New Directions in Equity Research Presentation at SIRCA 25 February, 2004 Dr Carol Royal and Loretta O Donnell

1. New Directions in Equity ResearchPresentation at SIRCA25 February, 2004Dr Carol Royal and Loretta O�Donnell

2. How this presentation will flow Unpacking a different research product: why, what and how? Supporting research: Australian cases, Lend Lease, Wesftield and NAB - change matrix and 8 HC practices Three products to systematically analyse soft variables Human capital investment rating system Alert system Customised report on human capital

3. The challenges�..

4. Institutional clients and current investment decision making practices

5. Value adding to quantitative data analysis While extremely valuable, quantitative data does not always provide richness of analysis, and may focus on lag, not lead indicators of future sustainability. A rigorous qualitative analysis, e.g. of management quality and human capital practices, may help distinguish lead indicators of future high performance. The pressure is on universities to create new courses to cope with the trend to more systematic qualitative analysis.

6. Limits to quantitative analysis Primary financial data can impede a true analytical understanding of an organisation�s performance; Properties shared by all organisations in a sector may be superficial, obvious or unimportant. Measures applicable to all organisations in an industry may ignore or understate differences between them. Primary financial analysis may also neglect complexity and variety in organisations.

7. Why add qualitative insights to the investment process? Debate in the business community over corporate collapses. Lack of perceived transparency in part due to the need for complementary metrics of robustness, longevity and sustainability of public companies. Need for lead, not lag, indicators � seeking clearer understanding of future organisational performance. Trend to disclosures, eg CEO remuneration Closer alignment with disclosure requirements of the Financial Services Reform Act

8. Effects of commoditisation From an individual perspective, much of contemporary equity research is trending towards commoditistion (Dawson, 2000) Sally Krawcheck, Global Head Equity Research, SSB, at SDIA conference, May 2003: �Clients are not paying for research� they can get it for free some of the time, information is now freely available� unless there are new an interesting insights, it is hard to ensure its value�. analysts get calls right about 51% of the time�

9. Effects of commoditisation 2 When research is not valued as highly as previously, bonuses for equity research staff may be affected. Anecdotal evidence suggests Sales role is being more highly valued, which affects remuneration. Equity researchers role is changing in a context of more financially literate graduates, and more freely available financial information on stocks. Qualitative analysis of soft variables can be useful to all analysts, both on the buy side and the sell side Soft variables are more than just management quality

10. Soft variables Pressure from stakeholders on equity research analysts to understand and report on soft variables such as: Management quality � systems and processes Leadership Remuneration/rewards Corporate governance These can be termed �human capital�

11. Evidence for the value of human capital to future financial performance Watson Wyatt Human Capital Index Collins and Porras Many other studies (see Royal and O�Donnell, 2002)

12. Human capital makes a difference to RTS

13. Human capital index (HCI) Watson Wyatt

14. The 47% increase in market value between 1999 and 2001 can be broken down into these HC practices :

15. Collins and Porras

16. Categories of analysis 1. Vision: core values, purpose and visionary goals 2. Organising arrangements 3. Social factors 4. Physical setting 5. Technology 6. Leadership 7. Products and services 8. Financial analysis 9. Market/environment Examples: Citicorp/Chase Manhattan, Proctor and Gamble/Colgate, Sony/Kenwood, Walmart/Ames

17. Data sources for Collins and Porras research Books written about the industry/company/leaders Harvard and Stanford Business School case studies and industry analyses Interviews with key major figures, employees, ex-employees, and outside experts about the industry eg analysts and academics. Business and industry reference materials, such as biographies and directories. Corporate annual reports and financial statements. Financial databases, including University of Chicago Center for Research on Security Prices

18. Visionary companies are resilient

21. Visionary companies embed themselves into the fabric of society (Collins and Porras).Imagine a world without� Disney�s Mickey Mouse, Boeing 747s, 3M Post-it notes and Scotch tape, HP calculators, Sony Walkman and Discman, Citicorp ATM machines, IBM 360 computers, J&J Band Aids, Motorola phones.

