Good Governance, the Best Investment

Great Companies America fund's James Huguet says the best-run outfits produce the strongest returns. Among his picks, AIG and 3M

"Companies with good corporate governance outperform." That's the investment guideline of James H. Huguet, co-CEO and chief investment officer of Great Companies -- and his Great Companies America fund (IGAAX ) has proven that rule by doing better than the Standard & Poor's 500-stock index since its inception.

Huguet uses a computer model to determine a company's intrinsic value, based on discounted free cash flow, among other factors, and looks for stocks that are trading below that intrinsic value. But he also pays close attention to how well-run a company is, including the quality of the CEO, whether or not there's an outside board of directors, and the nature of its financial disclosure.

Among the companies that pass Huguet's screen are General Electric (GE ), 3M (MMM ), American International Group (AIG ), and eBay (EBAY ). On the other hand, he's concerned about the management turmoil at Coca-Cola (KO ) and says he's in the process of reducing holdings there.

These were some of the points Huguet made in an investing chat presented June 10 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Jim, what's your view of the broad market at this moment in time?

A:

Well, we're optimistic about the market. There are several things that we see that are turning positive. I think the economy is positive and is picking up. It also looks like oil prices are starting to decline. The situation in Iraq is starting to get better, with the passage of the U.N. resolution. The worry about interest rate increases seems to be waning -- any increase will likely be minimal.

So the companies in our portfolio are trading, on average, at about a 19% discount to intrinsic value. So we've got all the positives that are needed to build a bullish market. We're not quite there yet -- people are still concerned about where oil will go and some of the corporate governance issues -- but overall we feel the market is starting to turn up.

Q: Where does Corporate America stand in terms of corporate governance right now, in general? Are more reforms needed?

A:

Well, corporate governance is, I think, an issue that involves really the whole company. When you say a company is having corporate-governance problems, it's an environmental issue where the company itself needs to decide it's going to adhere to corporate-governance guidelines and make every effort to deliver against these guidelines. If you say you're going to have a strong outside board, you need to change and make sure you do have outside people on that board.

There are a number of areas that companies really need to look at before they can decide whether they're doing it all. If I were a corporation, I would look to a company like GovernanceMetrics International, which rates companies on a very detailed analysis of their corporate governance. So I'd go into their database and evaluate what needs to be fixed.... And studies show that companies with good corporate governance outperform their weaker corporate governance peers.

Q: What's your approach to determining "intrinsic value," and does corporate governance play a role?

A:

We use a sophisticated computer model to analyze and determine the value of a corporation. It's based on a company's discounted free cash flow, and we make estimates in terms of revenue growth, margin improvement, and a number of other factors. All those factors result in this estimate of intrinsic value. Corporate governance isn't something we actually use in figuring value, but companies with good corporate governance are those that are consistently increasing their intrinsic values.

Q: Which companies meet the standards of your model? Can you give us a sampling?

A:

Sure. One of the companies that we have in the portfolio is Omnicom Group (OMC ). Omnicom is trading right at $80 a share. It's the world's largest advertising agency, at a time when advertising will improve as our economy will improve. This company is trading at 20% below its intrinsic value, which we measure at around $100.

Another company would be First Data (FDC ). It's trading around $43 a share and has an intrinsic value of close to $58 a share. And another one that we could talk about is Citigroup (C ), which is trading right at $47 a share and has an intrinsic value of close to $59 a share -- a terrific company that's trading at a significant discount.

Q: Besides corporate governance, what are some traits that make a company great in your eyes?

A:

Well, we look for companies that have outstanding CEOs. We believe that the CEO is the most important person in the company, and therefore we carefully assess the head of every company we invest in.

We also look for companies in good businesses that have high returns on invested capital. Also companies with strong barriers, like patents or brand franchises, are very favorable. And global businesses that can develop their businesses in economies that might outperform the U.S.

We look for companies that have been in business for 50 years, because we're looking for companies that have proven themselves -- they've been through wars, depressions, they've got the quality of management to build a company.

Q: What's your take on Cisco (CSCO ) and Microsoft (MSFT )? Do you feel they're good stocks to invest in?

A:

Yeah, we do. We own them in our tech fund. Cisco is a dominant company in the areas in which they're operating. Today Cisco is trading at around $23, which is pretty close to its intrinsic value, so my gut feel would be that, short-term, you won't see much movement. Microsoft, however, is trading around $27 a share, with its intrinsic value around $35 a share, so there's certainly some opportunity there to see it move up. Whether or not it will is anybody's guess, though.

Q: What are the best food companies to invest in?

A:

Well, we don't really, other than PepsiCo (PEP ), invest in food companies, mostly because they tend to have slower growth. Pepsi is technically a beverage company, but they do own Quaker and Frito-Lay. So while that may not directly answer your question, it's a beverage company that's growing and developing, but has a food component to go with it. It's trading at around a 15% discount to its intrinsic value.

Q: How about American International Group (AIG )?

A:

AIG is a company we invest in. We think they're the best-managed company in the insurance industry. On a global basis, they are the largest insurance company, expanding their business in Asia. [Maurice] Greenberg, the CEO, is one of the best at what he does. It's trading at a discount of about 25% to its intrinsic value, and we've owned AIG since we started our portfolio.

Q: What are your thoughts on GE (GE )?

A:

We think GE is a terrific company. The CEO is outstanding. He's making a lot of the right moves from a long-term perspective to prepare the company for the near future. He's making the kinds of acquisitions that I think are the right kind of acquisitions and is really focusing on the long-term growth of the company.

