Management motives: a tricky business
The power of management incentives can be underestimated. James Greenhalgh explains why.
Company analysis is all about the numbers, right? Knowing how to calculate price-earnings ratios, analyse return on equity and work out last year'scapital expenditure are certainly useful skills. But they're a smaller part of the story than you might think.
Just as important is trying to understand management's motives. Because, believe it or not, your best interests aren't always at the top of their minds.
Sometimes they're looking to maximise their pay packets; other times they're hoping to enhance their reputations or avoid negative perceptions. And quite often these motives conflict with shareholders' longer-term interests (although rarely in an obvious way).
- The 'soft side of analysis' is at least as important as the numbers
- Management can be influenced by pay and reputational issues
- Watch for earnings declines, acquisitions and management changes
Welcome to the soft side of analysis. Understanding management's motives is a surprisingly important part of assessing whether a company is worth buying – or selling. So here are some warning signs (or 'red flags'), how management behaviour can be shaped by them, and an analysis of what's going on beneath the surface.
Red flag 1: Failure is not an option
Placing a company into administration is something directors will go to great lengths to avoid. Not only is it an admission of personal failure, it's never a good look on the resume. And there are significant penalties for directors who let a company trade while insolvent.
|Failure is not an option||Last gasp capital raisings|
|There's a hole in my earnings||Desperate attempts to shore up earnings|
|Man with a hammer||Inflexibility with a declared strategy|
|Poison Pill||Erection of takeover defences|
|New day, new pay||Setting the bar for future pay|
So directors will usually tap you on the shoulder for capital, even when it's not in your best interests. But if you participate in a recapitalisation and the business continues deteriorating, you've effectively bailed out the company's lenders.
Take rural services business Elders, which could be an extra on Night of the Living Dead. The company raised $550m at the equivalent of $1.50 a share in 2009, but its market capitalisation is now $52m. Shareholders would have been better off had the company failed five years ago.
If your company is facing dire circumstances and directors raise capital, consider carefully if you might be throwing good money after bad.
Red flag 2: There's a hole in my earnings, dear Liza, dear Liza
Managers can have an almost unhealthy obsession with regular earnings growth. When circumstances conspire to cause a 'hole' in earnings, beware of haste in fixing it (dear Henry, dear Henry).
Consider luxury goods retailer OrotonGroup. Within months of losing its licence to sell the Ralph Lauren brand in Australia and New Zealand in 2013, the new managing director had signed deals with Brooks Brothers and Gap. The latter in particular sits uneasily with Oroton's luxury positioning. Only time will tell if these deals to plug the Ralph Lauren hole were conceived hastily.
Time has already confirmed the problems that emerged at Metcash in Andrew Reitzer's final year. Intelligent Investor Share Advisor downgraded the stock inThe Metcash earnings hole on 31 Aug 12 (Sell – $3.68) because new 'growth initiatives' were obscuring the deterioration in its flagship Supermarkets division.
These initiatives helped delay the subsequent earnings and dividend declines flagged in that review, allowing Reitzer to depart the company with his reputation intact. The board also allowed him to sell half his shares for 'retirement planning' purposes before departure. How very considerate of them.
Red flag 3: I'm a man, with a hammer
'To the man with a hammer, everything looks like a nail' is an evocative maxim. Here it means that if a management team has communicated their strategy, expect them to find ways to deliver it. How did this work for Stockland Grouprecently?
When Stockland's new managing director Mark Steinert presented his strategic review in May 2013, jettisoning his predecessor's three 'R's strategy in the process, he outlined the attractiveness of the industrial property sector ('the hammer'). With a major shareholder that wanted out, industrial property juniorAustraland looked very much like a nail, especially with a residential development business that would dovetail nicely with Stockland's.
Fast forward 12 months and Australand is now in Stockland's sights. Unfortunately its tardiness has forced it to offer a high price. It's what happens when the strategy becomes more important than the opportunity.
Red flag 4: Swallowing the poison pill
You might recall Perpetual's recent acquisition of The Trust Company. Two other bidders, IOOF and Equity Trustees, missed out on the acquisition, with IOOF receiving the consolation prize of a 12% holding in Equity Trustees from Perpetual. With the ever-acquisitive IOOF unlikely to sit still forever, Equity Trustees looked like its next meal.
But most management teams are rather attached to their jobs – not to mention their pay packets. So the temptation is to dissuade potential predators with a 'poison pill', such as an expensive acquisition and an accompanying capital raising to dilute the predator's stake.
And guess what? Equity Trustees announced last month that it would buy ANZ Trustees for a very pricey 15 times earnings before interest and tax. With a capital raising that diluted IOOF's stake to 6%, it's little wonder that company sold its shareholding in disgust. Equity Trustees' other shareholders have also been caught out by management's profligacy, with the stock falling 16% following the acquisition.
Red flag 5: New day, new pay
Management changes are an important reason to reassess a stock. Particularly as new managing directors – like new governments – prefer to get the bad news out early.
Take Coca-Cola Amatil, which has just appointed Alison Watkins as managing director. Barely a month after her appointment, she announced first-half earnings would decline by about 15%. The stock fell 15% over the next two days.
Could Watkins be influenced by how her long-term incentive will be set? Reviewing the remuneration report in Coca-Cola Amatil's 2013 annual report, a portion of her incentive will be based on earnings per share (EPS) growth from 2014 to 2016. It's clearly in her interests for the 2014 EPS number to be as low as possible. Will this be a case of 'watch out below'?
So there you have it. Situations like these can influence management behaviour in ways you might not expect. Where management's reputation or pay packet is at stake, beware of it placing its own interests above yours.
Of course, management will talk up the benefits of any action to you and even its own board. A sceptical investor is a prepared investor, so always ask yourself: What's in it for them?
Disclosure: When the article was originally published by Intelligent Investor Share Advisor (AFSL 282288) the author, James Greenhalgh, owned shares in Stockland Group, IOOF, Equity Trustees and Coca-Cola Amatil.
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