The Hermes PrinciplesWhat shareholders expect of public companies –

and what companies should expect of their investors

The aims of this documentHermes believes that companies perform betterwhere there is understanding between them and theirowners. A company is a joint enterprise betweenthose that run it – its directors and managers – andthose that own it – its shareholders. Investments inpublic companies are more likely to succeed ifinvestors communicate reasonable expectationsproperly and corporations better understand what isbeing asked of them.

Hermes would like to thank the senior businessfigures who contributed their comments in the writingof this document.

© Copyright Hermes Pensions Management Limited,2002

Contents 3 Introduction

4 Investment principles

5 Capital market behaviour

6 The Hermes Principles

7 Communication

8 Financial

15 Strategic

17 Social, ethical and environmental

19 Conclusion

The Hermes Principles

ISBN 0-9543843-0-X

3

Introduction

This document sets out principles to address a simplequestion: ‘What should owners expect from UK publiccompanies and what should these companies expectfrom their owners?’

Its aim is to create a common understanding,between managers and owners, of the proper goalsof a public company.

It sets out a number of expectations which Hermesbelieves should exist between owners and managers.By being explicit about appropriate expectations, weaim to get a better framework for communication anddialogue between boards and shareholders, and sohelp boards manage their companies better.

The ultimate goal of the company is to create wealthfor its shareholders. This in turn suggests a numberof actions which it is reasonable for shareholders toexpect of companies.

The expectations in this document are derived fromHermes’ extensive experience as an active andengaged shareholder on behalf of its pension fundclients (throughout this document reference toHermes as shareholder is in recognition of Hermes as the agent for the owners). Hermes invests in some of the best companies, that already delivershareholder value according to these principles. Wealso intervene in companies which have not deliveredshareholder value.

This experience, together with that of similar fundsaround the world with whom Hermes has closerelationships, has provided a number of lessonsabout why companies often fail in their primary goalof delivering long-term value. Our joint experience, ofachieving outperformance on those investmentswhere intervention has altered corporate behaviour,suggests there are good central managementdisciplines which will greatly increase the likelihood of value delivery. It is important that, as investors, we are explicit about the importance we place onthese disciplines.

We are not seeking to place new burdens onbusinesses. It is not in our interest as investors to dothat. What we might expect as one outcome of thisdocument is some reappraisal of the way thatbusinesses communicate with shareholders.

These principles are complementary to Hermes’position on corporate governance. Governance setsout the structures and processes by which a companyshould be controlled through its board. It shouldencourage positive entrepreneurial behaviour, whilehaving appropriate checks and balances through itsindependent directors and the right balance of powerto ensure decisions are wisely made. We monitor thegovernance of the companies in which we invest onbehalf of our clients closely, giving support to thosewhich demonstrate an appropriate structure, andintervening to change those which do not.

So far Hermes (and indeed all other fund managers)have been less explicit in addressing the question ofthe management implications of accepting the goal ofvalue creation. This document aims to fill that gap.We would be pleased to discuss these principles with the managers of public companies, othershareholders and any other interested parties tocreate the greatest possible clarity about ourexpectations.

We believe these principles have significantimplications. We would like to replace the damagingfinger-pointing which has characterised the City-Industry debate in the past, with a positive dialoguebetween managers and owners about the properpurpose of the corporation.

Responsible behaviour by boards requiresresponsible investors. A company that isdemonstrating commitment to delivering long-termshareholder value should expect ongoing supportfrom its shareholders. At Hermes, we aim to giveenduring support to companies which demonstratesuch a commitment. ■

At Hermes we aim to give enduringsupport to companieswhich demonstratecommitment to long-term shareholdervalue

Hermes Governance Codewww.hermes.co.uk/corporate-governance/PDFs/statement.pdf

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The Hermes Principles

Investment principles

Those who control the largest blocks of shares in theUK, are the investment ‘institutions’. The ultimatebeneficiaries of most institutional investment activityare those who hold pensions and life insurancepolicies. In Hermes’ case, several million peopledepend on our investment to secure their income inold age. Hermes’ clients have liabilities which extendfor a long period of time. A typical ‘average’ liabilitywould be well over a quarter of a century. It is theseliabilities that we seek to cover by investing in andbecoming the part-owners of public companies.

The interests of shareholders are not delivered byformal contract, as the interests of bond holders,consumers, or even employees are. The shareholders’interest is the objective of the company. The definitionand implications of this interest is the aim of thisdocument. We hold it as axiomatic that the primarygoal of a UK listed company is to be run in the long-term interests of its shareholders – to generate valuefor them.

