Theme and Background
This chapter discusses the central role of corporate governance in long-term value investing. Oakmark believes that the "governance" factor within ESG is not an independent issue but an inseparable part of long-term value investing. For short-term traders, governance is almost irrelevant, but for Oakmark, which holds positions for years, governance is a critical variable determining success or failure.
Core Thesis
Oakmark's core investment argument is: Governance assessment cannot rely on simple checklist items (such as whether the CEO and chairman roles are separated, whether compensation is benchmarked against peers, whether there is one-share-one-vote, or whether the board is diverse). Instead, it must deeply understand the internal consistency among board dynamics, management incentives, and capital allocation philosophy. Counterintuitive judgments include: willingness to invest in companies where the CEO also serves as chairman (provided the lead independent director has sufficient influence); acceptance of founders holding super-voting rights (provided management compensation is strongly tied to business value growth); opposition to high pay for mediocre performance, but support for high pay to attract talent, with additional compensation linked to exceptional performance that benefits all shareholders.
Key Arguments and Data
- Impact of Governance on Holding Period: For traders with a holding period of only a few months, governance is "almost irrelevant"; but for Oakmark, with a holding period measured in years, governance is "the dividing line between success and failure."
- Three Options for Capital Allocation: When a company has excess cash, management has only three avenues:
1. Deleveraging (reducing debt or increasing cash reserves)
2. Investing in unrelated businesses (internally or through acquisitions)
3. Returning capital to shareholders (dividends or buybacks)
- Oakmark's Preference Ranking:
- Opposes deleveraging (as portfolio companies typically already have reasonable debt levels)
- Opposes investing in unrelated businesses (unless the company has a competitive advantage in that area, such as Alphabet and Facebook investing in autonomous driving and AR)
- Supports returning capital to shareholders, with a particular preference for buybacks (since Oakmark only holds stocks trading below intrinsic value, buybacks can generate immediate positive returns)
- Buybacks vs. Dividends: Buybacks are criticized as a "one-time EPS boost," but Oakmark argues that when mature companies consistently generate excess cash, buybacks can be regularized without increasing leverage. Compared to acquisitions, buybacks require no premium payment, do not distract management, incur no restructuring costs, and face no information asymmetry risks.
- Compensation Incentive Design: Oakmark opposes incentive plans based on total sales or net profit (which encourage unrelated investments) and prefers incentives based on return on invested capital (ROIC) to encourage returning excess cash to shareholders.
Companies/Assets Involved
| Company/Asset |
Role and Key Data |
Bullish/Bearish |
| Alphabet (GOOGL) |
Cited as having "engineering talent advantages"; investments in autonomous driving and AR are considered "investments with competitive advantages" |
Bullish (positive assessment on capital allocation) |
| Facebook (META) |
Same as above, cited as having "engineering talent advantages" |
Bullish (positive assessment on capital allocation) |
| Traditional telephone companies |
Cited as a negative example of "recently writing down media acquisitions," representing "diversification without advantages" |
Bearish (failed capital allocation case) |
Investment Implications
- Governance Assessment Should Go Beyond Form: Investors should not merely score based on surface-level indicators such as CEO/chairman separation, compensation benchmarking, or one-share-one-vote. Instead, they should deeply understand board dynamics, the actual influence of the lead independent director, and the degree to which management compensation is tied to long-term value creation.
- Capital Allocation Is the Core Battlefield of Governance: For mature companies generating excess cash, how management handles surplus capital (buybacks, dividends, acquisitions, deleveraging) is key to assessing governance quality. Oakmark clearly prefers buybacks, as they can immediately create value when stocks are undervalued and carry lower risk than acquisitions.
- Focus on "Alignment" of Management Incentives: Investors should examine whether incentive plans are based on scale metrics (e.g., sales) or efficiency metrics (e.g., return on capital). The latter is more likely to encourage management to return excess cash to shareholders rather than engage in empire building.
- Beware of "Empire Building" Tendencies: A CEO who views the board as a "necessary evil" and only seeks rubber-stamp members is a major red flag. Conversely, seeking new directors with relevant experience (e.g., global expansion) is a positive signal.
Theme and Background
This chapter discusses how Oakmark addresses corporate governance issues within its actual investment process. The report notes that Oakmark does not adopt an activist strategy of "buying in and pushing for change." Instead, it avoids companies with poor governance through pre-screening and emphasizes the importance of face-to-face engagement with management during long-term holdings.
Core Views
- Core Investment Thesis: Oakmark believes it is better to avoid investing in poorly governed companies outright than to invest and then attempt to change them. Poor management can destroy significant value during the period when "activist investors" push for change.
- Counter-Intuitive Judgment: Oakmark does not rely on proxy voting to correct issues but instead avoids them through "pre-veto" (i.e., not buying). When disagreements with management arise, the preferred approach is private communication. If still unsatisfied, Oakmark sells the stock directly rather than engaging in public confrontation.
Key Arguments and Data
- Action Process: Oakmark's sequence for handling governance issues is: private communication with management → private communication with the board → selling the stock if still unsatisfied. Only in rare cases (where management harms shareholder interests and the stock is severely undervalued) does Oakmark publicly call for a change in management.
- Importance of Face-to-Face Engagement: Oakmark analysts meet with the CEO, CFO, and sometimes the Chairman or Lead Independent Director. The author typically accompanies analysts to company headquarters or hosts visiting management in their Chicago office. Zoom could not replace face-to-face interaction during the pandemic.
- Resumption of Travel: In May 2021, Oakmark analysts resumed business travel. The author has already attended management meetings for nine portfolio companies and expects travel frequency to be higher than normal for at least the next year to make up for meetings postponed due to the pandemic.
Companies/Assets Involved
- Alphabet Cl A: Oakmark Fund position 3.9%; Oakmark Select Fund position 11.0%; Oakmark Global Select Fund position 11.3%.
- Facebook Cl A: Oakmark Fund position 3.3%; Oakmark Select Fund position 5.2%; Oakmark Global Select Fund position 0%.
Investment Implications
- Implications for Investors: For long-term investors (holding periods of 5+ years), evaluating corporate governance should go beyond common "checklist-style reviews" (e.g., separation of CEO and Chairman, compensation benchmarking). True governance assessment requires a deep understanding of board dynamics and management capabilities, and face-to-face interaction is key to gaining this insight. Investors should prioritize companies whose management has already demonstrated strong governance capabilities, rather than hoping to drive change through activist tactics.