Vanguard's McNabb, on corporate power

UPDATE Nov. 13: Read an official text of McNabb's speech here.

EARLIER: F. William McNabb is chief executive of Vanguard Group, the $3 trillion Malvern-based mutual fund giant, and chairs the Investment Company Institute, the mutual fund trade group. McNabb headlined a program last week at the University of Delaware's Weinberg corporate-governance center, where Prof. Charles Elson introduced McNabb as a "leader in activist investing."  Highlights:

GO BLUE HENS: Being at the University of Delaware is great fun for us at Vanguard. We are great, great fans of what go on here at the Weinberg Center. If you think about the impact it has on how companies are run, on how the economy functions, on how markets function, the increased scrutiny around corporate governance, the Weinberg Center has been at the center of that. I love [how] it brings academics, corporate boards, investors, regulators, all the important constituents together...

The second reason I love the University of Delaware is really, really selfish. We have a huge number of alumni working just up the road in Valley Forge. I see students here -- I'll be glad to talk to you after. This is a great source of talent for Vanguard. Delaware is among the top 10, and knocking at the top 5, in terms of the number of [alumni] working at Vanguard. We're a people business... What you are producing is really important... thank you all for that. 

NO MORE MYSTERY: One fundamental premise we have, it's very simple but very important: We think corporate governance should not be a mystery. Corporate boards should understand how investors think, how they vote, what their expectations are. The reverse is true [investors should understand their boards.] We need to remove the mystery... It's starting to dissipate...

TALK TO US: I'm not going to name the company. But you would know them, a large West Coast company. They floated a shareholder proposal proposal that got a lot of scrutiny... Very embarrassing... They said, 'We've talked to our major shareholders'.

I picked up the phone and called [Vanguard fund controller] Glenn Booraem [who oversees Vanguard's governance office] And Glenn said, 'Really? I don't remember they talked to us'...

In subsequent converations we had with them, one of them said, 'You guys run index funds. We didn't think you cared.' So we had some work to do in our communications...

5% OF EVERYONE: We are the largest mutual fund company in the world... $3 trillion under management, 160 U.S. funds, 120 operated offshore. In the U.S.,  $1.9 trillion in equities... We hold the whole market.

We own about 5% of every publicly-traded [U.S.] company. We own at least 1 percent of every company in the world... Where our active managers have positions, we can own 8 or 9%... Doing right for investors keeps me up at night.

LOVE 'EM, HATE 'EM, OWN 'EM: We're permanent shareholders. Even in our active funds. We tend to hold companies almost forever.

That means if you're a board or a CEO of a company we own, we're going to own you whether your earnings are up or down. Whether everybody loves you or hates you. It's our obligation to do so. That's why governance has become so vitally important....

Our job is to create as much wealth for our investors as we can... in a risk controlled and diversified way... All we can influence is governance. 


1] Independent oversight and appropriate board composition is the first and most important principle. You gotta get the board right. Boards are respnsible for hiring and firing CEOs and for realy making sure the strategy, the risk controls, are in place. That's what a good board does.

We're kind of a representative democracy. The shareholders aren't there. The boards are standing in for the shareholders.

2] Second is accountability. The management has to be accountable to the board. The board has to be accountable to shareholders... In practice that's not always the case.

3] Shareholder voting rights have to be consistent with economic interest. One share, one vote. A lot of companies [don't. Prominent examples, which McNabb didn't mention, including Nike, Comcast and the New York Times, where a founder or founding family owns a small amount of stock but has extra voting control.] We shout about it: You want one vote to equal one share.

4] Fourth, direct board elections and minimal antitakeover... We have seen a handful of exceptions. In general, we find, having an annual election and no anti-takeover [provisions in a corporations's rules] has been a good thing for investors...

5] Five, compensation. The say on pay movement is one of the best examples of Improvement in corporate governance. We've actually seen a real improvement over time in how companies align [bosses' interest with investors']. If you look at the data, you would see a huge movement in companies aligning compensation effectively. [McNabb didn't mention when Vanguard would disclose its own executive pay, if ever.] 

6] We think boards need to be very engaged with investors and investors need to be very engaged with boards.

Our history is of real growth and evolution. Years ago governance didn't rise to the top of the investment world as a big topic.