Central to this goal is the need tocreate a financial surplus.

For long-term value creation, it is essential thatcompanies create a financial surplus in excess oftheir cost of capital. It is that surplus which pays forpensions and insurance policies. Growth, earningsper share, return on capital employed and marketshare measure the ways that surplus is created, butare not surrogate measures for the financial surplusitself. It is possible to demonstrate earnings-per-sharegrowth while destroying shareholder value.

Financial surplus is achieved by having acompetitive advantage.

Given the lengthy timeframe for realising the returnson projects and the uncertainty under which mostbusiness decisions are made, companies need to be

able to demonstrate that their investment decisionsare soundly based. A company should be able todemonstrate its competitive advantage, both atcorporate and at business unit level.

And in so doing it should demonstrateethical behaviour.

As a long-term diversified investor, we opposecompanies behaving in a way which knowinglypasses costs on to other companies or to the taxpayer, and as such is socially or environmentallyunacceptable, or unethical. It makes no sense ifbusiness success is achieved by creating other costs(‘externalising costs’) which the beneficial owners ofcompanies will ultimately pay for.

In summary, a company’s primary considerationshould be the generation of long-term shareholdervalue, and this should be based on appropriatefinancial disciplines, competitive advantage, andwithin a framework which is economically, ethicallyand socially responsible and sustainable.

Hermes believes these goals should be shared byother long-term investors such as pension funds andlife insurance companies. In our experience manymanagers tell us that their discussions with theinvestment community rarely focus on these issues.They ask how a company can be expected to showabsolute commitment to long-term shareholder valuewhen the majority of its investors fail to demonstrateadequately that this is what they require, or expresswhether they consider the company – as seen fromtheir perspective – is achieving it. Some of theseissues can be better understood by thinking about the behaviour of the capital markets. ■

The shareholders’interest is theobjective of the company

‘Several million people depend on Hermes’ investments to secure their income in old age.’

5

Much discussion between companies andshareholders is about helping investors to decide if, over the short run, a company’s shares are likely to rise or fall. This will usually be based on someconcept of over or undervaluation, often over a shorttime period. Therefore companies may feel investorshave an obsessional concern with short-termperformance. Often they are correct. Fund managerswish to understand short-term performance so thatthey can exploit relatively short-term movements inthe share price and hence outperform their peers in arelative sense. This attention to relative performanceis one of the key factors in assessment of fundmanagers themselves, yet pension fund or insuranceliabilities are met out of absolute returns over the longterm, not relative ones in the short term.

The principal way in which fund managers seek tooutperform each other is through buying and sellingcompany shares. If a fund manager judges that thecompany’s shares seem overpriced by the marketrelative to its future prospects, they will sell ormaintain the option to sell the shares, and vice-versaif it is underpriced. Trading in company shares does have a value. It keeps the market ‘liquid’,allowing funds to assess the value of their assetsproperly, and can be a signal to management ofperformance issues.

Because this trading activity implicitly dominates bothperformance measurement and information supply inthe investment industry, it can also dominate thediscussions between shareholders and thecompanies in which they invest, particularly whenbrokers themselves also seek to be intermediariesbetween investors and companies. The bestcompanies ensure that they have a proper dialoguewith their investors directly, not just throughintermediaries. However, too many companies focus investor relations activities on brokers andanalysts, rather than on those actually investing.

A large infrastructure of information sources andopinion supports this trading activity. The commissionbrokers receive on trading shares is the prime sourceof their income. Most brokers’ reports on companies,will be headed ‘buy’, ‘sell’ or some other tradingrecommendation.

As we have said, there is nothing wrong with thistrading activity in itself. What can cause problems is if the attention given to short-term performancedistracts company managers from the goal of creatinglong-term shareholder value. If there are someparticipants in the market who seek to bet onperformance over a shorter time period, so be it, butthis should not distract company managers from theirlong-term goals.

Warren Buffet, the legendary American investor,describes the process of share trading as ‘gin rummycapitalism’. Money managers ‘discard their worst cardat each turn’.

Consider an analogy. The marathon is a 26-mile race.During a marathon, people may take bets on who willrun the next mile the fastest. The person who runsthe next mile fastest may be well positioned to winthe race. But if the runners become so obsessed bythe betting on performance in the short term that theyexhaust themselves, they are unlikely to succeed.

