The old boys’ club and conflicts of interest
A company that makes substantial and sustainable owner earnings and enjoys a moat still needs a knight in the castle who can protect and enhance the moat.
The knight is a team. It is made up of a board and management. This is the third in a series of posts on the hallmarks of great companies. It is about the board and management. The board’s job is to govern. Management’s job is to manage.
There are three issues: the first is alignment of interest; the second is integrity; and the third is competence.
Alignment of interest
As for Berkshire Hathaway, Buffett says: “In line with Berkshire’s owner orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.” (Buffett, 1998, p.30)
In a speech given on July 20, 1982 at a Financial Analysts Workshop, Templeton noted that in the long run, shares of companies in which management owns a large stake generally will out-perform the others.
The company’s board of directors and the company managers are stewards of the capital entrusted to them by the shareholders. ‘Entrusted’ is the correct word. At the core of the relationship between the shareholders, on the one hand, and the directors and management, on the other, there is an agency problem fraught will conflict of interest issues.
It is human nature to look out for your own interests. Boards and management are supposed to put the interests of shareholders first. But very often, this just doesn’t happen.
It is distressing how often it seems the board of directors are simply ‘yes’ men effectively appointed by management. These ‘yes’ men attend a few meetings and receive a variety of fees, options and share units and in turn have to approve the compensation package of the management who appointed them. It is cronyism in action. The old boys’ club.
Stephen Jarislowsky (for 40 years the dean of Canadian money managers) writes: “The function of a board is to look after shareholders’ interests by assuring that a company has a sound executive and operates effectively and ethically so as to produce the best long-term results. The board must look after every shareholder even-handedly, and each director, no matter what group may have installed him, should also look after all shareholders alike, big or small. But I have served on boards where the shareholder was rarely mentioned. The board, made up mainly of friends (cronies) of management, was normally there to do no more than rubber stamp the decisions of management, and the participation of many of the directors was pretty negligible.” (Jarislowsky, 2005)p.62.
Shareholders have to make a judgment as to whether the directors are really providing strategic leadership for the company. They also have to judge what kind of relationship there is between the board and the CEO. If the board seems beholden to the CEO, the board will not be doing a proper job for the shareholders. As well there are boards dominated by an individual who seems to want to run the company and have the CEO act as his private lackey.
What I look for is a company where the CEO has the major part of his personal net worth tied up in the common shares of the company. In today’s terms this will involve an existing holding of common shares worth tens of millions of dollars. Better would be hundreds of millions of dollars or billions. This will mean that the interests of management and investor shareholders are aligned.
One key reason to check alignment of interest is that management compensation is generally a one way bet. We are forever told that a major component of compensation is long term incentives. This is baloney. If the company does well over the long haul, management scores big time. If the company fails, management lose nothing. All those deferred share units and options may become worthless if the company flounders but, they never had any value on day one in any event. What I like to see is a CEO with a very large holding of common shares that can lose value just like mine if the company does poorly. This will discourage management from using company capital to plunge into some big investment with hopes of a big score.
One should not blindly tally up the shareholding of management. For example, the chairman of the board may be the founder of the company. He may have stepped back from running the company and chosen a successor who is steadily building up his shareholding. In this case there is probably a suitable alignment of interests.
A slightly different case is next generation companies where the children of a founder control or have a major shareholding and serve on the board. These companies seldom fit the bill. They may be managed in an institutional fashion to serve the interests of the children of the founder.
Multiply voting shares require careful thought. Many investors shy away from these companies as they feel they may be managed to serve the interests of the controlling shareholder. The writer has never been especially bothered by multiple voting shares. But each situation needs to be examined on its own merits. It is worthwhile to occasionally review insider shareholdings. There is public disclosure of all trading by insiders and all shareholdings of insiders. In Canada this is done through the System for Electronic Disclosure by Insiders (SEDI) at https://www.sedi.ca/sedi/ .
I study the annual Management Information Circular with great interest. I look at the CVs of the board and CEO and think carefully about their shareholding.
Only the highest integrity on the part of the board and management will do. It can be difficult for investors to assess whether the board and management are acting with the highest integrity. Fortunately, the most successful companies are successful because they are run with high ethical standards.
I look for straightforwardness and honesty. Absolutely honesty is obviously important. More easily assessed is straightforwardness.
The glossiness and style of the quarterly and annual report to shareholders also provides some good evidence; more glossy, more suspicious. Even how the executives are dressed in photos in the annual report give clues. Reading the annual and quarterly reports and reading transcripts of meetings with analyst will also give the shareholder an idea of how the board and CEO are working together.
Company press releases and other news reports and internet blogs and information are also available. An astute reading of these sources will soon disclose whether management is attempting to put one over on everyone.
