead of living off the buying and selling of others”.

    $ and morality are hard to reconcile because $ is about competitive self-interest, while morality is all about altruism. $ rewards shrewd savvy while M honors innocence and its consequent poverty. $ icons have nicknames like “The Grave Dancer” (Sam Zell) while Nuns have names like Prudence and Constance. Their respective views tools and armor are “out of element” when used in the other field.

    “Honesty Index” draws the same skepticism as does “Quality Index” (click link above to read the article) when quality is defined in moral terms (constancy, honesty, integrity etc.) vs. $ terms.

    The creator of the proposed quality index said: “I wasn’t necessarily looking for quality operators as measured by profit margins or ROIC, but rather honest companies that seemed to treat shareholders, employees, and customers right.”

    Lovely thought – but he’s singing to the wrong choir.

  3. @andrew
    Investing in good companies is certainly the right thing to do, at least in the Kantian vision of morality (if everyone did it, it would be good for the world).

    But I sense that you are sniffing a little at moral investing. Does it seem a little namby pamby to you?

    Yeah, I can see that. But I also think there are two practical reasons to invest in companies with good character.

    1) There is no honor among thieves…if they’re out to screw the world, they’re out to screw the shareholder.

    2) Immoral organizations may be less operationally efficient. If you get sued often, you’re spending a lot on lawyers (even if you win). If you don’t get sued, but you’re worried about getting sued, you’re paying a bunch of lawyers to sit around and consume your working capital. And if your organization is full of crooks, you’ve got to have lots of people minding the till (or just managing people, rather than the business).

    More and more, I’m beginning to think that the character of an organization’s management team is the single driver of future returns. Honesty may very well be a competitive advantage.

  4. Proposed “Quality Index” Criteria:
    A blueprint for better
    When it comes to companies that value their shareholders and shareholders’ capital, here are the measurable criteria we (the writer of the article and his analyst partner) like to see:

    * Insider ownership between 5% and 50% of outstanding shares (showing a management team that’s committed to the company but doesn’t necessarily control the company).
    * Limited to no takeover defense provisions such as poison pills that protect entrenched management.
    * Limited shareholder dilution over time (indicating a respect for the company’s owners).
    * Either good returns on invested capital or a common stock dividend (evidence that the company thoughtfully allocates capital).

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