It is important that company managers understandthat much of the questioning they receive frombrokers and fund managers will be to help them make a decision about the short-term direction of thecompany’s shares and hence whether or not to buy or sell shares. This is entirely legitimate. But it shouldnot determine the basis on which a company is run.Nor is it an alternative to proper stewardship byshareholders as owners. ■

The best companiesensure they have aproper dialogue withtheir investors directly,not just throughintermediaries

Capital market behaviour

‘Some participants in the market seek to bet on performance over a short timeperiod. This should not distract company managers from their long-term goals.’

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The Hermes Principles

Hermes’ overriding requirement is that companies be run in the long term interest of shareholders.Companies adhering to this principle will not onlybenefit their shareholders, but also we would argue,the wider economy in which the company and itsshareholders participate. We believe a company run in the long term interest of shareholders will need to manage effectively relationships with itsemployees, suppliers and customers, to behaveethically and have regard for the environment andsociety as a whole.

CommunicationPrinciple 1 ‘Companies should seek an honest, openand ongoing dialogue with shareholders. They shouldclearly communicate the plans they are pursuing andthe likely financial and wider consequences of thoseplans. Ideally goals, plans and progress should bediscussed in the annual report and accounts.’

FinancialPrinciple 2 ‘Companies should have appropriatemeasures and systems in place to ensure that theyknow which activities and competencies contributemost to maximising shareholder value.’

Principle 3 ‘Companies should ensure all investmentplans have been honestly and critically tested in termsof their ability to deliver long-term shareholder value.’

Principle 4 ‘Companies should allocate capital forinvestment by seeking fully and creatively to exploitopportunties for growth within their core businessesrather than seeking unrelated diversification. This isparticularly true when considering acquisitive growth.’

Principle 5 ‘Companies should have performanceevaluation and incentive systems designed cost-effectively to incentivise managers to deliver long-term shareholder value.’

Principle 6 ‘Companies should have an efficientcapital structure which will minimise the long-termcost of capital.’

StrategicPrinciple 7 ‘Companies should have and continue todevelop coherent strategies for each business unit.These should ideally be expressed in terms of marketprospects and of the competitive advantage thebusiness has in exploiting these prospects. Thecompany should understand the factors which drivemarket growth, and the particular strengths whichunderpin its competitive position.’

Principle 8 ‘Companies should be able to explain whythey are the “best parent” of the businesses they run.Where they are not best parent they should bedeveloping plans to resolve the issue.’

Social, ethical and environmentalPrinciple 9 ‘Companies should manage effectivelyrelationships with their employees, suppliers andcustomers and with others who have a legitimateinterest in the company’s activities. Companiesshould behave ethically and have regard for theenvironment and society as a whole.’

Principle 10 ‘Companies should support voluntary andstatutory measures which minimise the externalisationof costs to the detriment of society at large.’ ■

The Hermes Principles

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Principle 1 ‘Companies should seek an honest, openand ongoing dialogue with shareholders. They shouldclearly communicate the plans they are pursuing andthe likely financial and wider consequences of thoseplans. Ideally goals, plans and progress should bediscussed in the annual report and accounts.’

A company cannot control its share price, which willbe affected by many external factors. However, it canseek to be clear about its goals, and the financial,strategic and ethical disciplines by which it ismanaged. This will create the best chance of acompany being evaluated properly, and gaining thefull benefit of access to a lower cost of capital throughpublic capital markets, and of delivering value to itsowners. This is a continuing process of providinginformation and correcting misinformation to ensurethe fullest possible understanding of the company bythe market. If a company does not communicateproperly, it may not get proper credit from itsshareholders, even if it is succeeding.

It is important that companies are honest about theirprospects, and do not seek to excuse current failureby promising success in the future. For thosecompanies with a long investment time frame, suchas those involved in drug development or aerospace,there may be considerable delay between aninvestment and its subsequent return. However, theremay be cases where companies simply promisebetter return in the future without any credibleoperational or strategic plan to achieve thatimprovement. It is therefore important that companiesare able to articulate a credible plan as to how andwhen performance and shareholder value will be

delivered. Many companies do this very well, but a lotof annual reports go into great depth describing therange of a company’s activities and aspirations forgrowth, while failing to explain how or whethershareholder value is being created by these activities.

There is one important rider to this discussion. Theprice of a company’s share reflects the market’s viewof the company’s prospects, and therefore its cost ofcapital. If a company’s share price is low, it probablyreflects fundamental doubts about its prospects.Where this is the case, and management areconfident that the business is worth more, it is quiteappropriate that they should respond by reappraisingthe capital structure and, if appropriate, buying backtheir own shares. A company which is maximisingshareholder value should always consider arepurchase of shares where this provides superiorreturns to investing in the business. ■

The Hermes PrinciplesCommunication

Principle 1 ‘Companies should seek an honest, open and ongoing dialogue withshareholders. They should clearly communicate the plans they are pursuing andthe likely financial and wider consequences of those plans. Ideally goals, plansand progress should be discussed in the annual report and accounts.’

