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How Johnson & Johnson (JNJ) Risks Your Money

Johnson & Johnson (NYSE:JNJ)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 (NYSE:JNJ)‘s  board asked shareholders to do.

In its 2013 proxy, Johnson & Johnson (NYSE:JNJ) 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 Johnson & Johnson (NYSE:JNJ) 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 Inc. (NYSE:T) and Wells Fargo & Co (NYSE:WFC), both of which had shareholder proposals in their 2013 proxies pushing for an independent chair.

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