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One Way This Company Risks Your Investment

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Investing genius Charlie Munger advises us to "[n]ever, ever think about something else when you should be thinking about the power of incentives." But that's just what Johnson & Johnson's  (NYSE: JNJ  )  board asked shareholders to do.

In its 2013 proxy, Johnson & Johnson argued against a shareholder proposal pushing for an independent chairperson. The board claimed that "it is important to maintain the flexibility it currently has to tailor its leadership structure to best fit the company's specific circumstances, culture, and short and long-term challenges."

In the end, the board's preferences won out, as the proposal failed  to receive majority support. Let's take a look at why giving J&J this flexibility may make your investment risker.

Increased risk
When a company's CEO serves as its chair, he leads the same entity that chooses board members and creates their compensation packages. This governance structure allows the chairman/CEO to wreak havoc on a company by filling the board with friends and allies and reward them for their loyalty with excessive compensation and perks. In turn, this power allows the chairman/CEO to give the rest of the board significant incentives to give favorable performance evaluations, push through excessive compensation packages, and rubber-stamp management decisions.

In other words, the dual chair/CEO structure can give the board incentives to back management decisions, even when they aren't in the best interests of shareholders. Now, this doesn't mean that a chairman/CEO will necessarily engage in this type of behavior, but the empirical data does show that this dual role is a red flag.

Data gathered by corporate governance guru Nell Minow's organization, GMI Ratings, supports my view that companies with the same person serving as CEO and chairman are riskier investments.

The data-driven argument
One of the metrics that the GMI study examines is the correlation between the dual chairman/CEO roles and a company's AGR, or accounting and governance risk. Factors affecting a company's AGR risk include "accounting items that might signal fraudulent financial statements" and "governance characteristics associated with firms prosecuted by the US SEC for accounting fraud."

According to the study, businesses with the same person serving as CEO and chairman are 86% more likely to be identified as "Aggressive" by GMI's AGR model. While the AGR model takes the dual chair/CEO role as a risk factor, its influence in the ranking is not substantial enough to create such a large result.

Companies with a dual chair/CEO structure also have higher ESG (environmental, social, and governance) risks. GMI Ratings derives ESG by noting the presence of "red flags" such as "significant votes against pay policy, over-boarded directors and the presence of a poison pill." The more "red flags" a company has, the lower its score.

According to the study, companies with the same person serving as CEO and chairman are almost twice as likely to earn an ESG score of "F." Some of the companies that earned a failing ESG grade that have a combined CEO and chair include AT&T and Wells Fargo, both of which had shareholder proposals in their 2013 proxies pushing for an independent chair.

As is the case with the AGR model, the ESG model considers the dual chair/CEO role as a "red flag" -- but its influence isn't nearly substantial enough to account for such a large differential.

Risks at Johnson & Johnson
In its shareholder proposal, the American Federation of State, County and Municipal Employees, AFL-CIO -- or AFSCME -- argues that there is a particularly strong call for an independent chair at J&J, which has been called out by the media for "struggling to rebuild its reputation as one of the world's most trusted brands after a series of product recalls, manufacturing problems and government inquiries."

I believe they're right. J&J has faced significant scrutiny over the last few years for decisions that appeared to put short-term profits ahead of its customers. For example, the company earned the ire of the Food and Drug Administration for its continued sales of defective insulin pumps produced by its Animus unit and failure to report cases in which the pumps may have contributed to deaths or injuries. Also, J&J has had a huge number of product recalls over the last few years, including non-prescription drugs like Tylenol and Motrin, prescription drugs for HIV and seizures, contact lenses, and faulty hip implants.

The Foolish takeaway
When the CEO and chairman roles are combined, you want to be very sure that you can trust leadership to do what's in the best interest of shareholders. With so many recalls in recent years, I believe that J&J's leadership has compromised investors' trust.

I believe that prevention of problems like those at J&J requires a board that is empowered and incentivized to offer strong oversight and sufficiently critical performance evaluations. Without governance changes that can make this happen, I think shareholders would do well to apply a discount to their valuation of J&J.

Is bigger really better?
Involved in everything from baby powder to biotech, Johnson & Johnson's critics are convinced that the company is spread way too thin. If you want to know if J&J is nothing but a bloated corporate whale -- or a well-diversified giant that's perfect for your portfolio -- check out The Fool's new premium report outlining the Johnson & Johnson story in terms that any investor can understand. Claim your copy by clicking here now

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9/29/2016 4:00 PM
JNJ $117.27 Down -2.12 -1.78%
Johnson and Johnso… CAPS Rating: *****