Round up of latest research

Exponential advances in technology the great disruptor

Understanding the new machine age is one of the great board challenges of our time. Disruption to industries, business models and labour markets is expected to intensify, with experts suggesting a “breakthrough point” in new technologies is rapidly advancing.

A leading investor, Hamish Douglass, has examined eight technology trends and their effect on industry. Douglass is Chief Investment Officer of Magellan Asset Management, one of this country’s most successful fund-management groups in international equities.

“We believe there is evidence that technology may be nearing a tipping point,” wrote Douglass in Magellan’s latest Annual Investor Report. “Technology is now advancing at such a rate that a breakthrough in Artificial General Intelligence may be rapidly upon us.”

Douglass says markets may be underestimating technology because most changes in life occur in a well-established linear trajectory (such as ageing). Many technologies are progressing exponentially: a measurement multiplied by a constant factor for a given period (think, computational power doubling every two years).

Douglass cautiously predicts eight key technology changes over the next two decades:

  1. Development of an intelligent virtual personal assistant, who knows you, understands natural language and can anticipate your needs.
  2. Development of augmented and virtual reality through widespread adoption of new interfaces. Virtual reality can replace the real world with an immersive simulated experience, such as experiencing an overseas travel destination.
  3. Digitisation of goods via mass commercialisation of 3D printing. This could result in hard goods becoming digitised, similar to what happened in music and book publishing.
  4. Digitisation/automation of white-collar tasks. Artificial intelligence or machine learning could take over from traditional white-collar workers, such as lawyers, accountants or funds managers.
  5. Development of advanced, fully autonomous robots. They could replace highly specialised manual workers, such as surgeons.
  6. Commercialisation of driverless cars and expansion of car sharing. Self-driving cars could dramatically reduce road deaths, congestion and transportation costs, and increase productivity as people are free to do other tasks while being driven.
  7. Breakthrough advances in medical technology and longevity. Technology could transform health into a model that is personalised, preventive and proactive.
  8. Development of humanoid intelligent robots. They will undertake jobs that require human interface, such as being a receptionist, store assistant, waiter or bartender.

Douglass lists a number of questions about technological disruption that his investment firm is asking. The list is instructive for boards grappling with the right questions to ask management about the new machine age and its potential effect on their organisation. 

Strengthening external-affairs capabilities

Chairmen of larger ASX-listed companies are anecdotally spending more time with external stakeholders. They are meeting institutional investors, proxy advisory firms, regulators and non-government organisations, such as environmental groups.

But how successful are their external-affairs activities? And how prepared are boards to spend more time on external affairs as stakeholders seek greater say in strategy?

These are important questions. As governments respond to financial shocks with new regulation, organisations will need to strengthen their external-affairs capabilities. Successful engagement with external stakeholders, at executive and board level, can help shape stakeholder perception and/or influence governance policy.

A recent McKinsey & Co survey found external affairs to be a rising priority for CEOs and boards. External affairs ranked as a top-three priority for more than half the CEOs surveyed, and almost a third of boards said external affairs had become a top-three priority.

“Engaging external shareholders is more important than ever to company leaders,” according to the fifth McKinsey Global survey on external affairs. “Yet while most executives believe outside stakeholders will be increasingly involved in their industries in coming years, few say their companies have taken an active approach to engaging stakeholders or that they have found success in their external-affairs efforts.”

Only 11 per cent of executives surveyed said their organisation frequently succeeded at shaping government and regulatory decisions. Only 22 per cent of respondents felt their organisation successfully managed its corporate reputation.

“Overall, respondents reported little progress – and even some declines – in the strength of their organisations’ external-affairs capabilities since the 2012 survey,” wrote McKinsey.

Boards, too, are struggling with external affairs, according to the survey. Only one in five directors surveyed said their board was effective at setting a framework for how their company managed stakeholder relationships, at balancing stakeholder interests in their decision making, or at interacting regularly with the most relevant stakeholders.

"While external engagement has risen on the board agenda in recent years, few respondents say their board members oversee these activities well,” wrote McKinsey.

McKinsey identified capabilities that drive more effective external-affairs outcomes:

  • Building a fact-based narrative to support positions.
  • Tracking the quality of relationships with the most relevant stakeholders.
  • Engaging the CEO to support external-affairs activities.
  • Aligning external affairs with organisation strategies.
  • Balancing local engagement with corporate priorities.
  • Mapping the stakeholder landscape to understand networks of influence.
  • Engaging stakeholders in response to unfavourable policies.
  • Prioritising the external-affairs agenda based on value at stake.
  • Attracting talent with the right skills in external affairs.
  • Having a coordinated response to crises.

Directors who seek to understand their organisation’s external-affairs capabilities – and those of the board – could use McKinsey’s framework to prompt discussions in this area.

