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The Good, the Bad, and the Ugly

07/18/2016

By Jack O’Connell 2016-06-17 09:30:50

A new report from Wells Fargo rates shipping companies on the basis of their corporate governance scores. Is it possible to do well by doing good?

By Jack O’Connell

I don’t know about you, but to me the words “corporate governance” and “shipping” are about as far apart as any two expressions can be. Do they even belong in the same sentence together? Do they have anything even remotely to do with one another? “Maritime corporate governance” strikes many as an oxymoron, including yours truly, and in all my years in the boardrooms of shipping companies I don’t think I ever heard the term “corporate governance” mentioned.

But that hasn’t stopped the good folks at Wells Fargo Securities, led by Senior Analyst Mike Webber, from issuing a groundbreaking report on the subject called “Shipping’s Corporate Governance War.” Why “war”? Because it’s a battle between the good guys and the bad guys, and in an age of increased shareholder activism the good guys seem at last to be gaining the upper hand.

Nine months in the making, the report names names and is a response to “that small group of actors creating a sector-wide drag on valuations and market standing.” Those bad actors give a black eye to the entire industry, and the report states in no uncertain terms that “We believe there is no longer a place in the public Shipping markets for companies that do not prioritize corporate governance and capital stewardship.”

We’re talking about public companies only, of course. Private companies – and most companies in the shipping sector are private – can do just about whatever they want. But when these small, family-owned-and-controlled companies decide to spread their wings and go global by listing their shares on the New York or Oslo or Singapore stock exchanges, a whole new set of standards applies. And that’s where the trouble starts, because many of these companies have a tough time giving up the old ways and adopting the new. To put it bluntly, they have trouble putting shareholders’ interests ahead of their own.

Rules of the Road

What exactly are those new standards, and what is meant by “corporate governance” anyway? In general it means avoiding conflicts of interest and so-called “related party transactions” (favoring a board member’s company, say, over an independent third party to perform a service). But it goes way beyond that, and the smart folks at Wells Fargo came up with the following six factors (five objective, one subjective) to determine a company’s overall corporate governance score:

  1. Related Party Commercial Managers: Most companies outsource the marketing and chartering of their vessels. Those with inhouse marketing departments score an A, as do those companies that outsource to an unrelated third party. Companies that use a commercial manager owned or controlled by a company officer, for example, flunk this test.
  2. Related Party Technical Managers: The same criteria apply to the outsourcing of technical services like vessel maintenance and repairs and drydockings. Employing your brother-in-law’s company is a no-no. Best to do it inhouse or via that independent third party.
  3. Sale & Purchase Fees: Wells Fargo calls this a “major red flag” as it basically involves kickbacks to management for things like new vessel orders, the sale of major assets, or the purchase of products and services from others. “We believe S&P arrangements between related parties often incentivize investment decisions based on deal size and frequency, rather than returns,” the report warns.
  4. Related Party Transactions: This is another major red flag as it entails significant conflicts of interest between the parties involved. Such transactions, says Wells Fargo, have “the potential for transaction values to deviate from market prices given the incentives for premium valuations charged between the two parties (and higher risk). This most readily presents itself via acquisitions from private fleets or related entities, with a number of dry bulk, tanker, and containership owners acquiring or selling assets to their personal fleets.” Sound familiar? You bet it does. The pages of Lloyd’s List and TradeWinds are filled with examples on a daily basis.
  5. Independent Board Membership: This is a given in the broader corporate world and means that a solid majority of Directors should have no business or personal connection to the company whatsoever. The higher the percentage of independent Directors, the higher the company’s corporate governance score.
  6. Subjective Factor: This is a catchall, but necessary, category that takes into account “additional company specific aspects not represented in our five primary corporate governance factors.” Such aspects might include a company’s track record, its history of investments over the years, and its standing in the community.

Using these six factors, Wells Fargo gave each of them a weighting of 17 percent and applied them to the 42 companies in its survey, dividing the results into four quartiles. Quartile 1 featured the ten best performers while Quartile 4 featured the eleven worst. The results? Ardmore Shipping (ASC), Euronav (EURN), Navigator Holdings (NVGS), Kirby Corp. (KEX) and Avance Gas Holding (AVANCE) were the top five companies rated while Tsakos Energy Navigation (TNP), Scorpio Tankers (STNG), Scorpio Bulkers (SALT), StealthGas (GASS) and DryShips (DRYS) were the five worst.

