Last year, Forbes magazine referred to CalPERS as the American sokya. In case you don't know what a sokya is, in Japan a sokya is a person who blackmails corporate managers into doing things. Well, I can assure you, we at CalPERS are neither predators nor corporate sokyas.

I do want to explain to you what we actually do at CalPERS, and how we're using EVA® now in our corporate governance program. I should mention that CalPERS is a relative newcomer to the EVA fold. I've known about EVA as an investment analyst and as a portfolio manager for several years. But this is the first implementation of it at CalPERS and in our corporate governance program.

But first, let me tell you a little about of CalPERS. The California Public Employees Retirement System is the largest pension plan in the U.S. We are a defined benefit plan, and perhaps most important, our defined benefit and health benefit plans are underwritten by the taxpayers of the state of California, which is the seventh largest economy in the world. So our capacity for sustaining risk is fairly high.

The annual operating budget for CalPERS itself is about $180 million. We have a large and experienced investment staff, so we can take on fairly complex issues. We also have a history of innovation at CalPERS, not only in the corporate governance area, but in many investment related areas.

To put some numbers on it: As of the end of February, CalPERS had about $138 billion in total assets. The public markets part of the total is about $128 billion. That's the part that I have responsibility for. Alternative investments and real estate make up about 7% of the total.

The key part of the mission statement at CalPERS – what we're in business to do basically – is to help provide financial and health security for our one million members. Our strategic plan is very specific about how we expect to meet the goals of the mission statement. One plan is that we want to be sure we have sufficient funds on hand to meet payments when that day comes. We think we'll have positive cash flow, very large positive cash flow, until 2012 and probably beyond that.

But we have a 20-to-30 year planning horizon on the actuarial and investment side. We clearly have a shorter horizon on some of our investment decisions, but as far as how the plan is structured, we have a long-term horizon.

Also, our key objective is to minimize and stabilize the cost to the taxpayers of providing these benefits. And the way we do that is by enhancing shareholder value. In all the investment decisions that we make, enhancing shareholder value is a key element.

How do we do that? Well, two primary ways. Number one, we have active investment managers. Our active investment managers are all over the lot in what they try to do. But unlike many plans that have had a fairly negative experience with active management, our active managers have actually added value. And that's been good.

Second, much of our equity assets are in passive portfolios, what some people call index funds. We certainly use passive management at the portfolio level to construct the portfolios, but we consider ourselves an active investor. You can construct passive portfolios and still be active investors. And we're active investors in our corporate governance program.

Why do we do corporate governance? Well, it really boils down to a fairly simple statement. By acting like shareowners, rather than shareholders – by exercising our ownership rights – we feel we can keep management focused on what they're there to do as our agents. That, of course, is to add value. We believe that focused management will add value across time, which will result in higher investment returns for us. It's a very simple chain.

Why do we think it works? Well, aside from any sort of philosophical argument, we have our own board, which is very much involved in our corporate governance effort. Several years ago, we retained Wilshire Associates to actually study what kind of effect our corporate governance program was having on our investment returns.

So they looked at the performance of the companies that we had placed on our focus list since the beginning of our efforts. First off, they tracked the companies for the five years prior to us putting them on our list. The research showed that the five-year performance was 85 percentage points below the market, risk adjusted. Then Wilshire looked at the companies' five-year performance after the companies were put on one of our focus lists. I'm happy to say that those companies have outperformed the market substantially – to the tune of about 34 to 35 percent, after adjusting for all the risk.

So, corporate governance has paid off for us. In fact, Wilshire estimates that our corporate governance effort adds about $150 million a year to our investment results.

The question is, how did we come up with the companies that we put on our list?

Well, prior to last year, we would basically start with all the companies that were in our large, internally managed passive fund. We have a fund that tries to mirror the Wilshire 2500 index. Then, we'd take a sub-set of those companies – around 1,600 of them – and look at the companies that had very poor share price performance over the three prior years. We looked at both absolute performance and performance relative to their industry peers. So, from the 1,600, we constructed a subset of the poorest performers.

Beyond that, we also looked at poor corporate governance practices. These have to do with board structure, management compensation, corporate charter, and antitakeover provisions – things that we believe are not in the best interest of shareholders. And we codified those to the point where we can apply those across a broad list of companies.

So what we were really looking for in our prior screening process was the intersection of those two sets of companies. And that was the universe out of which we chose the companies for our list. Every year we've been choosing about ten companies for the list.

Now, this process has worked well. The performance you saw a minute ago, just on a pure price performance basis, indicates that this is a good way to select companies on which to focus. But my concern in coming to CalPERS was that we were seeing companies at a very late stage. We were seeing companies where price performance was very poor and coming in at a time when things might be very difficult at the company.

I wanted to get two things. I wanted a better measure of companies that had really been performing poorly, because many times we'd see a company that had been performing poorly for reasons that were only tangentially related to management's efforts. I wanted a more direct measure of what managements were – and were not – doing. And I also wanted an earlier warning system than simply looking at the stock market. I wanted to see if we could identify companies earlier on, before things got as bad as we sometimes see in our focus companies.