Management that hides behind adjusted figures are suspect. Management that gloss over the inevitable negatives in some quarterly figures are suspect. Management that acknowledges the periodic weak numbers and accepts responsibility are being straightforward with shareholders.
With practice is becomes quite easy to read between the lines. A certain level of boosterism is inevitable. One quickly becomes suspicious when this goes too far. One can also read these sources for insights into the entrepreneurial bent of management, leadership qualities, conservative approach to accounting, long term view, vision, strategy and administrative qualities.
I find I can learn a lot from reading transcripts of management’s presentations to analysts and the way questions are handled. In all of this the investor must keep a skeptical if not cynical frame of mind. If the questions are actually answered it is a good signal. If the tough questions are answered directly, frankly and clearly, one can begin to develop some confidence.
Katherine Graham’s father had bought the Washington Post newspaper at an auction in 1933. After the death of her husband she became controlling shareholder and was responsible for writing communications to shareholders. She quotes from a letter she received from Warren Buffett when he first became a shareholder of The Washington Post Company in 1972. Buffett wrote:
“I am additionally impressed by the sense of stewardship projected by your communications to fellow shareholders. They are factual, complete and interesting as you bring your established newspaper standards for integrity to the newer field of corporate reporting.” (Graham K. 1997) p.512.
All shareholders should be looking at corporate shareholder communications to see whether they convey to fellow shareholders an appropriate ‘sense of stewardship’. A lot of communications are opportunities taken by a CEO or Chairman to blow their own horn and justify high compensation.
Before investing in a new company it is often hard to get a handle on the calibre of management. Often one can only fall back on the company’s economic performance and strong balance sheet as an indicator of board/management capability. Once you own shares in a company, it is worthwhile to periodically ask yourself whether the board and management of companies you are invested in are superstars or simply journeymen.
Jarislowski says: “The world has become too competitive for anything but superb management – people devoted almost seven days a week and willing to commit long hours to the task.” (Jarislowsky, 2005)p.127.
Fisher places emphasis on the entrepreneurial leadership and administrative qualities of management in combination with the nature of the company’s products and services as well as its market position. These are aspects of companies that Ben Graham did not emphasize. In this regard Buffett and Fisher have similar ideas. Fisher particularly emphasizes the entrepreneurial ability of management as the key ingredient to companies’ ability to enjoy spectacular growth. For Fisher, Warren Buffett’s moat came about by a combination of factors that would lead a company to increase profitable sales for years to come. Fisher put it this way: “If a company’s management is outstanding and the industry is one subject to technological change and development research, the shrewd investor should stay alert to the possibility that management might handle company affairs so as to produce in the future exactly the type of sales curve that is the first step to consider in choosing an outstanding investment.” (Fisher, 1958,1996)p.51.
Rephrasing this in 1974, Fisher wrote that outstanding companies have “a corporate chief executive dedicated to long-range growth who has surrounded himself with and delegates considerable authority to an extremely competent team in charge of the various divisions and function of the company.” He added that the normal course would be a program of succession planning from top to bottom of the management team. Hiring executives from outside could be a damning sign. (Fisher, 1958,1996)p.188. Last year I sold an entire position where the CEO, who I had great confidence in, left and was replaced by someone I thought a journeyman.
One good question to ask oneself is whether the board and management are running this company for the long haul. If the company appears to be knuckling under to the investment community’s penchant for short term results the company should be avoided. It is too easy for management to massage profits higher by cutting back on R&D, capital expenditures or advertising.
I am also interested in the age of the CEO and where he’s at in his career. With older CEOs one is interested in the succession plan. This can be particularly tricky when the CEO is also the founder of the company. I recently decided to invest in a superb company with a five year average return on capital (ROC) comfortably above 20%. My main concern was that the CEO was about 70 years of age. I couldn’t be sure of a succession plan. His common shareholding in the company was well over $100 million.
Ultimately I decided to invest on the supposition that he probably either had a succession plan or a personal exit plan. The company would make a good takeover candidate.
When I look at a company’s financial statements I am intuitively skeptical, because I know the numbers can be massaged. When I look at company management and the board I am intuitively cynical, because I know that many of the communications from companies are self-serving.
The first post in this series is How to identify great companies to invest in – Part l
The second post in this series is How to identify great companies to invest in – Part ll
For readers wanting to dig deeper into the subject of how to identify great companies, take a look at Part 6: The Hallmarks of Superb Businesses
In particular, see Chapter 31. General approach to choosing common stocks
The above post is essentially a condensed version of the following Sections:
31.16 Common share ownership by management and directors
31.21 Understandable and superior business operations
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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