22. Collins and Porras � Good to GreatVisionary companies outperform the market

23. Why analyse human capital?Because there is money in it

24. .

25. You can�t make money out of analysing soft variables until they can be clearly defined.

26. What happens if we don�t systematically read the soft indicators? Recognising human capital patterns in organisations is a valuable lead indicator of future financial performance. Reading HC patterns allows a trained observer to recognise tell-tale signs before there is a tangible impact on the organisation and its share price eg Enron, HIH. �Patterns are recognisable, repeatable and give rise to an expectancy of outcomes.� (De Bono, 1990)

27. Lead versus lag indicators � 2 options

28. Enron: rhetoric versus reality

29. Not just about company collapse Also general purpose in the markets It is possible to anticipate aspects of future management behaviour, positive and negative

30. Examples of soft variables which make a difference to performance Based on research evidence, Hubbard et al, Dunphy, Royal and O�Donnell, Shields et al. Distilled into 8 common human capital practices i.e. what is being done to execute strategy. 4 common processes i.e. how strategy is executed By understanding key HC practices, we can distinguish between rhetoric and reality.

31. Hard analysis of 8 soft variables  Work design Recruitment Training Careers Rewards Culture Leadership Corporate governance

39. Australian examples: Worthy of investment based on soft variables? The paradox of Lend Lease The resilience of Westfield The future of NAB

46. Lend Lease processes (2) Adapt quickly Bovis Lend Lease was quick to gain a lucrative contract for the clean up of the World Trade Centre Movement back to Civil and Civic roots, as external environment changes.

48. Lend Lease Processes: (4) Manage downside risks Clear internal rate of return hurdle rates are high e.g. ComLand purchase at St Marys Military homes for US Air Force, 1356 homes, 50-year project. Clear exit strategy in theory, but in practice took a $300 m writeoff of US funds management So, returned to its roots as a single focus construction group eg via non-core sales eg MBO of the Holliday Fenoglio Fowler.

51. Westfield now WESTFIELD Holdings (WSF) is a known quantity with proven management and earnings growth capability � In fact it holds the record for earnings growth of all Australian companies. Its business model -- separating ownership from management -- hasn't changed for thirty years. 6 November 2003The Australian

53. Now NAB � key soft variables These variables are likely to impact performance.

54. Another Australian case: Selected soft variables at NAB Recruitment Encourages high retention and low staff turnover, but senior management are nearly always drawn from inside, can create parochialism and status quo decision making. Draw on strategy and systems which worked in the past, and assume that it will work in the future (ref: Hubbard, Miller). Careers Traditional support for internal career paths, ie promote from within has stifled management decision making especially in terms of risk management. Values have trended to individualism rather than collaborative decision making.

55. Key soft variables - NAB Rewards Remuneration systems which fostered individual high performance were not consistent, across all business units, with traditional NAB prudential values. Culture Internally inconsistent � analysis of data indicates perceptions of NAB, by some stakeholders, being an �arrogant� organisation, lacking in transparency. Communication, traditionally strong, had weakened in the pursuit of individual performance at a number of levels in the organisation.

56. Key human capital/soft variables � NAB 1. Leadership Previous head Cicutto had an incremental/fine tuning leadership style, given its 150 year history of Presbyterian stable savings culture. His long career within NAB shaped his leadership style. Core paradox: organisation seen as arrogant when the CEO was not arrogant. Using the change matrix, future leadership style needs to be more directive, in line with need for corporate transformation.

57. Key variables � NAB - Leadership Board may or may not have known about pressure from senior management on forex traders to use principal trading as a profit generator. If so, there was no apparent questioning of this approach, creating a yet unresolved corporate governance and leadership issue. Given public data sources available to the finance industry, only one side of the debate is presented.