Surprised? I didn’t think so. But what may surprise even savvy MarEx readers is that the companies with the highest corporate governance ratings significantly outperformed those with the worst. According to the report, Quartile 1 companies returned an average of 55 percent over the last three years while companies in Quartiles 2-4 had an average 35 percent negative return over the same period, proving that good guys don’t always finish last. For reference, the S&P 500 returned an average of 29 percent over the same three-year period.

Wells Fargo attributes this happy result to “the general idea that higher degrees of corporate governance can be an influential aspect of a more favorable relative risk/reward profile relative to that of companies with lower degrees of governance.” That’s a long-winded way of saying that superior governance produces superior results and that you should buy well-managed companies.

Webber and his team deserve a hearty round of applause for writing the first report of its kind that I am aware of and for shining a bright light on a dark area of the shipping world that is too often ignored or, worse, tacitly accepted. The report is a great benefit to investors and will hopefully be updated on an annual basis.

Too Small to Matter?

One of the reasons maritime companies perform so poorly when it comes to corporate governance issues is that they are too small. They don’t have the time or the staff to bother with such things. Corporate governance and the larger issue of corporate social responsibility are way down on their list of priorities. Making a buck comes first, and safety is usually their only concern when it comes to operating responsibly. And while this may be understandable and even rational, it is not a welcome state of affairs.

At a conference a few months back I sat in on a presentation by Rand Logistics (RLOG), a Nasdaq-listed, U.S.-based company with a fleet of 16 vessels on the Great Lakes. RLOG is struggling with a heavy debt load and a stock trading below $1. At the end of the presentation an investor raised his hand and commented that “Despite all your efforts to delever and cut costs, the stock gets worse and worse. Your market cap stands at $17 million. You shouldn’t even be public.”

And that’s the crux of the matter, isn’t it? Most of these companies shouldn’t even be public. If you look at the market cap of the 42 companies in the Wells Fargo survey, most of them are below $500 million. It’s hard to be socially responsible when your stock is trading in the single digits.

Greg Miller, Senior Editor at IHS Fairplay, hit the nail on the head when he penned a piece in February aptly titled “Does Shipping Even Belong on Wall Street?” He notes the proliferation of micro-caps in the shipping sector and argues that most of these companies should remain private. Over the last decade, he says, “U.S.-listed shipping companies are not getting fewer and larger. They are getting smaller and more numerous… There are 56 U.S.-listed shipping companies in 2016 versus 31 in 2006. The U.S.-listed shipping sector’s aggregate market capitalization, adjusted for inflation, was higher a decade ago than it is today.”

This is not fertile ground for investors. In a highly cyclical and capital intensive industry, the risks are just too great. The wave of bankruptcies in the dry bulk sector is just the latest example of the dangers of investing in microcaps and shipping stocks in general. There are exceptions, of course, the Maersks and Kirbys and SEACORs of the world, which have much larger capitalizations and can weather most storms. But even these companies are struggling in the current environment. Best to stay away entirely, unless your tolerance for risk is much higher than mine and you want to “get in on the bottom.”

Annual Reports, Anyone?

Regular readers of this column know that I usually write about annual reports in the May/June edition, and some of you may even be disappointed that I didn’t. So I’ll mention one new and innovative development.

When it comes to corporate governance and responsible stewardship of investors’ capital, no company rates higher than General Electric. GE is the gold standard of corporate social responsibility, and this year – as part of a continuing effort to enhance the quality of its financial reporting – it introduced what it calls an “Integrated Summary Report,” combining key elements of its Annual Report, Form 10-K, Proxy Statement, and Sustainability Report.

“The Integrated Summary Report shows investors GE through the lens of management,” states CEO Jeff Immelt, and it largely succeeds. The emphasis is on strategy and results, as it should be, and there are enough catchy charts and cutesy illustrations to satisfy everyone’s taste. For wordsmiths like me, GE is a gold mine of new coinages – “digital twin,” “horizontal capability,” “health cloud” and “the GE Store” – to mention a few. Verbs like “attack,” “win” and “lead” are everywhere. They aptly convey the “can do” attitude that makes GE a consistent winner. The new report is well worth a look. – MarEx