8

The Hermes Principles

Measuring returnsPrinciple 2 ‘Companies should have appropriatemeasures and systems in place to ensure that theyknow which activities and competencies contributemost to maximising shareholder value.’

Many who work outside the financial system mightassume that it is easy for managers to determinewhether they are delivering, and for shareholders todetermine whether they are getting the best financialreturns. In reality things are much more complex. It istherefore important that shareholders are clear aboutwhat measures of return companies should use.

The primary goal of a company should be tomaximise shareholder value. In financial terms this isbest measured by the present value of the cash flowsfrom investment, discounted at an appropriate cost ofcapital. The best companies are demonstrably awareof the importance of the Weighted Average Cost ofCapital (WACC) to all decision making (figure 1,right). For most companies, the post-tax weightedaverage cost of capital (WACC) might be around 7-8% per annum over the long term (figure 2, opposite).WACC is an important number. If a company sets ittoo high, it will discount too heavily the value itcreates, particularly over the long term. If it sets it toolow, it will invest in a way which destroys value.

Financial reporting disciplines often do not accuratelymeasure or report the cash returns from anyinvestment and hence whether WACC is beingachieved. Modern financial accounting is based onmeasuring the assets of a company (as expressed inthe balance sheet), and transactional movementsbetween today’s balance sheet, and the one drawnup the previous year (the profit and loss account). It is a hugely important discipline, but one which

cannot measure the true value of the company.

Basic financial accounting measures are widely usedas targets for managers and companies, primarilybecause the ubiquity of accruals-based, historic cost,financial accounting systems makes them easy touse. If, from time to time, companies wish to focus onsuch measures, this may be quite appropriate for

Principle 2 ‘Companies should have appropriate measures and systems in placeto ensure that they know which activities and competencies contribute most tomaximising shareholder value.’

The Hermes PrinciplesFinancial

Figure 1 WACC – principles A company will usually be funded by a mixture ofequity and debt. WACC – the weighted cost ofcapital – is the cost of funding taking into accountthe cost of debt and equity capital.

WACC can be a difficult number to calculateprecisely. It is important that investors know thatcompanies understand their cost of capital, butvery few companies state clearly in their annualreport and accounts their WACC assumptions.Given that WACC underpins the financial goals ofa company seen from an investor perspective thisis somewhat surprising. One of the fewcompanies that does make a clear statement onits WACC is Geest plc. It is also a good exampleof frank reporting to shareholders.

‘Geest seeks to enhance shareholder value. The average post-tax return on invested capitalincluding goodwill in 2000 was 16% (1999: 17%)versus a weighted cost of capital (WACC) of lessthan 10%. Geest has had an inefficient balancesheet entirely funded by shareholders, and as aresult we have operated with a sub-optimalWACC. As borrowings increase to fund ourgrowth, our WACC will decrease.’Geest plc annual report 2001

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managerial and motivational reasons. Companiesshould bear in mind that the ultimate goal is long-termshareholder value, and that this is best measured interms of cash flow returns. We welcome initiatives bycompanies and their advisers to establish systemsbased on this measure.

Most companies have planning systems whichinclude a full discounted cash flow model of theoptions available to them and make objectivedecisions on this basis. Indeed it is rare for boards ofdirectors to approve any investment which does notdemonstrate a positive present value. The questiontherefore arises; ‘if companies plan to delivershareholder value, why do some fail to do so?’

There are many reasons why the value gap exists.For example, although impact on shareholder value is usually measured before any investment is made, it is less often measured afterwards in a fullyobjective way. Boards should be encouraged toreview investment assumptions and projections afterthe event to track against reality, rather than justcomparing the outcome through budgetaryprocesses. If they don’t, managers and investors will have little guide as to which of their decisionshave been successful.

Secondly, plans, though based correctly on presentvalue, can fail to incorporate the full consequentialcosts associated with a project on the wholebusiness.

Thirdly, internal company goals can detract from thecreation of shareholder value. For example,companies may encourage the maximisation ofreturns on capital, rather than the maximisation of

absolute cash outperformance; or seek to grow scalewithout delivering value to shareholders.

Figure 2 WACC – amountAs this document is written in late 2002, anaverage FTSE 100 company cost of debt mightbe around 6% (4% post-tax). A large FTSEcompany may have a cost of equity of between7% and 9%. Therefore WACC for an averagelarge FTSE company may be of the order of 7%-8%, and higher where risk perceived by investorsincreases the cost of both equity and debt capital.