58. Key variables � NAB � Corporate Governance Did not foster transparency. Underpinning recruitment systems were internalised. Argus felt the Board should be composed of former CEOs. Tendency to appoint retiring senior executives to the Board. Tends not to be a highly questioning environment. Trends towards the status quo. Board did not realise the business context would change as quickly as it did. NB Remuneration Shields et al study .

59. Key variables � NAB � Corporate Governance Old school, Harrow and Cambridge. No clear human capital systems underpinning succession planning. No grooming the next chair. �No need for a deputy�. Allen an accidental chairman, inheriting the job from predecessor. Lack of order in changing key organisational roles. No working risk management committee until September, 2003. Mandate unclear. Lack of checks and balances.

60. 4 processes � and what let down the NAB Emergent and planned strategies - need to be clearly communicated, flexible and adapt rapidly to change. Adapt rapidly - No urgency to change practices. Alignment - internal and external alignment critical for efficiency, Manage downside risk - technical, financial, operational and reputation

61. NAB � soft HC signals of future performance Leadership: Stewart�s career history demonstrates that in his previous role at Woolwich he was able to negotiate better conditions for workers indicating he can communicate across all levels dig deep to rectify underpinning HC systems, potentially creating higher quality of management. Can manage across several levels of change matrix. Culture: Can potentially create a cultural change, with a clearer alignment between internal and external environmental pressures. He can deal with separate cultures and has managed two different cultures: fast and innovative as well as bureaucratic (Woolwich and Barclays) . Break from patrician traditionalism. A �shop floor� employee, plucked from the ranks because of demonstrated talent.

62. NAB early signals under new management High level Board functioning is essential to execute new agenda. Outspoken CEO (Stewart) is a counterpoint /complementary figure to plain speaking and contrite Chair (Kraehe). Likely to have a positive impact on leadership practices within the firm. New Chair was head of risk management committee, likely to be conscious of all elements of risk: strategic, financial, technical, operating, political, legal and reputation risk. Desire for world class board, but evidence is yet to emerge. So far, only two new (ex-banker) appointments but no departures. Succession planning and development for directors needs to be made transparent. Problems with systems and processes run deep and will need structural realignment with strategy. A practical, hands on, boots and all CEO may be the appropriate leader at this point (refer to change matrix). It is the first time in its history it is relying on an outsider CEO. Also, now has a relative outsider Chair, creating opportunities for a more transformational leadership style.

65. What can you do with these insights on these soft variables? These options can be used by different financial services organisations, at different times, for different purposes. In a competitive marketplace, there is a service suitable for all styles of professional investment managers and brokers.

66. Three products with potential for maintaining and potentially increasing your own performance Human capital investment rating system. Alert service. Customised human capital reports.

67. A. Human Capital Investment Rating System

68. B. Alert Services

69. Potential sources of an alert system Academic journal library sources Structured interviews Professional seminars and forums eg AHRI, AICD Regulator�s reports, eg Standards Australia Academic and industry and government working papers Content analysis of interview data Document analysis Media analysis Archival and historical analysis Electronic sources eg Standards Australia recommended websites Historical materials from companies

70. Example of an alert service Australian performance management study (2003) on the current state of performance management systems in 1000 Australian companies. Staff development and retention top priority for Australian bosses: (2004) Australian employers are now focusing their attention on staff development and retention as well as improving productivity, a report has revealed. The Buck Stops Here: Private Sector Remuneration in Australia (April 2003) � an analysis of executive remuneration in Australia�s top 100 companies, with correlations to share price performance. Leadership Development of Senior Executive Study (2004): Study interviewing Australia�s top 100 organisations conducted by CEDA and AHRI and Mt Eliza business school. These studies name all companies.

71. C. Customised human capital reports

72. Why do this? � Making money through product differentiation

73. Don�t risk your own individual performance by underestimating the value of rigorously analysing soft variables A financial analyst from the past�..

75. Our overall framework for analysis The Drivers of Human Capital Model