We've owned GE since we began the portfolio. It's trading at about $31 a share, relative to its intrinsic value of $44 a share, and we think it's a very good long-term investment for our shareholders, so GE has a major position in our portfolios.

Q: What are some of the red flags in corporate-governance practices that turn you off to a company? What should the average investor keep an eye on?

A:

No. 1, you want to look at the board of directors and the structure of that board. What you want is ideally a strong outside board. The board is so important in terms of looking at, or determining, who the next CEO will be, setting policy, any of those kinds of factors that are extremely important in assessing/evaluating a company.

You would also want to look at how the compensation committee operates. That, again, is a key factor -- if they have one and how it's set up. There are issues as you look at directors -- do they attend board meetings, are they on other boards? (You don't want somebody on 15 other boards.)

When you look at financial disclosure, another key area, you want to see if there's an audit committee there, whether or not the company's under investigation for accounting issues. You want to look at shareholder rights -- do shareholders have confidential voting? You certainly want to look at how they're passing out stock options. And you want to look at corporate behavior. Environmentally, do they have policies in place? Are they doing workplace safety adequately? Those are some of the things in the corporate-governance area I think you would want to look at.

Q: How about 3M (MMM )?

A:

We think they're really a terrific company. The new CEO, [James] McNerney, came from GE and has done a terrific job in managing the company. The stock price has moved up nicely since he has taken over. We have the highest regard for him and what he has done for 3M.

3M's one of our holdings and is a major holding in our Great Companies America portfolio. It's trading right on its intrinsic value, so I don't think you're going to see a fast move in price, but I still think it's an excellent long-term investment.

Q: How do you rely on the financial data supplied when many companies, auditors, and financial firms have lied?

A:

One of the people on our portfolio management team is a CPA, as well as a CFA. We scrutinize returns of the companies we invest in very closely. If we see discrepancies or issues that concern us, we will contact the CFOs of these companies and try to figure out what's going on.

We would like to believe the kind of companies we're investing in are not the kind in which fraud will take place -- there are government agencies and regulations in place to prevent this. But as we've seen in the past, that's often not a deterrent.... So as an investor, it's not 100% safe and never will be, but I feel more comfortable with...the level of disclosure we're seeing from companies today.

Q: How does Coca-Cola (KO ) look, since they lost one of their executives?

A:

We've owned Coca-Cola since we started the fund, but we're in the process of reducing them as a holding. We're concerned, quite frankly, about the board of directors and the failure of the board from a management selection standpoint since the late '90s.

[Douglas] Daft, the man who's leaving, is being replaced, and we're concerned about the constant CEO turnover and how the new CEO doesn't fit the profile of what we look for in a CEO. We believe this management change has created enormous turmoil in the company and has had a negative impact on morale, so we're very concerned about Coca-Cola and how it's being managed.

It still has a high return on invested capital and a strong global franchise, but it's struggling right now, and we're concerned about the management of it.

Q: Did your focus on corporate governance predate the market's steep fall and the outbreak of scandal?

A:

Yes, we've always looked at corporate governance. We've always looked at the board of directors, the level of disclosure. Quality of management has been one of the screens we've used since we started the portfolio.

We believe we've gotten much better at corporate governance by using a firm to help us with this. It's a very complex issue, it requires a lot of analysis, and when a number of issues started being raised about corporate governance, it started to be much larger on our radar screen, and we ramped up our efforts to make sure the companies we invest in have high corporate governance standards. Our portfolio was ranked No. 1 in corporate governance out of all the large-cap growth portfolios by GovernanceMetrics and Lipper.

Q: Jim, you cited CSCO and MSFT. Any other tech companies survive your screen? Particularly, Net companies such as eBay (EBAY )?

A:

eBay is one of our holdings -- we think they're a terrific company. We also own Yahoo! (YHOO ), which has done very well and has excellent management. We also own Symantec (SYMC ). We invest in EMC (EMC ) in the storage area. We own Electronic Arts (ERTS ), and we also invest in Analog Devices (ADI ).

Q: How many holdings are in the Great Companies America fund? How has it fared? And what's the ticker?

A:

We have 22 companies in Great Companies America. The ticker is IGAAX, and over the life of the fund, we have outperformed the S&P 500. It's ranked by Lipper as one of the top-performing funds in its sector, on a three-year basis.

Q: Any thoughts on Colgate-Palmolive (CL ) and Procter & Gamble (PG )?

A:

We own both those companies, and both of them are excellent. Colgate has really focused on three sectors -- the toothpaste business, the pet-food business, and their personal-care products. They are truly a global company -- probably the most global U.S. company in consumer products. They have an outstanding CEO, it's extremely well-managed, and it's really focusing on the areas in which it can increase profits.

P&G is probably the best consumer-products marketer in the world. Their CEO has done an outstanding job of focusing the company. The stock has done quite well since he has taken over, and the company is really running on all eight cylinders right now. It's trading close to its intrinsic value, vs. Colgate trading at a slight discount. Both of them have very strong brand franchises that can function on a global basis.

Q: Jim, finally, if you're looking for dividend income, what choices would you make?

A:

Well, the kind of companies that we like -- like GE, P&G, Colgate-Palmolive -- those are companies that not only have sound dividends but have the potential for future growth as well. If a dividend is important to you, then you might want to look at utilities, but out of the ones we invest in, those are the kinds we'd recommend.

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