As pension fund investors, our required return onequities is projected at 8%. The FSA assumedinvestment returns for assessing maturity targets of life policies are 6%-8%. The purpose of highlighting these numbers is not to setexpectations for returns on investment, but to set them into context in a realistic way.Reasonable expectations are more likely to result in rational plans that will deliver reasonableoutcomes.

Good companies make realistic assumptions.However some are tempted to make unrealisticassumptions about profitability and then discountat a high rate to counter the risk of their optimism.This has implications for the types of projects thatwill be invested in. With higher discount rates timedistant returns count less in relative terms. Anoverly high discount rate discriminates againstlonger term projects and builds in unhelpful short-termism.

The Hermes Principles – Financial continued

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The Hermes Principles

The Hermes Principles – Financial continued

Principle 3 ‘Companies should ensure all investment plans have been honestly and critically tested in terms of their ability to deliver long-termshareholder value.’

Returns and growthPrinciple 3 ‘Companies should ensure that allinvestment plans have been honestly and criticallytested in terms of their ability to deliver long-termshareholder value.’

The purpose of the capital markets, through whichmost institutions make their investments, is to allocateresources to those companies and projects wherethere is a high return and away from those whichhave lower returns. When capital markets workeffectively, they will, through this process, encouragehigh productivity of capital and a high level ofeconomic growth. High capital productivity and highgrowth will generate long-term shareholder value andstrength in the overall economy (figure 3, right).

As a shareholder Hermes wishes to promoteinvestment and growth that is sustainable.

We would not want companies to pursue growth forgrowth’s sake. If they do they may prevent investmentby other companies which may have a better chance of creating sustainable long-term value. Creating thatvalue usually demands that a company has fullythought through its strategy, a subject which isdiscussed later.

Figure 3 Growth in the economy andgrowth prospects of individualcompaniesThe UK Treasury trend growth projections are2%-3%. Clearly some companies will be capableof achieving growth substantially higher than this.However, as a diversified investor, it has longbeen apparent that the sheer numbers ofcompanies aspiring to growth substantially inexcess of this does not stand up in overalleconomic terms. We would encourage everycompany to exploit profitable opportunities togrowth. However plans should be based on thereality of likely future customer requirements andon competitive pressures, which mean that realprice reductions and service improvements maybe needed simply to stand still.

Similarly, trend economic growth is just that, an average. Investment plans should makereasonable assessments of changes in economiccircumstances in the normal course of an economic cycle.

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Growth and riskPrinciple 4 ‘Companies should allocate capital forinvestment by seeking fully and creatively to exploitopportunties for growth within their core businessesrather than seeking unrelated diversification. This isparticularly true when considering acquisitive growth.’

Where companies do have the opportunity to growprofitably, they should do so with full momentum,communicate their plans clearly, and expectshareholders to support them. One aspect ofsophisticated capital markets is that they allowshareholders to diversify their risk very broadly. AtHermes, we invest our clients’ funds in the shares of over 3,000 companies worldwide, plus corporateand government bonds, cash and property.

As shareholders we expect listed companies to exploittheir competitive advantages and to grow, provided thisgenerates a capital surplus. This may involve takingconsiderable risks, and appropriate risk assessmentshould be done. However, even then we fullyrecognise that some plans may fail. That is why ourinvestments are spread so widely. As a result we cansupport companies which take well judged risks inorder to grow.

Companies often seem unwilling to take advantage of this, and instead seek to balance risk within theirportfolio of businesses. At one time strategicconsultants would wrongly recommend that allcompanies should have a balance of businesses,some of which were generating cash, others of whichwere spending it. They falsely suggested that if acompany had businesses which absorbed cash, it should buy ‘cash cow’ businesses to fund them.Those with ‘cash cow’ businesses should acquirebusinesses which needed investment capital.

Essentially the advice would be that a companyshould try to create its own internal capital market.Such approaches make little sense to diversifiedinvestors (see figure 4, above).

Conglomeration is not an adequate financial strategyon its own. We recognise we are putting considerabledemands on managers. They may feel that they takeless risk by backing several business ideas, rather

Principle 4 ‘Companies should allocate capital for investment by seeking fullyand creatively to exploit opportunties for growth within their core businessesrather than seeking unrelated diversification. This is particularly true whenconsidering acquisitive growth.’

