To borrow a phrase from part 1, for over a decade there were more red flags flying over Unilife than ‘a 1960s communist rally’. Without an established product pipeline and new management, to say nothing of a reasonable price, this injectable syringe maker was a company we could never recommend.
The reason for choosing it as our ‘red flags’ example was not because of the ease of spotting them but to show how easy they are to miss, even in situations as conclusive as this. It would be simple to assume investors caught up in the crash were stupid or foolish but that would be unfair. If avoiding stocks like Unilife were merely a question of pulling out a checklist and ticking a few boxes the recommendations history of this publication would be almost error-free, and clearly it isn’t.
More importantly, the best opportunities tend to be difficult to buy, which is why one person’s red flag is sometimes another’s good fortune. If you want to buy cheap stocks, you’re going to have to deal with a few warts. Avoiding them is a question of their kind and number.
Some red flags more important than others
Behavioural issues lead to practical problems
Be fussy about management
As Table 1 shows, we’ve grouped red flags into behavioural and practical categories, with the latter frequently an expression of the former. A fish, as they say, rots from the head. Unilife featured many of these unwelcome behaviours but there are more.
Graham Witcomb nominates Zicom Group, run by a father and his two sons. Collectively, in 2015 they took home S$1.0m in salaries despite the business making just S$1.7m in net profit. The company also has a liberal attitude to the granting of options, issuing them at low prices without any high watermark clause. If targets are missed and the share price doesn't go up, more shares are issued at the lower price. There's no downside for management here.
At the shareholders' expense
Behaviour like this is more common among smaller companies, where founders or large, private shareholders can dominate the register (Zicom has a market capitalisation of under $40m). With less scrutiny, there’s more scope for self-enrichment. The issue is one of representation. In theory, a company is owned and run by management for the benefit of shareholders. In practice, some companies are run for the benefit of management at the expense of shareholders.
Management theorists call this an agency problem and nowhere is it more colourfully expressed than at Disney circa 1997. Chief executive and chairman Michael Eisner’s grip on the company was so absolute that the 17-member board featured Eisner’s personal attorney, his child’s school principal and Sidney Poitier.
The California Employees Pension Fund has developed a three-point test to establish whether a board is independent or not (it must have a majority of independent directors; the chair must be one of them and not also act as CEO; and the compensation and audit committees must be exclusively composed of outsiders). In 1997, Disney was the only S&P 500 company to fail on all three measures.
When a CEO’s grip on a business is so tight the checks and balances on decision making are gradually whittled away. Behavioural red flags eventually turn into practical warning signs. Arrogance and self-regard ultimately lead to a host of other problems, from nepotism and extravagance to a stacked board, disgruntled employees and grandiose expansion plans. When ego takes over it is shareholders that pay the price.
Behavioural red flags
Practical red flags
This takes us into different territory. When I asked your analytical team for the biggest warning sign of all, remuneration incentives rather than behavioural factors were their principal concern. That makes sense. Give a small ego CEO a big monetary incentive to do stupid things and they will.
In a speech titled the 24 standard causes of human misjudgement, Charlie Munger named incentives as the number one driver of human behaviour. Unilife featured a ludicrously compensated CEO and a board and senior executive team that was paid handsomely, perhaps as a way of keeping them sweet. Although this is a bad sign it is not conclusive evidence of a poor outcome. Ramsay Healthcare shareholders would be well pleased with the company’s performance over the past few years despite paying CEO Chris Rex over $30m in 2013-14 and employing what many consider to be aggressive accounting policies.
Egregious salaries are tolerable as long as they accrue from activity that also benefits shareholders. Unfortunately, in many cases they don’t. A few years back the management teams of the entire AREIT sector were incentivised to expand assets under management, a mission that they performed admirably by buying over-priced assets offshore. Only when the GFC hit did shareholders pay the price. Misalignment of remuneration with shareholders’ interests is a major warning sign. And remunerating managers on share price performance is not alignment, merely an incentive to talk share prices up and under-invest in a business.
A suitably experienced board is another issue. Woolworths is a good example, one we should have paid more attention to. Before recent resignations the board featured engineers, builders, an accountant and a more than a few bankers. The lack of retail experience on the board compared with the relentless drive for more margin should have worried us more than it did. There was plenty of hubris, too.
Inexperienced boards are more prone to what Peter Lynch called ‘diworseification’, with NAB’s foray into the UK and its purchase of Homeside highlights in what one commentator calls 30 years of strategy failure. Rio Tinto’s acquisition of Alcan was another obvious failure, as was Suncorp’s purchase of Promina, Foster’s foray into wine and ANZ’s Asian strategy. These are all predictable failures.
It would be easy to conclude that any Australian company embarking on an offshore expansion should be considered ‘under watch’. But then one risks missing out on success stories like CSL, Cochlear, Flight Centre and, daddy of them all, Westfield. There is nothing absolute in the spotting of red flags, no conclusive waving that screams ‘avoid’.
One way of dealing with this complexity and the natural human bias to optimism is to list all of the factors that concern you and then make the counter-argument. List each point side-by-side to see how the arguments weigh up. Instead of applying fixed rules and jumping to conclusions, in this way we force ourselves to more deeply consider all relevant facts.
One final point. There will be cases where, despite ill-conceived management incentives and behavioural red flags, companies will do well. We do not need to invest in these businesses for our portfolios to perform well. We can afford to be cautious, avoiding companies that might not pass the smell test but where nothing is rotten. We don’t have to be invested in every stock that goes up to do well. Be fussy.