DEAR CEO: Then a number of years ago my predecessor Jack Brennan began publishing industry guidelines... a really big step... A few years after that, Jack Brennan began writing letters to many of the portfolio companies,  laying out our guidelines... We've continued to improve... [Vanguard funds controller Glenn Booraem, who is in the audience] sent 900 letters to companies... earlier this year... 350 saying, 'Here's something we don't like. We'd like to engage with you'... Of the 350 companies, 80 have already made the changes. It didn't even go to shareholder proposals. They said it made sense. A bunch more are under discussion. [Others] will rise to shareholder proposals. We'll get a chance to exercise our judgement there.

IT WOULD BE TOO BAD IF REPORTERS FIND OUT: Investors are begining to reach out to companies to talk.. We get a lot of phone calls... they want to talk before it gets to a vote. Or before it gets to the press.

Engagement has to evolve to being more bilateral.

BEST PRACTICES: Microsoft gets a lot of coverage. Microsoft actually has created an outreach program where they use a lot of videos to talk about significant issues with their investors... So you get a sense of how a board committee was thinking about its interactions with management... The board is trying to engage proactively, as opposed to waiting for us or someone else to come in. This is a model that's going to be copied.

Dell is another company that's been in the press a lot because of their decision to go private. Dell formed a special committee of the board who wanted to talk to the owners of the company -- the investors -- proactively about the process and how they were arriving at the level that makes sense if the company was going to be taken private or sold.

Whether you agreed [with the price Dell wanted to pay investors], the process was very good. So there are two simple examples of proactive engagement.

AND WHILE YOU'RE AT IT: We're beginning to talk about engagement around other topics. Not just strategy... Also board composition.

[Rochelle] Shelly Lazarus of the General Electric board is in the audience. GE published a skills matrix in a proxy statement, it was really interesting... They laid out how to think about forming the ultimate team to run a really great board. It was very consistent with [a forthcoming article from the] Weinberg Center. It reinforced this idea it's almost like putting an athletic team together. It may sound really basic. But go back two decades, none of this was in discussion.

Rakhi Kumar, who leads corporate governance at State Street [Global Advisors], they've just come out with a very cool set of assessments around board tenure. In the aggregate, and on an individual basis. It flags whether this should be an issue. They flag outliers and you can begin engaging what's going on in terms of tenure.

FORCED RETIREMENT: There are boards where average tenure is 30, 40 years. You have to ask if they ware really independent.

The idea of term limits is all of a sudden beginning to emerge as a new trend. I am excited about [this.] I think it would be a great evolution in governance if companies would also set term limits... Preclude the loss of independence... Fresh ideas... In some companies, you need to be there six, seven years until you have an idea [how the business works]... 15 years makes sense. Others, 12 or 20... It's something that we should be debating about.

PERMANENT ACTIVISM: The emergence of these frameworks are really beginning to help us frame these outliers. What's happening is an institutionalization of what these activists have been doing.

When the activist movement re-emerged, I was sitting where you guys are: in graduate school and listening to the Carl Icahns of the world. Activists would look at a company, they would say, 'There's a short-term gain to be made here. We can flip it in six months, and make a ton of money for our investors.' If you were an Icahn investor, it could be very good for you. [But not necessarily a long-term strategy.]

MORE CONSTRUCTIVE: The activists are becoming more constructive.... What they're flagging are companies who are outliers from a strategy perspective, or a cost-tied-to-strategy perspective.

They are seeing situations where the strategy just doesn't make sense. Maybe we need to change the manager. Maybe we need to change direction. 

Boards used to be there, really, to listen. And, in a sense, concur, if you will, with the strategies management is concocting and putting forth.

The best boards are actively engaged in the strategy. They are very careful not to cross the fine line between being a director and being management.

If the board is standing there on behalf of investors, you want to make sure the strategy makes sense. The activist movement flagged some situations where that wasn't the case. Two examples:

RAILROAD WAR: I was up at Harvard Business School recently with a group of CEOs. John Kotter, the great strategy professor, runs what we at Vanguard call CEO Kindergarten. I attended in '08 amid the financial crisis. I felt I was more in CEO Nursery School. He brings the groups back every year for a reunion. I'm in CEO middle school now, it's my 7th year.