Figure 4 AcquisitionsFor a company making an acquisition of another,shareholder value will only be created if theacquiring company is able to add value to theacquiree which is greater than any premium theyhave to pay. Acquisitions can be a way of buildingbusinesses that would take years to build fromscratch. Acquisitions can be beneficial wherecompanies concentrate on buying activities withwhich they are familiar and which fall within theirown competence and capability. They can, forexample, extend the core business' product rangeor geographical reach. However evidence fromfirms such as KPMG and PA Consulting hasshown that as many as 80% of acquisitions fail todeliver shareholder value. Against this evidencewe would urge management to be particularlycareful before embarking upon acquisitive growth.There as many pitfalls, not least the acquisitionprocess itself. Companies should stay within theenvelope of their proven skills and competencesand should not seek acquisitions of businessesoutside that boundary. Cultural compatibilitybetween acquirer and acquiree is also essential.Executive incentive schemes should be designedso that acquisition for its own sake, as opposed toenhancing value, is discouraged.

The Hermes Principles – Financial continued

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The Hermes Principles

than putting all their resources and focus into themanagement of a few of their best opportunities. Inthat way they may feel they can spread the financialrisk. More often, however, such approaches fail.Successful companies are usually the leaders in theirfield. By minimising financial risk, businesses oftenincrease the likelihood that they will fail to gain aleadership position, and hence they increase theirstrategic risk. This is not in the long-term interests ofshareholders, who have other ways of diversifyingfinancial risk.

We recognise this is a tough discipline to place onmanagers and may require a change in attitude ofinvestors as well as boards.

Incentivising long-term performancePrinciple 5 ‘Companies should have performanceevaluation and incentive systems designed cost-effectively to incentivise managers to deliver long-term shareholder value.’

Over the last few years there has been much debateon the subject of executive remuneration. Headlineshave tended to focus on the specific amount ofremuneration rather than the principles behind it. Forlong-term shareholders, the primary issue is simply toensure that remuneration is adequate to hire andretain appropriate staff, and to incentivise directorsand managers to deliver long-term shareholder value.Many remuneration and incentive packages fail tomeet these criteria. The fact that they don’t isapparent from the continued use of measures whichdon’t reflect long-term value. Many top managementincentive schemes are highly geared through options;some pay out for performance which is indifferentwhen measured on a relative scale, hence they canreward failure as well as success.

As shareholders we are concerned about thegeneration of value in the long term. Companiesshould only expand where they can achieve anadequate return. However it does mean that, in takingdecisions, directors and managers should beconcerned about effects on the long-term value, notjust on apparent performance in the short run. Ifshareholders have been fully informed about long-term company prospects, efficient capital markets willensure that companies which do take a long-termview will be appropriately rewarded.

Boards need to be sure they are not detracting from

The Hermes Principles – Financial continued

Principle 5 ‘Companies should have performance evaluation and incentivesystems designed cost-effectively to incentivise managers to deliver long-term shareholder value.’

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long-term performance by the signals they mayreceive from an investment community concernedwith the trading of shares. This was discussed earlier.It is important that corporate managers are not misledby questions which are directed at helping fundmanagers trade shares, into believing that theobjective of a company is to deliver short-termresults, whatever the cost. This is not just a problemcaused by the behaviour of brokers, or boards overlysensitive to their views, but also the relative passivityand silence of investors in undertaking theirstewardship duties.

Lowering the cost of capitalPrinciple 6 ‘Companies should have an efficientcapital structure which will minimise the long-termcost of capital.’

It is the role of capital markets to make fundsavailable in those areas where return will be highest.It is the role of companies to secure funds on behalfof their shareholders, where costs will be lowest. Thismeans that companies should seek an appropriatebalance of debt and equity. If they do so, they willlower their overall cost of capital, thus generatingshareholder value.

The appropriate debt/equity ratio is a question for the board, and will be dependent on the particularcircumstances of the company concerned. However,we would note that there are companies which have,for considerable periods of time, had substantial cashbalances or undergeared balance sheets. This maybe inappropriate in an organisation which is seekingto maximise shareholder value.

Equally there are companies which have foundthemselves ‘overgeared’, but believe that theirrelationship with their shareholders is such that theyfeel unable to come to the equity market for thenecessary funds. Sometimes their shareholders’attitude reflects a healthy scepticism about thecompany and its prospects. However, excessivelynegative attitudes can also lead to a significant loss of long-term value for shareholders, as companieswhose underlying businesses may be strong areforced to take inappropriate measures to protectshort-term cash flow. It is therefore essential thatthere is honest and open dialogue between directors

Principle 6 ‘Companies should have an efficient capital structure which willminimise the long-term cost of capital.’