Vital to become more investor savvy

Boards may need to become more investor savvy with the rise of shareholder activism in the United States and other developed markets.

Russell Reynolds Associates’ Anthony Goodman argued in The Harvard Law School Forum on Corporate Governance and Financial Regulation that mounting activism pressure and the increasing “activation” of institutional investors was forcing companies to rethink investor relations.

“We have seen this trend first-hand in our work with boards, as well as in conversations with institutional investors, wrote Goodman. “The most forward-thinking boards are doing what it takes to thrive in the new environment.”

Goodman proposed seven steps for boards to become more investor savvy:

  1. If the board is not getting the right information regularly, consider enhancing the organisation’s investor-relations and corporate-secretary functions.
  1. If the organisation is in a sector prone to activist intervention or has a track record of poor performance or governance concerns, identify a specialist provider to help the board understand investor sentiment.
  1. Think like a long-term investor when developing or reviewing organisation strategy. Look at the strategy and capital structure through an activist’s eyes.
  1. Build an activist-preparedness plan with the board’s advisers.
  1. Develop a board-shareholder engagement policy and disclose it.
  1. Identify and train board leaders who can meet investors when needed.
  1. Consider adding investor-savvy or savvy investor talent to the board.

Goodman said investor-savvy directors have five core qualities:

  1. Trust of the CEO and board, and courage to speak the truth and deliver bad news.
  1. Ability to listen actively to investors and provide feedback to the board and executive team.
  1. Ability to move between broader strategic issues and financial detail. An investor-savvy director can discuss high-level strategy as well as financial detail.
  1. Ability to build relationships with institutional investors.
  1. Experience with regulations (in Australia, the investor-savvy director must understand the listed company’s continuous disclosure obligations and key investor-relations issues, such as the risk of selective disclosure to analysts.)

Goodman’s views about the growing involvement of boards in investor relations, and shareholder activism’s influence, mirrors comments earlier this year by David Beatty, Conway Director of the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto.

Beatty, a prominent global governance expert, told the Australian Institute of Company Directors that shareholder activism would transform governance over the next few years. “Every Fortune 500 company in the US now has at least one activist fund running the ruler over it, to assess if its assets are being underutilised,” he said.

Beatty said shareholder activism was forcing companies to rethink how they create, shape and communicate strategy to the market. The result: executive teams and boards spending more on investor-relations activities.

Analysing key CEO personality traits

Arguably, no board task is more important than choosing, incentivising and monitoring the right CEO. The decision, more art than science, is a key to governing for performance.

But what do boards look for when choosing a CEO? How much emphasis is given to the CEO’s personal attributes and which ones most affect firm performance?

United States academics investigated CEO personality traits in a working paper published in July for the Stanford Graduate School of Business. They wanted to understand the relationship between personality traits of senior executives, their investment and financing choices, and firm performance.

The study was based on linguistic features from more than 70,000 conference calls between executives and analysts for US-listed companies.

From that, the researchers estimated scores for five key personality traits of 4,591 CEOs and examined the association with the CEO’s firm performance. The five traits were: agreeableness, conscientiousness, extraversion, neuroticism, and openness to experience.

On firm policies, the researchers found a positive association between openness and research and development (R&D) intensity. CEOs who scored high on openness were seen as more creative and preferred innovative cultures, risk-taking and experimentation.

That is useful information for boards of technology companies, for example, which require CEOs who can shape nimble, innovative organisational cultures and encourage sensible risk taking.

Conversely, highly conscientious CEOs who prefer rules are less attracted to innovative cultures that value risk-taking and inventiveness. Such CEOs might suit established organisations, such as government enterprises, that are more rules-based.

Other academic studies suggest the conscientious CEO’s adherence to rules could affect firm performance and that excessive conscientiousness might result in rigidity, inflexibility and focus on trivial details.

The researchers also found a robust negative association between CEO extraversion and return on assets and cash flow. That is consistent with the argument that extraverted CEOs like to dominate and the benefits of extraversion might not help corporate decision making.

Moreover, extraverted CEOs can suffer from short-lived enthusiasm for extreme events, resulting in aggressive strategies that are prematurely terminated.

The study found the association between neuroticism and firm performance was ambiguous and depended on the combination of other personality traits. Predictions between the CEO’s openness to experience and firm performance were also ambiguous.

The authors acknowledge limitations in their extensive study and the need for further research. But they make an important contribution in how (or whether) differences in CEO personality traits affect executive decision-making and firm performance.

Openness and conscientiousness, it seems, have the biggest positive or negative association with firm performance. Paying more attention to these personality traits in the next CEO interview might help boards with their most important governance decision.

Happy workers make for successful companies

A business magazine “staple” over the past decade has been lists that rank the best places to work. Such lists provide publicity for firms that are seen as good employers and attract job seekers. But does being a good employer lead to stronger firm performance?

