Boards fail on strategic focus

An interesting article in the January 2015 edition of The Harvard Business Review by Dominic Barton and Mark Wiseman, Where Boards Fall Short: most boards aren’t delivering on their core mission of providing strong oversight and strategic support for management’s efforts to create long-term value.

The problem

In March 2014, McKinsey and the Canada Pension Plan Investment Board (CPPIB) asked 604 C-suite executives and directors around the world which source of pressure was most responsible for their organizations’ over-emphasis on short-term financial results and under-emphasis on long-term value creation. The most frequent response, cited by 47% of those surveyed, was the company’s board. An even higher percentage (74%) of the 47 respondents who identified themselves as sitting directors on public company boards pointed the finger at themselves.

Furthermore, a mere 34% of the 772 directors surveyed by McKinsey in 2013 agreed that the boards on which they served fully comprehended their companies’ strategies. Only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries.

Another McKinsey study in 2012 that compared 41 multinationals based in emerging markets with 303 based in developed economies found that from 1999 to 2008, the emerging market firms often had much more of a long-term orientation than the Western firms, paid out far less, on average, in dividends (39% versus 80%), and reinvested in fixed assets at a rate roughly twice as high.

The authors identify four familiar areas where change is essential in order to sharpen the focus of Boards on strategy and long-term value creation.

Selecting the Right People

Only 14% of 692 directors and C-suite executives surveyed by McKinsey in September 2014 picked “a reputation for independent thinking” as one of the main criteria that public company boards consider when appointing new directors.

Having a diversity of perspectives and proven experience in building relevant businesses, as well as deep functional knowledge, is critical. But if McKinsey surveys are any indication, too many directors are generalists. And as Don Lindsay, the CEO of Teck Resources, a large Canadian mining company, told us: “One of the big problems with generalist directors who don’t have a natural interest in the business is that it can take a long time to convince them to make important decisions.”

That is indeed a problem. Former IBM CEO Lou Gerstner recently observed in the McKinsey Quarterly that the willingness to tackle outmoded orthodoxies decisively is crucial to sustained value creation. “In anything other than a protected industry, longevity is the capacity to change, not to stay with what you’ve got,” he said. Companies that last 100 years are never truly the same company, he noted. “They’ve changed 25 times or 5 times or 4 times over that 100 years.”

However, recent McKinsey research has shown that during a 20-year period, the majority of 1,500-plus U.S. companies were content to maintain the status quo and dole out roughly the same amount of capital to business units that they did the previous year. These businesses moved forward in low gear as a result. By contrast, the most aggressive reallocators—companies that shifted more than 56% of their capital across business units over that period—delivered 30% higher total returns to shareholders. Boards that combine deep relevant experience and knowledge with independence can help companies break through inertia and create lasting value.

To ensure that it can see around corners, Mars, the privately held food-and-drink powerhouse, has created a five-member advisory group of external experts to complement its three family board members. Each adviser is an expert on a specific driver of company value, from demographic health concerns to food safety regulations, and regularly addresses how trends in these areas may affect the firm’s strategy and priorities with the board and senior executives. For executives serious about creating long-term value, injecting more of these kinds of informed perspectives into the conversation at public company boards is not optional; it’s imperative.

Spending Quality Time on Strategy

“The first question I would ask boards is whether they are spending enough time and effort assessing the organization’s long-term strategy,” Sir David Walker, the chairman of the board at Barclays and a noted authority on corporate governance in the United Kingdom, told us. “If they are honest, the answer will almost always be no.”

Most governance experts would agree that public company directors need to put in more days on the job and devote more time to understanding and shaping strategy. Some recommendations get quite specific. Robert C. Pozen, a senior lecturer at Harvard Business School and the former chairman of MFS Investment Management, says that directors of large, complex firms should spend at least two days a month, or 24 days a year, on board responsibilities, in addition to attending regular board meetings. Others suggest that the appropriate number is as many as 54 days a year, the standard for directors of companies owned by private equity firms, according to a McKinsey study in the United Kingdom. The notion of regular group outings for directors—holding board meetings in, say, retail stores or new R&D facilities, or asking members to tag along on sales calls—is also now in vogue.

While we recommend that directors dedicate at least 35 days a year to the job, in our view the precise number of days a board meets or the mix of field trips isn’t the main issue. If the aim is fostering the proper long-term view, what matters most is the quality and depth of the strategic conversations that take place.