One CEO came up to me there and told me, 'I can't believe you guys sided with Bill Ackman.' I'm thinking, 'We're not involved in Herbalife' [a well-known Ackman target]. I called Glen Booraem [who oversees Vanguard's governance office.]. He found it: Canadian Pacific Railway. This was 2012.

Ackman said, 'This is a great franchise in Canada that has been really mis-run. It could have tremendous long-term value for shareholders.' He proposed bringing in a railroad legend and a board very much [assembled] by thinking of it from a skills perspective. We ended up thinking, 'This makes a ton of sense.' ... We ended up siding with Bill Ackman... That was a signal event. I began thinking... Activists as short-term, was more myth than fact.

FAMILY BREAKUP: This one was darker: Commonwealth Real Estate Investment Trust came under scrutiny from Corvex and Related Companies [activist investors]. The track record of this REIT has been extraordinarily bad compared to the index, which had performed well. This company was way off the chart [in a bad direction]. 

The more you dug into it, there was a family management team, they violated one of our principles: they had a lot of voting power, with very little economic interest. It was run like a private company, but with public shareholders...

People read the headline: 'Vanguard sides with Corvex.' How'd that happen? It was a company where the governance principles were't really being followed.

'ARE YOU KIDDING?' I think we've been moving in a better direction. Two interesting developments:

Shareholder Director Exchange is a new group who's really trying to put tools and protocols in place for investors and directors to talk... to measure how effective engagement is.

The second area around engagement, the idea of boards actually formally creating a shareholder relations committee, I'm excited. The first time we floated this idea, it was at a session with directors and CEOs.

The CEOs said, 'Are you kidding? Our directors [in talking to investors] don't know when they violate [SEC Regulation] FD [which limits private communications between investors and company officials]. We'll be in court together.' The backlash was overwhelming.

ACTIVISTS IN THE BOARDROOM: Fortunately I had the portfolio manager of our healthcare fund with me. She had been around 30 years, she's a brilliant investor. She said, 'Time out, guys, I don't want to talk about what you're doing next quarter and succession plans... I want your board to talk to me about how I think about your company. If you're Eli Lilly, don't you want to know what I think, as the biggest holder of your stock, about your strategy, the quality of your management team, and the overall direction of the company, versus Merck, Glaxo, any competitor?'

And the CEOs squirmed a ittle bit more. The independent directors sat up and said, 'That's not a bad idea.' They get most of their information from management. The most progressive boards are beginning to bring in outsiders.

In the old days, when sellside analysts [had more influence], a really progressive board would bring that analyst in to talk about why they had a Sell on the stock. [Now they talk to activists instead of analysts.] 

That would be would be a tremendous step in improving the process of how companies are governed. As a permanent investor, we'd really, really welcome that kind of development.

This will be part of the dialogue as we continue to evolve the way we govern corporate entities. To make our market the best market in the world...

WHAT BOARDS DO: Getting capital allocation right is really important [to shareholder value.] If you boil it down to two things [boards do, they are] hiring and firing the CEO, and working with the CEO to make sure capital is most effectively deployed... Get those right [and the company will be in] great shape. I think there should be a lot more attention paid to it.

TERM LIMITS: I'd like to see [director] term limits.. A lot of boards, the only limit is age... You may want to go there. But the board is collegial, they are working well together. [It can get complicated.]

TERM LIMITS AT VANGUARD, TOO? We were lucky, we had some [directors at their age limit. So our board replacement was]. graudal [we didn't want to scare investors] I think if you put in term limits, the best directors will stand up [and accept the limits.] I think we'd get their faster... 

Tell directors, 'This is not a permanent endowment. You may be performing well, but our needs may have changed.' There should not be a stigma attached to that.

BUYBACKS: I don't think there's been as much scrutiny on [whether] shareholder buybacks are a good use of capital. In the last 5 years, the math has worked well for companies. [Rising stock prices make a company's own stock a good investment.]

But our view is that in the next decade, equity will be a lot tougher than the last five years. The real expectation has been 6 or 7% a year in the next decade, vs. 9 or 10% [in past decades.] Are you just financial engineering and not really deploying capital the best?... My bias, cash is king.