Whitworth: The Alchemist In the Boardroom

In fact, he says, Home Depot board members responded positively when Whitworth and Relational Investors co-founder David H. Batchelder first called late last year to say they had bought $1 billion worth of the company's stock but wanted the board to consider major changes in the company's strategy and direction. The two men made clear in a letter to Nardelli that they were unhappy with the company's performance and buttressed this with voluminous proprietary research. Privately, the board itself had similar misgivings and elected to give the men a hearing.

"They have been terrific board members. Dave [Batchelder, Relational partner and Home Depot board member] has been a fabulous director, and I am confident he will make significant contributions to our company," says Ken Langone, lead director of Home Depot.

Although Relational has a staff of a dozen or so analysts who scrutinize more than 1,000 companies with market caps of $2.5 billion or more, Whitworth is highly focused on a very specific kind of investment. He starts with companies in mature industries that are profitable and have had dependable cash flows for many years. Of those, he's on the lookout for ones that are underperforming both their peers and their potential, as identified by Relational's analysis.

There are a fair number of companies that might fit this bill at any given time, Whitworth says, but even then he's not going to invest in many of them. Some might have deep structural issues that can't easily be altered. "But then there's another set that seems to have lost their way," says Whitworth, who founded Relational with Batchelder in 1996 with a $200-million stake from the California Public Employees' Retirement System. "Generally, the first indication is a history in the financial data of spending money in a way that doesn't get adequate returns for the investor. Sure, the company is still profitable and holds a defensible position in its industry with good products, but the question is, how are they spending the profits they make from that? Those are the ones we end up focusing on."

One of the things Whitworth says he's learned over the years is that almost invariably, there is a correlation between companies that fit his investment profile and the finding of major corporate governance problems. Usually, these come to light in their excessive executive compensation policies— and in the composition of the board. By the latter he doesn't necessarily mean what's ticked off in the governance metrics of proxy advisers such as Institutional Shareholder Services. Useful as those measures might be, to Whitworth they're only a starting point. To see what's really going on at a board, Whitworth says, "takes a lot more research than most outside groups are willing or able to do."

One example is Sovereign Bancorp, which Relational bought into in 2005. On the surface, the company had put in all the right board processes, earning it a 98 percentile corporate governance score. But underneath lay a jumble of related-party transactions and other conflicts that didn't show up in all the official filings. According to public records and media reports reviewed by Directorship, the lead director owned a company that did landscaping for the bank, which, though it involved small sums, was nonetheless undisclosed. Another director bought and sold Sovereign branch offices, sometimes in private transactions. Board members were paid $320,000 a year vs. $80,000, which is more typical among financial companies of a similar size. A good part of their pay came from bonuses triggered by management's bonuses, which the board itself was in charge of setting. Relational's analyst spent three months pouring over Sovereign's records and even traipsed off to Pennsylvania and New Jersey to dig through court records to flesh out what was really happening.