As we argued in our HBR piece “Focusing Capital on the Long Term” (January–February 2014), boards also need to do more to develop and communicate nonfinancial metrics that will help guide strategy, especially when income statements don’t capture the emerging story. The board of Tullow Oil, a multinational oil- and gas-exploration company headquartered in the United Kingdom, does this well. To measure the company’s performance, it uses a balanced scorecard of financial and nonfinancial objectives—which include progress in carrying out key development activities; implementing capital spending plans; achieving environmental, health, and safety goals; and maintaining a healthy, well-funded balance sheet.

But we’re not fans of the practice of creating focused strategy committees on the board that are similar to the committees on audit or risk. We agree with Walker, who told us: “Strategy is the fundamental challenge of the organization, and it should engage the entire board.” That collective effort is critical to ensuring the right long-term debates and decisions.

Engaging with Long-Term Investors

While boards may be guilty of pushing executives to maximize short-term results, we have no doubt where that pressure really originates: the financial markets. That’s why in “Focusing Capital on the Long Term,” we insisted that it was essential to persuade institutional investors, whose ownership position makes them the cornerstone of our capitalist system, to be a counterforce.

Boards can and should be far more active in facilitating a dialogue with major long-term shareholders. Certainly many investors would welcome such engagement. BlackRock, the world’s largest asset manager (with more than $4.5 trillion in holdings), already strives for what CEO Larry Fink calls “robust, ongoing communication” with both the management and the board at many companies it holds stakes in. “That doesn’t mean that we want to tell companies what to do,” Fink told us. “We do, however, want to make sure there is a high-quality board and management team in place, and that we have ready access” in order to serve both the long-term interests of the company and “the long-term interests of our clients.”

Bank of Montreal, one of the largest banks in Canada, encourages shareholders to directly contact its independent directors, in particular about such topics as succession planning, corporate governance practices, and disclosure. And the board of Kinross Gold, one of the world’s largest gold-mining companies, holds regular one-on-one and group meetings with representatives of its institutional shareholders, who are encouraged to provide feedback. The company has adopted a policy that explicitly states what topics are suitable for directors to discuss (board structure and composition, CEO performance, material strategic decisions, overall corporate performance), and the independent chairman serves as the point of contact between shareholders and the board. (To allow this kind of exchange, institutional investors with a long-term focus should be more willing to lock up their shares—by agreeing not to buy or sell them in the public markets for a period of at least two to three years. This would give them the ability to adopt insider status, excusing them from certain disclosure restrictions that apply to other public investors.)

We believe more companies should and will adopt this approach. Fifty per cent of the sitting directors who responded to our September 2014 survey agreed that regularly communicating the company’s long-term strategy and performance to key long-term shareholders would be one of the most effective ways to alleviate the pressure to maximize short-term returns and stock prices. But if these conversations are to give directors the context and confidence to carry out their fiduciary duty, they must be dialogues, not one-way communications.

Paying Directors More

If we are going to ask directors to engage more deeply and more publicly, to spend a lot more time exploring and communicating long-term strategy, and to take on any attendant reputational risk, then we should give them a substantial raise. There is a growing consensus that directors should sit on fewer boards and get paid more—substantially more than the current average annual compensation of $249,000. We fully agree, but the even more important issue is how that pay is structured. A number of companies have already shifted the mix toward longer-term rewards.

A few years ago, Johnson & Johnson established minimum ownership guidelines for nonexecutive directors to better align their interests with shareholders’. J&J requires each director to retain the company shares issued upon election to the board and to own shares equal to five times his or her annual cash retainer. Coca-Cola grants non-option stock awards that become available only after a director has left the board. General Electric follows a similar scheme.

We’d go one step further: To really get directors thinking and behaving like owners, ask them to put a greater portion of their net worth on the table. This could be achieved by giving them a combination of incentive shares, a portion of which vests only some years after directors step aside, and requiring incoming directors to purchase equity with their own money.

The overarching goal should be to insist on a “material” investment that more strongly ties a director’s financial incentives to the company’s long-term performance. In some cases this could mean putting as much as 10% of a director’s net worth at risk.

Dominic Barton is the global managing director of McKinsey & Company and the author of "Capitalism for the Long Term".
Mark Wiseman is the president and CEO of the Canada Pension Plan Investment Board.