Quality of Management – an untapped opportunity?
13 February 2020
According to a recent study by McKinsey & Company, only half of the companies in the Dow Jones Index have Chief Executive Officers with previous experience in corporate finance; in Europe the situation is worse. Less than a third of EuroStoxx50 companies are headed by CEOs with experience in the field.
At a board level, numerous initiatives have taken place with the aim of improving corporate governance. However, this runs the risk of simply being a box ticking exercise. Alarmingly, according to a separate long-term comprehensive study also done by McKinsey & Company, only 16% of Directors actually understood how their firms created value.
Returns on invested capital vs earnings per share growth
We view this situation both as an underestimated risk and a relatively untapped opportunity. Companies which aggressively channel capital expenditure according to returns on invested capital (ROIC) tend to outperform. Firms in which management compensation is based on ROIC also outperform when compared to companies whose compensation is tied to earnings per share growth. This implies that the market does not fully price in equity stewardship. Ultimately, it is not only the company’s senior management and Board members who do not fully appreciate the importance of capital allocation, but also the investors themselves.
Whilst the situation today is slowly improving, most management variable compensation is still tied to earnings per share growth. Yet, unless companies generate returns above their cost of capital, this does not create shareholder value. In pursuit of growth, management can easily erode shareholder value by acquiring, or undertaking projects whose returns are below the cost of capital.
The ways in which management allocates capital forms an integral part of our investment process. We closely observe and evaluate holdings and potential holding’s capital expenditures, research & development, mergers & acquisition, shareholder distributions via dividends and buybacks and advertising.
Mergers & Acquisitions very often destroy shareholder value; however…
The market is sceptical of mergers and acquisitions and rightfully so. M&A is probably the most common way management destroy shareholder capital. Yet a handful of businesses consistently create shareholder value by usually bolting on acquisitions.
JD Sports is one such example. It is important to highlight that the company has a client centric focus approach and unrivalled understanding of the consumer buying behaviour of its targeted audience. Leveraging on this knowledge, the management has taken informed decisions and skilfully executed it by acquiring companies which are at the bottom of the market cycle or in administration. The firm then cuts costs and turns these subsidiaries around, leading to market expansion and the elimination of competition at the same time. This repeated process has enabled the company to generate consistent cash returns on invested capital far in excess of the company’s cost of capital. From a seemingly average business, the firm has amply rewarded shareholders by being the top performer on the London Stock Exchange since the turn of the century; it is also the top contributor since the inception of the Garraway Global Equity Fund, despite the high number of top-quality businesses that the fund is pleased to own.
Another holding which is a textbook example of how to create shareholder value is Roper Technologies. The company is a serial acquirer of “capital light” software companies with large amounts of deferred revenue. The deferred revenue exists because its businesses receive cash up-front. Working capital is another source of cash within the conglomerate. Roper uses this cash to reinvest into additional businesses. This compounding effect has led Roper to compound free cashflow at a 17% annual rate of return over a 15-year period.
Roper targets companies which have large bases of recurring revenue in oligopolistic, niche markets with small total addressable markets. That revenue base is protected by strong switching costs that frequently post customer retention rates of over 95%. The niche markets are too small for other competitors to enter. The company’s free cash flow conversion consistently hovers around 140%, or 29% of revenue. The key for success lies in its decentralised approach whereby each manager is responsible for making decisions for their specific business unit underlying company’s focus on cash returns on invested capital. In management calls, it is frequently pointed out that this metric is highly correlated to long-term stock market returns.
Research & Development
Research & Development is our preferred area of capital allocation as it tends to be far cheaper to develop rather than acquire. As a weighted average, the Fund’s companies spend nearly four times as much as the average listed company in Research & Development. Edwards Livesciences is one of many good examples.
The company was spun off from Baxter in the year 2000. As a focused entity, gross margin increased from 47% in 2000 to 76% in 2019 and it now generates a cashflow return on invested capital of 15.8% compared to its 10-year average CFROIC of 12.8%. The firm has a leadership position of over 60% global market share in tissue heart valves and complimentary leadership position in critical care monitoring equipment. Over the past five years, Edwards has invested over 15% of revenue in research and development. This has helped the company to forge a leadership position in minimum invasive value therapy, which is one of the hottest areas in cardiac devises. This innovation-led growth has enabled the firm to increase its targeted audience. Traditional treatment required an extensive surgical procedure, for which a third to a half of elderly patients are deemed too frail and high risk.
The firm has an enviable track record in innovation. It is the pioneer in heart valves and continues to be seen as the best in class. Whilst it is no guarantee, these factors give us confidence that the firm can keep on delivering for its shareholders.
Share buybacks do not always lead to underperformance
Perhaps one of the Fund’s most underrated and under the radar capital allocators is Starbucks. Notably, in 2018 Starbucks sold its consumer-packaged goods business, involving coffee pods and packaged coffee beans to Nestle for the consideration of just over $7 billion, equal to 10% of the company’s market capitalisation at the time. The company used the proceeds to increase its buyback program to $25 billion, approximately a third of its market capitalisation. This happened to be at a time when the shares were undervalued because the company reported lacklustre like for like sales figures which heightened fears that the business had reached saturation levels in the United States. The real culprit, however, was that the outlets were overwhelmed by foot flow from its deliveries and increased passenger traffic from its digitisation efforts which resulted in queues and inefficiencies - issues which the company has since managed to successfully address. Investors, rightly so, are sceptical of buybacks - in general management share buybacks underperform the market by about 2% per annum. However, in certain situations, it is a great investment.
As highlighted earlier, capital allocation is strongly linked to share price movement over the long run and it also offers downside protection. In a challenging economic environment, market forces are far less forgiving of sub-optimal profitable business. This is why we undertake a painstaking process to try and identify the very best companies and are quick to dismiss investment opportunities when we are not convinced by the management rationale.
These are just a few examples – we can provide many more. Please do not hesitate to contact us to discuss this further.
Fund Manager - Garraway Global Equity Fund
Malcolm’s investment philosophy is based on three core principles, which he refers to as the 3Ms: Moat, Management, and Margin of Safety.
This article focusses on Management. We recognise that the quality of Management is a crucial input in the long-term success of our strategy.
The Fund invests in companies managed by individuals with a proven track record, we focus on managers who are good allocators of capital. We also analyse the way the management treats and manages its employees, as well as the overall corporate culture. Finally, we only invest in companies that appropriately address agency problems by aligning management’s interests and shareholder interests. It is not surprising to note that the share prices of companies with significant management investment and stable share ownership, in aggregate, outperform those that do not.