The Hermes Principles – Financial continued

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The Hermes Principles

and shareholders, so that a company can haveaccess to the necessary funds to maintain aneffective capital structure.

Investment institutions should support companiesseeking to achieve such a goal. ■

The Hermes Principles – Financial continued

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Principle 7 ‘Companies should have and continue to develop coherent strategiesfor each business unit. These should ideally be expressed in terms of marketprospects and of the competitive advantage the business has in exploiting theseprospects. The company should understand the factors which drive marketgrowth, and the particular strengths which underpin its competitive position.’

case’ assumption must be that if a business has nocompetitive advantage, it is difficult to see why, over a number of years, it will be able to sustain a superior return, and hence generate long-termshareholder value.

In assessing competitive advantage, a companyshould be able to explain what particular strengths orresources it has access to, which allow it to maintainthe advantage. A company may have a costadvantage which derives from scale, factor costs,brands, technology or a combination of many of these and other features. (These are often referred toas ‘core competencies’). The greater the competitiveadvantage which a company enjoys, the highershould be its profitability relative to other industryparticipants.

In asking that companies express themselves in thisway, we are not seeking to limit the methods by whichstrategies are created. We are well aware that in goodbusinesses, strategy development is a creative andintuitive activity, subject to organisational, cultural andpersonal influences, as well as to analytical inputs. Wewould never wish to stifle this creative process.

However, if shareholders are to be able tounderstand, and from time to time to challenge, theway in which the companies they own are managed,then there is the need for some minimum expressionof the strategy and the competitive advantage whichunderpins it.

It is therefore an essential requirement thatmanagement is able to describe a coherent strategyfor each of the businesses they are in. ■

Strategic expectationsBusiness unit strategyPrinciple 7 ‘Companies should have and continue todevelop coherent strategies for each business unit.These should ideally be expressed in terms of marketprospects and of the competitive advantage thebusiness has in exploiting these prospects. Thecompany should understand the factors which drivemarket growth, and the particular strengths whichunderpin its competitive position.’

Long-term shareholder value requires the generationof return well into the future. Today’s financialaccounting returns are often an inadequate predictorof future prospects for shareholder value. This isparticularly true for businesses which are highlycyclical or where new investment takes many years to pay back. For this reason, if shareholders are toassess the degree to which a company will generatelong-term value, they will need to understand thestrategy of its businesses. It is business strategies,quite as much as balance sheet assets, thatshareholders invest in.

As with measuring financial returns, it is importantthat, as shareholders, we define what we consider tobe an adequate strategy. We believe an appropriaterequirement is that boards should be able not only todiscuss the goal of strategy, but also the method bywhich that goal is to be achieved.

Critical to describing the method is a clearunderstanding of (i) the demands and the dynamicsof the market, and (ii) the business’s competitiveadvantage in terms of, for example, consumer value,cost or access, which allow it to maintain a superiorreturn to other competitors within the market. A ‘base

The Hermes PrinciplesStrategic

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The Hermes Principles

Corporate strategyPrinciple 8 ‘Companies should be able to explain whythey are the “best parent” of the businesses they run.Where they are not best parent they should bedeveloping plans to resolve the issue.’

What is true at business unit level is equally true atcorporate level. Many larger quoted companiesparticipate in a number of different businesses,whether these are defined by market, product oractivity. In each case it is essential, if the corporategoal is to generate long-term shareholder value, thatthe board can explain why it is the ‘best parent’ of anysubsidiary company it owns. If a business wouldgenerate greater value if it were independent, ormanaged by another corporate body, then the boardshould consider plans to divest it. ■

Principle 8 ‘Companies should be able to explain why they are the “best parent”of the businesses they run. Where they are not best parent they should bedeveloping plans to resolve the issue.’

The Hermes Principles – Strategic continued

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Behaving ethicallyPrinciple 9 ‘Companies should manage effectivelyrelationships with their employees, suppliers andcustomers and with others who have a legitimateinterest in the company’s activities. Companiesshould behave ethically and have regard for theenvironment and society as a whole.’

Well managed companies cannot ignore the impact oftheir activities on the wider society. Company activityshould be subservient to the law. Basic economicefficiency would argue it is appropriate that companiesare open about the impact of their activities. Doingwell economically and behaving responsibly are notmutually exclusive.

This does not mean that businesses have limitlesssocial obligations. It is the responsibility of businessesto generate a capital surplus. But it is not appropriateto generate such a surplus without regard to widerobligations.