US researchers explored this relationship in their paper, Employer trustworthiness, worker pride, and camaraderie as a source of competitive advantage”. It was published in the July edition of the Journal of Strategy and Management.

The study is timely. High-performing boards are spending more time understanding their firm’s organisational culture and its alignment with strategy. They know that the right organisation culture is the best form of risk management and defence against unethical behaviour.

Leading directors also understand that organisation culture is more important in an era of digital disruption and rapid labour-market change. Being perceived to be a “great place to work” has never been more valuable as employee mobility increases.

The authors drew samples of firms from four of North America’s most popular Great Places to Work (GPTW) lists, including the annual Fortune “best companies to work for” edition. They argue that such lists, while initially a public-relations tool, have become more robust and that firms, recruiters and current and potential employers pay more attention to them.

The authors found significant links between being a GPTW and firm performance over time in terms of productivity and higher operating profits as a percentage of sales.  They wrote: “A firm that is perceived by employees as a GPTW can achieve long-term competitive advantages.”

The results will not surprise directors who intuitively understand the value of organisational culture and its effect on firm performance. Staff who perceive that they work for a great employer are likelier to be more productive, happy and willing to change.

But the authors argue that great working environments are still rare. Other studies have found the primary defining characteristics of GPTW organisations are the level of trust between management and employees; pride that workers have in their work; employee camaraderie.

These are more important than firm policies and practices in becoming a great place to work.

Getting it right on remuneration

Setting performance targets for executives is among the most challenging – and potentially controversial – governance tasks. Boards risk condemnation if underperforming CEOs are paid too much, or if high-performing CEOs take home too much of the spoils.

Remuneration committees must strike a delicate balance: setting sufficiently challenging EPS (earnings per share) targets to incentivise the CEO to deliver firm outperformance, but not so high that the CEO can never achieve the earnings target and consequently becomes demotivated.

One of Australia’s top executive and board-remuneration consultants, Egan Associates, considered the vexing issue of EPS hurdle rates in long-term incentive plans in its latest newsletter.

It studied 40 of the 100 ASX-listed companies by market capitalisation that disclosed the use of an EPS hurdle in the company’s long-term incentive plan for executives. 

Twenty-nine companies disclosed a prospective EPS threshold and maximum for the future vesting of grants to executives. The EPS compound annual growth (CAGR) thresholds ranged from 2.5 per cent to 10 per cent – a hurdle that may be less challenging than it appears.

Egan compared the EPS CAGR in long-term incentive plans with EPS targets in stockbroking analyst forecasts for listed companies in its sample. The analysis would show if the company’s assessment of EPS CAGR used in executive pay incentives differed greatly from the market’s.

The EPS CAGR for threshold vesting was lower than the growth required to meet analysts’ forecasts for 22 of the 29 companies. The growth for maximum vesting was lower than that required for forecasts for 18 of the 29 companies.

Boards, it seems, are more conservative with EPS CAGR targets in long-term incentive plans than stockbroking analysts are with EPS CAGR targets used in their company forecasts.

Investors could, therefore, argue EPS targets in executive pay lack ambition.

Egan wrote: “In terms of rewards for threshold EPS performance, it is (our) observation that threshold EPS CAGR hurdles are set at a level which the Board believes represents an attainable outcome arising from a sound though not superior performance.”

However, a decrease in the number of securities that vest for threshold EPS CAGR performance over five years suggests companies are using the volume of grants as a performance incentive.

“Previously, 50 per cent of securities would vest at the threshold for most companies, while it is now becoming increasingly popular  to have 25 per cent or less of securities vest at threshold performance, with the balance vesting on a pro rata basis through to the stretch or maximum hurdle, “ wrote Egan. “This may reflect an acknowledgement that threshold EPS hurdles are attainable under a sustainable though not necessarily a growth model, which may not match analyst expectations.”

Egan says several factors may be at play when boards set EPS CAGR hurdles. They include:

  • The board using a stricter definition of EPS CAGR.
  • The board setting different hurdles for different cycles in the organisation’s strategy, knowing some goals are easier to meet in parts of the cycle than others.
  • The company’s assumptions may be more conservative and/or knowledgeable around the effect of global developments on its trajectory compared with the market.
  • The board chooses targets well in advance of the beginning of the performance period in order to properly document the amount of equity to be granted and performance conditions, thereby hopefully avoiding future disputes.
  • The board may hold reservations about setting stretch targets too high in case they encourage risk taking or gaming of the measure with share buybacks or creative accounting.
  • The board may be concerned about losing executives to competitors if hurdles are perceived as being significantly more difficult than the rest of the industry. Hurdles may be the result of negotiations with management around what they believe is achievable.

Egan says canvassing stakeholder views is generally the best method of achieving an incentive that will motivate rather than discourage a leadership team - one the keys to governance for performance.