Superb businesses
Eating their own cooking
Short termism negatively impacts our investing in three ways: 1/ We can hurt our investing performance by managing our investments with short term thinking; 2/ We can be hurt by the short sighted approach of investment analysts and advisors; 3/ and, we can be hurt by short termism on the part of the board and management of companies we invest in. This post deals with this third topic.
I place great emphasis on the quality of the board and management. I will not invest in a company unless I have complete confidence in both the board and management. 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.” (Jarislowsky, The Investment Zoo: Taming the Bulls and Bears. 2005) p62.
Prevalence of ‘short-termism’
Corporate Knights magazine, in its Spring 2014 issue, reported on a McKinsey & Company survey of 1000 executives and board members which underscored the prevalence of ‘short-termism’:
“>63 per cent of respondents said the pressure to demonstrate short-term financial performance had increased over the last five years;
>79 per cent felt most pressure to demonstrate strong financial performance over two years or less;
>only 7 per cent said they were pressured to deliver strong financial performance over a horizon of five years or more;
>73 per cent felt they should be using a time horizon of more than three years;
>86 per cent agreed that having a long-term horizon would help them make better decisions.”
Illustrating the problem
Let’s say a company decides to embark of a major facility expansion program. It is currently the low cost producer in its industry. This status has allowed it to generate excess capital. Many analysts and shareholders have been expecting the company use these funds to increase its dividend. The company’s directors have substantial holdings of common shares and think long term. They decide the company cannot rest on its laurels. It must continue to invest to stay ahead of the competition. The company announces a major facility expansion project. Benefits from the capital project, in terms of increased sales and profits, will not be seen for at least eighteen months.
The market reacts badly. Analysts say that there will be no ‘visibility’ on increased earnings for many quarters and worry that the increased earnings may never materialize in this competitive industry. A substantial gap opens between price and intrinsic value. The gap is not caused by inefficiency of the market in processing the information. It occurs because the street seems congenitally programed to short term thinking, that is, Mr. Market frames narrowly and seems incapable of framing broadly.
What my little made up story illustrates is that the board and management need courage and long term commitment to run the company for the long term. Many executives, especially when their annual bonus depends on regular increases in earnings, will opt for short termism.
How investors can deal with the problem of short termism
There are two things an investor can do. The first is to ensure that the long term interests of the board and management are aligned with shareholders. The second is read carefully to see whether the board and management show a long term vision for the company. And be eternally vigilant to watch out for the company exhibiting short termism.
Skins in the game and eating own cooking
How do we make sure the board and executives’ interests are aligned with shareholders?
Regarding 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, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p30
The world is filled with what is generally called the ‘agency’ problem. Everyone has their own financial interests. In investing you would expect the board and management to look out for the interests of shareholders. Even the most honest and competent will find it difficult to put the interests of shareholders ahead of their own interests.
In 1776, Adam Smith wrote in the Wealth of Nations about joint stock companies:’
“The directors of such companies…being the managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
The only way investors can protect themselves against the agency problem is to only invest in companies in which the leaders of the company have a major part of the personal net worth in common shares of the company. I like to see the leaders with at least tens of millions and preferably hundreds of millions or billions of dollars invested in the company.
We are told that management compensation today is designed to ensure management has a long term financial stake in the company so as to align their financial interests with shareholders. The investor should rightly be skeptical of these compensation schemes. For me the only thing that counts is very substantial actual common share ownership.
Options just don’t cut it. Options give executives a one way bet. If they bet the company’s capital big on some risky project and it is a total failure, they have lost nothing. If it is a huge success they become big winners. I insist on the board and management having major skins in the game alongside me. I like them to face downside as well as upside in any capital allocation decisions.
The idea is that if the board and management ‘eat their own cooking’, they will run the company with a long term view. This is generally true. As well though, investors should also be monitoring the company to make sure it is governed in this fashion.
Showing long term vision
Let me give you a practical example. I quote from the 2020 annual report of a stock I have owned since 1998, some 22 years. “Toromont TSX:TIH is a diversified growth company with a clear objective: to increase shareholder value by driving consistent and profitable earnings growth over the long term. 2019 was our 51st year as a public company.”
Of course, just saying that doesn’t necessarily make it true. But it’s a start. I find you often have to read between the lines.
Let’s try another example. Warren Buffett wrote in the Berkshire Hathaway Chairman’s letter for 1988: “In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.”
He’s telling us two things. First, he is telling us that his favorite holding period is ‘forever’. But, he’s also telling us indirectly that Berkshire Hathaway is being run for the long term. The business of Berkshire Hathaway is investing in other companies. If Buffett told us the company was actively engaged in stock trading and short term buying and selling derivatives, I would interpret that to be short termism.
Quarterly and annual reports
I regularly read the quarterly reports and annual reports of companies I own. I also read the transcripts of the quarterly earnings calls. Some argue that those sources are all fluff and salesmanship. I don’t agree. If I get the impression the CEO is feeding me a line of goods I’m not interested. A couple of years ago I sold my entire holding in a company I had held for several years and done well in, after reading the transcript of an earnings call. I sensed the founder of the company, who owned hundreds of millions of dollars in the company, had lost his long term vision.
As an aside, this homework is one reason why one shouldn’t own too many stocks. I prefer a concentrated portfolio. It’s easier and less time consuming to monitor your companies carefully.
So, whenever I am reading anything by or about the company I always ask myself whether it is evident from what is said that 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. If the CEO, in the earnings call transcript, speaks in a forthright fashion about short terms issues facing the company I can have confidence they are looking to the long term. I try to pick up on any clues the company is run with the long haul in mind. Or conversely, any clues that short termism is creeping in.
Can regulators do anything about short termism?
In arecent article in the Harvard Business Review titled: Don’t Let the Short-Termism Bogeyman Scare You – Does Business Need a New Model?, Lucian A. Bebchuk argues that lawmakers should stay away from measures designed to protect boards and management from short termism. He discusses takeover defenses, staggered boards, dual-class share structures, and dual-class recapitalizations—that limit the power of shareholders and insulate corporate leaders.
Investors don’t need to worry about that kind of debate. As they say, control the controllables. Don’t invest in companies not run for the long term. Incidentally, I’m perfectly happy with dual share companies. My vote doesn’t count for much anyway.
Conclusion
Investors want to invest for the long haul. It can only be done by investing in companies that are run for the long haul. The two main ways to ensure that are firstly, to only invest in companies where the board and management are seriously invested in the company, and secondly, judge for yourself whether the company communication exhibit a clear commitment to running the company for the long term.
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Long term thinking involves broad framing. You can read more in the blog here.
Investors defending against management spin and ourselves
And here:
Overcoming mistaken short term thinking with Kahneman style risk policies
And also, take a look at Section 12.04 Success through Broad Framing
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To read up on dealing with short termism in our own portfolio management see
Chapter 12. Short Term Thinking and our Flower Garden
To read about short termism and the investment industry take a look at
Section 12.07 Wall Street takes the short view
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To look more generally into how to select companies to invest in, take a look at:
Part 6: The Hallmarks of Superb Businesses
Chapter 31. General Approach to Choosing Common Stocks
Section 31.15 Board and management
Section 31.16 Common share ownership by management and directors
Section 31.20 Management
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics for investors.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Chapter Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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