Of course, to require companies to behave ethicallyraises many questions, both theoretical and practical.We live in a society where it is appropriate forlegislators to pass laws which govern companyactivities. These do not necessarily set a minimumrequirement.

It is not our role to act as moral philosophers, still lessdo we wish to micromanage companies’ responses toethical issues, any more than we would wish tomicromanage their commercial operations. However,we believe that ethical behaviour by companies islikely to involve some notion of fairness andreciprocity; that managers seek to understand the

position of those whom their action affects, and thatthey deal fairly with them.

Many ‘special interests’ may challenge corporateactivity from a sectional point of view. We would wanta company to engage in a process of understandingthe appropriate pressure which society is legitimatelyputting on it, and its industry, and respondaccordingly. Once a company has understood theargument it may, of course, be appropriate for it toresist such pressures.

Principle 9 ‘Companies should manage effectively relationships with theiremployees, suppliers and customers and with others who have a legitimateinterest in the company’s activities. Companies should behave ethically andhave regard for the environment and society as a whole.’

The Hermes PrinciplesSocial, ethical and environmental

18

The Hermes Principles

Externalisation of costs

Principle 10 ‘Companies should support voluntary andstatutory measures which minimise the externalisationof costs to the detriment of society at large.’

Business, of course, has to work in a competitiveenvironment. This can create the conditions wherethere is a high incentive for businesses to‘externalise’ costs – ie to make a profit for thecompany while high costs are incurred by society atlarge. Since Hermes opposes such activity we askcompanies to welcome those frameworks, voluntarywhere possible, statutory where necessary, whichencourage businesses not to externalise costs. Thisis not to encourage regulation per se. Of course it isimportant that where regulation exists it recognisesthe need to allow the greatest possible flexibilitywhich will encourage positive entrepreneurship.However, most investors are widely diversified; itmakes little sense for them to support activity by onecompany which is damaging to overall economicactivity. The ultimate beneficiaries of most investmentactivity include the greater part of the adult populationwho depend on private pensions and life insurance. It makes little sense for pension funds to supportcommercial activity which creates an equal or greatercost to society by robbing Peter to pay Paul. Wherecompanies are aware that such conditions exist, it isappropriate for them to support measures to alignshareholder interests with those of society at large. ■

The Hermes Principles – Social, ethical and environmental continued

Principle 10 ‘Companies should support voluntary and statutory measures whichminimise the externalisation of costs to the detriment of society at large.’

19

In this document Hermes has explained what weexpect from the companies we invest in. This hasimplications for financial returns, for strategy and for the wider responsibilities of businesses. We trustthat, in our joint enterprise with companies, theseprinciples help set a framework for what companiesshould expect from responsible investors. We believethat companies with concerned and involvedshareholders behaving as owners are more likely toachieve superior long-term returns than those without.We hope that this creates both a constructiveplatform for communication and dialogue, and a basison which it is appropriate for shareholders to discussand question management behaviour.

We believe most businesses in this country do seekto achieve these goals, and do so through a systemof corporate governance which meets ourgovernance standards. Management of companieswhich are run in the long-term interests ofshareholders can be confident of Hermes’ support,including the expectation that we will support them ina hostile takeover situation and in raising capital.

In drawing up these expectations for companies, we are not seeking to limit management scope orcreativity. Still less are we seeking to micromanagecompanies. The disciplines we have outlined are thenatural disciplines we would expect of companieswhich seek to maximise long-term value for theirshareholders.

At all times Hermes stands ready to discuss these expectations with companies. If there arecircumstances where they are too rigid we will ofcourse be flexible in responding to particularcircumstances. But, barring those specific occasions,we do expect companies to seek to exercise thedisciplines we have outlined. For most thosedisciplines will already be in place. Others will seek tointroduce them. Those companies which do not meetour expectations should anticipate that, as engagedowners on behalf of our clients, we will wish to pursuewhy they have failed to do so.

A corporation is a joint enterprise between itsproviders of capital and those boards who managethe business. It cannot be right that investors incompanies have neglected to behave like owners and instead appear more like spectators observingevents without any sense of being able to helpdetermine outcomes.

We look forward to an active and constructivedialogue with the companies in which we invest. ■

Conclusion

Published byHermes Pensions Management LimitedLloyds Chambers1 Portsoken StreetLondon E1 8HZ

www.hermes.co.uk

Hermes Pensions Management Limited is regulated by the FSA

The authors;Tony Watson, Chief Executive, HermesPensions ManagementDavid Pitt-Watson, Managing Director of theHermes UK Focus Fund

The Hermes Principles

ISBN 0-9543843-0-X