Aligning Interests: (no freeloading on my tab!)
Colins St Asset Management
Fat salaries. Big bonuses. Plummeting share price. Sound familiar?
That an article discussing the benefits of aligned interests should even need to be written deeply concerns and somewhat surprises me.
Nevertheless, it's clear from our experiences that there are plenty of companies where the interests of the executives and the interests of the shareholders are in direct and lopsided conflict.
It boggles my mind that investors would put up with such situations, but it seems that many people out there are either unconcerned that the managers and directors looking after their money don't care about their goals or are simply too busy speculating to notice.
So, though it pains me to my value investing roots to prepare this article, here are our thoughts on where investor interests and attention should be (in our humble opinion).
"Show me the incentive, and I will show you the outcome." - Charlie Munger, Berkshire Hathaway
There are many factors we consider when looking to invest in a company. No doubt, the basic matters such as balance sheet strength, return on equity, and competent management rank highly, but even when all of those factors are in place, a conflict of interest between the incentives for the management team and the interests of shareholders can see an otherwise attractive investment opportunity devolve into an expensive 'learning experience'.
It should go without saying that a management team and investors should make all possible effort to ensure that their interests are aligned, but shockingly it is far less common than one would expect.
Where investors are concerned with positive long-term outcomes, strong balance sheets, return on assets, return on invested capital, and primarily an increasing share price, many managements incentive schemes (both short term and long term) stunningly disregard some (or all of those factors) in lieu of more 'inventive' measures of success.
We've seen management teams align their incentive schemes to revenue, or market cap growth, we've even seen some propose that the management team be rewarded for product growth.
In each of those circumstances, we've seen time and again, management teams sacrifice balance sheet strength (via leverage), long term share prices (with dilutionary capital raisings), and margins (in search of wider and less profitable products). None of that behaviour suits shareholders, but all too often, the powers that be, who create long and short-term incentives get lost in the excitement of a good story or an exciting 'opportunity' and forget that the only role a management team should be playing is that of enriching the company's shareholders.
Now it's important to note that even a perfect alignment of interests is not a guarantee of success. There have been plenty of companies with the best of intentions that have failed. However, we would suggest that over the long term, misaligned interests are a guarantee of failure.
HOW TO ALIGN INTERESTS:
There is no one-size-fits-all approach, but broadly speaking there are a few basic things a board should look to do.
2. An improvement on our first point is to align management interests with shareholders by insisting that they become shareholders.
3. Once we've seen management align their interests to both the upside and the downside of the company, we also like to see the directors consistently increase their stake in the business.
If we can find a competent team that is prepared to support the company and align their interests with shareholders, it is one of the best indicators we can find for positive outcomes. A great example of this in practice is National Tyre and Wheel (NTD.ASX).
National Tyre and Wheel is a Queensland based business that, through its 28 different distribution centres spread over 3 countries, distributes tyres across a range of industries and sectors as diverse as emergency services, agriculture, off-road adventure driving and industrial vehicles (such as forklifts). The Board and Senior Management have been working together for over 30 years, well before the company was listed on the ASX.
Key things that I like about the structure and alignment of interests within National Tyre and Wheel include:
Some other questions investors should be asking:
There are no perfect solutions, but there are some simple steps we can take, and some indications we can look out for.
If the company is consolidating, incentives should reflect that. If the company is growing, then the incentives would be reflective of that.
It's worth offering highly attractive incentives to entice and retain quality staff. At the same time, it's important that those benefits are earned.
If the company's employees and Board are confident in the outlook of the business, receiving part of their salary in equity is enticing.
A toxic culture may achieve seemingly good outcomes in the short term but could have catastrophic consequences in the long term.
Again, there is no guaranteed method for ensuring success, but knowing that the management team are working towards the same goals that we investors seek, and that a loss to investors will be equally felt by the management team is as good an indicator of the quality and prospects of a business as any we've been able to identify.
How we align our interests.
At Collins St Value Fund we take these lessons to heart. We expect the directors of the companies we invest in to align their interests with ours, and we expect nothing less from the investors who have entrusted us to look after their capital.
As such the team have meaningfully invested in the fund and have done so on the same terms as all our investors. Additionally, the fund only receives a fee when our investors profit (focussing our attention on both genuinely protecting the downside and maximising the upside) - there are no fixed management fees skimmed off the top of investors capital as we believe, that in the Australian equities context, they incentivise little more than asset gathering, rent-seeking, index hugging and, ultimately, mediocrity.
Author: Michael Goldberg, Managing Director and Portfolio Manager