SACRAMENTO, Calif. - The $124 billion California Public Employees' Retirement System will be searching out corporate managers who aren't adding real economic value to the businesses they run.
CalPERS' adoption of new statistical procedures - called economic value added, or EVA - is part of its revamped corporate governance program for 1997-'98.
Using EVA, investors can uncover some corporate managements that pump up their stock values using common accounting procedures.
Some of those managers and their companies might suffer the public humiliation of winding up on CalPERS' corporate governance focus list. The list publicly identifies 10 companies that have poor stock performance and that, in CalPERS' view, also have poor corporate governance practices.
CalPERS' list - expected at the beginning of the year - is believed to influence the lists of troubled companies drawn up by other shareholder activists.
The decision to use EVA was made at the CalPERS' October investment committee meeting.
EVA is a company's after-tax net operating profit, minus its cost of capital for one year. A company with a series of negative EVAs is sometimes characterized as a wealth destroyer, rather than a wealth creator.
Big firms have negative EVAs
Stern Stewart & Associates, New York, is a consulting firm CalPERS is using to evaluate the EVAs of companies. According to that firm, in 1997, NYNEX Corp. had a negative EVA of $617 million; RJR Nabisco Holdings Corp. had a negative EVA of $1.2 billion; Digital Equipment Corp. had a negative EVA of $1.4 billion; Westinghouse Electric Corp. had a negative EVA of $1.59 billion; Tele-Communications Inc. had a negative EVA of $2.5 billion; and General Motors Corp. had a negative EVA of $3.5 billion.
One year's negative EVA doesn't mean a company would make CalPERS' focus list or that the company was in trouble. It would take three years of negative EVA to raise concerns.
Even then, the company would have to be underperforming in the market and have poor corporate governance practices before it would be considered for CalPERS' list.
But by adding EVA, CalPERS executives expect to add strength to their reasons for putting a company on the focus list.
According to Stern Stewart, a company with repeated negative EVA will lose value as investors lose confidence in the firm.
CalPERS will look at EVA figures over a three-year period. The fund will use EVA as its first screen for focus list candidates.
Fund executives hope the EVA test will help them find underperforming corporate managers who might otherwise go unnoticed.
How EVA works
EVA is a more direct measure of performance of corporate managers. Stock market performance is, at best, an indirect measure, said Robert L. Boldt, senior investment officer at CalPERS.
According to CalPERS officials, stock market performance, even over a three-year period, frequently doesn't fully reflect the basic economic performance of a company.
EVA, an attempt to measure a company's true economic profit, employs the assumption that a business is not adding value unless the return on total investment from its endeavors exceeds the cost of capital.
"EVA helps you to differentiate companies that are simply manufacturing gains in their (earnings) per share by plowing back retained earnings in projects that do not cover the shareholders' required return," said Bennett Stewart, a senior partner at Stern Stewart.
"You see right now with long-term government bonds yielding 6.5%, the evidence shows that stock market investors expect about 6% more than that overtime," said Mr. Stewart.
A company can reinvest earnings in a project that produces an 8% return. That company's earnings per share will continue to climb, but the company's EVA will not, said Mr. Stewart.
Tennis without a net
"Earnings per share is like playing tennis without a net. There is no charge for the use of retained earnings. So it is quite tempting for mangers to plow back retained earnings and to earn poor returns, less than what the equity holders expect," said Mr. Stewart.
EVA can pinpoint companies that are expanding in size, but not in value, said Mr. Stewart. Stern Stewart also attempts to correct accounting distortions in measuring the EVA, he said.
CalPERS' officials believe EVA is the best measure of corporate management's economic performance.
According to a CalPERS report, by including both stock price performance and economic performance in its screening measures, the fund "pinpoints those companies where poor market performance is due to underlying economic performance problems and not due to industry or extraneous factors."
"It is an enhancement" to the selection process for the focus list, said Sheryl Pressler, CalPERS' chief investment officer.
She said the new process asks if a company is "generating a real economic profit or would you have been better off investing" elsewhere.
CalPERS also is commenting on U.S. corporate managers in other ways.
Reviewing proxy votes
According to CalPERS data for the 1996-'97 proxy season, CalPERS voted only 9% of the time against directors' elections and only 12% of the time on director stock options.
But CalPERS voted its proxies negatively 36% of the time on executive stock plans and 39% of the time on executive bonus plans.
Those votes appear to have more to do with executive pay than with any negative attitude toward corporations. CalPERS voted negatively 22% of the time on management proposals, but 57% of the time on shareholder proposals.
CalPERS officials haven't made up their mind yet about whether to develop a focus list for foreign firms.
Mr. Boldt, the investment officer, told trustees CalPERS didn't want to "ruffle feathers" of international corporate managements.
Still, executives of foreign companies didn't escape CalPERS proxy votes. For fiscal 1996-'97, CalPERS voted on proxies of approximately 780 international companies with an aggregate market value of $23.7 billion.
Among international firms, French companies got most of CalPERS' negative votes. It voted against management proposals of French companies 33 times.
CalPERS voted against corporate management in Switzerland, Thailand, Brazil, and Malaysia, once each; Australia, Germany, Spain and Singapore, twice each; Hong Kong and South Africa, three times each; Japan and the United Kingdom, six each; Philippines, seven; the Netherlands, nine; Korea, 10; and Indonesia, 15 times.
Most of its negative votes on international proxies involved increases in equity capital issued without pre-emptive rights to existing shareholders, use of all the authorized capital to ward off hostile takeovers and amending articles of incorporation where no pertinent information was provided.
In the United States, Mr. Boldt said the fund has some success in voting its proxies with Apple Computer Corp., Cupertino, Calif., and the Student Loan Marketing Association, Washington.