So we came up with our new screening process. We still use the two sub-sets, but we now have a third screening process. I call it peer-poor-economic performance. It's really EVAŽ. So now what we're looking for is the intersection of companies with poor share price performance, poor performing economics, poor corporate governance principles, and poor EVA.

The process that we actually use goes like this. We start with 1,600 companies that are in our portfolio. We then use an EVA screen, which is the primary screen that we apply. Applying that screen gives us around 300 companies. We take those and go on to the next step, which is our price performance screen.

We then take the same 300 companies and carry them to our corporate governance screen. We've set that up so we can screen a large number of companies over a reasonable period of time. Then, we take about 25 companies and really look at them very closely. We have a large research staff that can look at these companies one by one and get down beneath the statistics and try to help us decide whether the company really deserves to be on our top ten focus list. This is the procedure that we use now, with the new EVA® screen.

How do we do it, how do we use EVA? The first thing we do is calculate the three year change in EVA, divided by the dollars invested for each company at the beginning. So we have a ratio of change in EVA over a three year period, divided by beginning capital for each company.

We then do the same calculation for each of 56 industry groups. Ultimately, what we're going to do is compare that ratio of change in EVA per dollar of beginning capital for each company to it's industry. So we're not looking just absolutely at that number, but relative to industry peers.

Then, we simply subtract the company's ratio of change in EVA per dollar of capital from that of the industry. And then we rank the companies on this basis – all the 1,600 companies on this basis – and choose the 300 lowest.

Well, by the time we narrow it down to ten companies, we're obviously talking about companies that have performed miserably. This year, we went to one company on our list and they said, "What would you like us to do?" And we said, "Here it is. " And they said, "Done." We took them off the list.

So we've got nine companies this year on our list. And let me just talk about two for a minute, because I think there are two especially bad companies on the list – Michael Stores and Sybase. Sybase is on for the second year, so we really have some things to do at Sybase. And Michael's is really a bad one from the corporate governance point of view. So far, Michael's won't even talk to us. I don't know what we're going to do about that, but we'll figure out something. And Sybase is talking--there's a lot of talk, but not much action.

What are the issues we discovered this year? Number one, when we got the initial list, it had a lot of high tech companies on it. And in California, that's not a good thing. We think high tech companies are wonderful, so why should they be on this list?

So the first question we had was: Is this whole process inherently unfair to high tech companies with high R&D expenditures? And we convinced ourselves that was not the case, but it was an issue.

Second, there are a lot of small companies on the list this year. Well partly, that's because small companies have performed poorly relative to large companies. So we had to took at whether EVA is inherently unfair to small companies. And again, we came up with the answer, no.

Third, how should we deal with the fact that we don't have complete disclosure? As public investors, we of course have to live with the information that's provided. And the first thing we found in talking to managers at some of the companies on our list is that we didn't have all the information we needed. We'd go to these companies, and they'd say to us, "Well, you didn't take this into account." And then they gave us non-public information which changed our EVA calculation. Well, how do we deal with this issue?

What we've told them is they need to have better disclosure. If that's an important piece of evidence, which it must be, they should disclose it.

And finally – and this is a really funny one – we had a couple of companies that said, "Look, it's not fair to us for you to use EVA because we don't use it internally." I'm not going to even talk about that.

Why did we choose EVA? Well, number one, we think it's a very effective common performance measure that we can apply across industries, across types of companies, even across national borders. It's basic economics.

Number two, we think it's the best measure of what managements add as our agents in the company. It's the best direct measure. Number three, we think it's the measure most linked to what we are concerned with, which is the creation of shareholder value across time. Unlike earnings or ROE or any of those other measures, EVA gets at what we're really after: the creation of value by earning returns above our required cost of capital across time.

Finally, and this may be the most important thing of all, it's a mechanism which potentially ties the compensation of third- or fourth-level management inside the company to what we care about, which is shareholder wealth. It's a direct chain from the lower levels in the organization – the lowest business unit that can be definded – up to the company and through to us, as shareholders.

Why Stern Stewart? This isn't meant to be an advertisement, but it's going to sound a little bit like one. Number one, we wanted an independent view. We could have done this calculation on our own. I have a large research staff that could have calculated EVA for a large number of companies, but we really wanted an independent view.

Number two, we chose the company to do this which is generally recognized as the leader. Stern Stewart has credibility in dealing with data complexities. Again, when we go in to see these companies, the first thing that they want to try to convince us of is that they don't belong on our list. And we didn't want to walk in and have to deal with complexities about how the calculations were done and feel that we didn't have a firm grip on that. And so we chose Stern Stewart because we knew they did.

This is a very important one to us. We're watched very closely and people love to snipe and find places where we make mistakes. So we wanted to make sure – since adding another measure to our corporate governance screen would be important – we wanted to make sure that we set a high standard in doing that. Thus, we wanted to choose the company that invented it and is generally associated with it. And that's Stem Stewart.