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Custodians of capital: why company management matters

26 January 2018

Custodians of capital: why company management matters

Management teams have a meaningful impact on shareholder returns

Every day a company’s management team makes decisions to allocate capital and resources to specific projects, divisions and expenses – and by default, not to others. This critical decision-making process – which is at management’s sole discretion (with oversight by boards of directors) – carves out a company’s future business path and subsequent cash flows. Since this ultimately dictates shareholder returns, ‘Management’ is one of the components we evaluate as part of our 3 M investment process (along with Moat and Margin of Safety).

As stewards of our clients’ capital, we also recognise that management teams act as secondary custodians. We believe we can tilt the odds of generating appropriate returns on client capital in our favour if we partner with strong, proven leadership teams.

Evaluating management is often subjective, and not always scientific

There is no perfect way to evaluate management or to distinguish easily between good and bad teams. In addition, companies aren’t static: management teams and operating environments change. We focus on factual, historical footprints and try to remain impartial by considering the following factors:

  • Resource allocation (financial and human)

Arguably, is any CEO’s most important task. However, very few of those new to the role of CEO will have any experience or training in resource allocation.

  • Return on capital employed

This will drive long-term shareholder returns and should be the key consideration in any management team’s decision-making process (above other factors such as growth, diversification and margins).

  • Management's focus on cash profit

It is often said that ‘the top line is for vanity and the bottom line for sanity’, which speaks to the flawed focus that some management teams have on business growth, as opposed to profitability. Another common saying states that ‘net income is an opinion, while cash flow is a fact’. This alludes to the variability of accounting profits and management’s ability to influence these – flexibility that cash flow reporting does not allow for.

Alignment through ownership leads to better decision-making

Over and above these criteria, we strongly prefer to invest with management teams who are directly aligned with us (and our clients) through meaningful ownership in their own businesses. Aligned management teams think like shareholders: they prioritise growing per-share value over growing the size of the business. We believe their decision-making is vastly superior to that of a professional management team without any stake in the company.

Importantly, we don’t view share options or similar incentive structures as ownership. Such arrangements often hold little real risk (since it is not compulsory to exercise them), or lead to aggressive, unsustainable behaviour to meet short-term profit targets. On the other hand, while many South African management teams appear to view share buybacks as a last resort when allocating capital, we believe that companies can create significant value by buying back shares at a discount to intrinsic value. Companies who routinely buy back their own stock rather than acquiring costly new businesses or diversifying into new industries often deliver superior shareholder returns.

Responsible owners make superior capital allocators in cyclical industries

Ownership is not always a foolproof assessment metric – ‘empire building’-type CEOs may well view size (and not shareholder value) as success, even if they do have ownership stakes. It is therefore critical to assess capital allocation track records.

This is especially true in cyclical industries, as these businesses are cash flush with strong balance sheets at the top of a cycle. Good management teams will resist the urge – and often also pressure from institutional shareholders – to spend this money on seemingly attractive acquisitions or growth ventures that could cost shareholders once the cycle turns. Rather, they will recognise the importance of keeping cash on hand to weather the inevitable downturn and potentially deploy in an environment where prices are depressed. Indeed, acting contra-cyclically is a major contributor to value creation in cyclical companies – even more so in challenging industries such as mining and construction, where cash flows are more uncertain.

Case study 1: the South African construction sector

In Table 1, we consider the shareholder returns of two construction companies with management teams that have a meaningful ownership stake compared to the industry average: WBHO and Raubex. In an industry that is challenging at the best of times, these returns are not necessarily impressive in isolation. However, the benefit to shareholders is illustrated by the difference between the returns of these companies and those of their peers, where management teams are less aligned. We believe that ownership – and subsequent decision-making around capital allocation – play a significant role in WBHO’s and Raubex’s outperformance.

In tough cyclical industries, consistency often matters just as much as growth. However, given the nature of a boom-bust cycle, this is hard to achieve: it is much more difficult to maintain profit in a downturn than it is to grow profit in an upcycle. It is therefore significant to observe the difference in volatility of reported profit margins between WBHO and Raubex and their peers (as shown in Graph 1). It is even more telling if we consider that in aggregate, WBHO and Raubex have had uninterrupted positive net profit margins in both favourable and challenging cycles, while the sector has collectively had multiple periods of net losses in the last 15 years.

Case study 2: the South African banking sector

If we review the South African retail banking sector using the same criteria applied to the construction sector, we see similar results, as shown in Table 2. Capitec and FirstRand have significantly outperformed their banking peers over the past 15 years. Once again, we believe that this can be attributed in large part to higher ownership levels.

‘Skin in the game’ tends to result in better shareholder outcomes

This article is not intended give a negative or positive assessment of any particular sector or company. Rather, it reflects our view that management teams with significant ‘skin in the game’ – who use their own money to buy stocks in the company – often make better capital allocation decisions and generate greater shareholder returns. Indeed, an ownership mentality is usually a distinguishing factor. A long-term mindset also helps to resist the urge to ‘swing for the fences’ on transitory ideas or to grow at any cost to impress short-term market commentators. Since we view investments on an absolute basis and define risk as the potential for permanent capital loss, this offers an additional line of defence in protecting our clients’ savings.

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Click here to read the next article: Evaluating management: a bondholder's perspective by Tyron Green

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