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Open Letter To Norway’s Sovereign Wealth Fund: Target Lions Gate Entertainment

Norway’s Sovereign Wealth Fund’s CEO Yngve Slyngstad recently told the Financial Times that the fund is looking to restructure compensations plans at certain companies in its portfolio. “We have so far looked at this in a way that has focused on pay structures rather than pay levels…We think, due to the way the issue of executive remuneration has developed, that we will have to look at what an appropriate level of executive remuneration is as well.” As the fund looks for a company it can target, we offer a candidate: Lions Gate Entertainment (NYSE: LGF ). How Reforming Executive Compensation Creates Value For Investors We applaud the fund for looking at both the structure and the size of executive compensation packages. Many of the fund’s 9,000 holdings overpay their executives for hitting targets that don’t create shareholder value. Over the past several months, we’ve written a number of articles about the risks that excessive and misaligned executive compensation plans pose to investors. We’ve dissected examples of poor compensation plans leading to significant shareholder value destruction, from Valeant (NYSE: VRX ) to Men’s Wearhouse (NYSE: TLRD ). When boards of directors pay executives based on misleading and easily manipulated performance metrics, they harm investors in two ways. Immediate wasted money: the compensation going to executives, in the form of cash or equity, decreases the amount of cash flows available to investors. Long-term value destruction: poorly designed compensation plans incentivize behavior that leads to poor operational and strategic decisions with respect to the long-term interests of shareholders. For more evidence of the outsized impact of compensation plans on a business, look no further than Home Depot (NYSE: HD ). From 2001-2006, CEO Robert Nardelli earned $240 million in compensation. For comparison, his counterpart at Lowe’s (NYSE: LOW ) made around $30 million over that same time, about 1/8th of Nardelli’s compensation despite Lowe’s being between 1/4th to 1/3rd Home Depot’s size. In addition, Nardelli’s compensation was heavily tied to EPS-which he boosted by buying back billions of dollars of shares every year-and sales growth, which he accomplished by investing heavily in the company’s low margin, low return on invested capital ( ROIC ) wholesale business. These moves helped Nardelli’s bonus, but they created little value for investors. During Nardelli’s tenure, Home Depot’s stock was essentially flat. In the midst of a bull market and a housing bubble, Home Depot delivered almost no returns to shareholders! In 2006, activist Ralph Whitworth took a 1.2% stake in Home Depot and began agitating for a change to the company’s executive compensation practices. He was able to force Nardelli out, significantly reduce CEO pay to less than $10 million a year, and institute a compensation plan with long-term incentives for increasing ROIC. Figure 1: Stock Prices Move In Line With Return On Invested Capital Click to enlarge Sources: New Constructs, LLC and company filings Figure 1 shows how Home Depot significantly underperformed Lowe’s stock during Nardelli’s tenure. It also shows how it significantly outperformed after Whitworth’s reforms, gaining more than 200%. This link between stock prices and ROIC is intuitive and well-known among more diligent investors. Increasing ROIC is the best way to create long-term value for shareholders . Linking executive compensation to ROIC has helped companies such as AutoZone (NYSE: AZO ) outperform the market for many years. Don’t just take our word for it either. S&P Capital IQ recently released a study showing a significant statistical link between ROIC improvement and outperformance. Finding A Target: Lions Gate Entertainment Lions Gate turned heads when it handed CEO Jon Feltheimer over $60 million in equity awards as part of a new five-year contract. The board lauded the company’s strong performance in 2014 as justification for the large stock award, but our numbers show that ROIC actually fell from 12.1% to 11.1% that year. As Figure 2 shows, the problem goes far beyond just 2014. Over the past five years, Lions Gate has spent a larger portion of its enterprise value on executive compensation than any of the companies in its self-identified peer group for which we have five years of data. Figure 2: High Executive Compensation + Poor Return On Invested Capital = Bad News For Investors Click to enlarge Sources: New Constructs, LLC and company filings. “TTM” = Trailing Twelve Months. Figure 2 also shows that Lions Gate’s ROIC has dropped to just 2.3%, putting it near the bottom of its peer group. That’s due in part to disappointing results from several films this year. It also reflects a compensation plan that does a poor job aligning executive incentives with shareholder interests. Both annual and long-term incentive bonuses are tied to a non-GAAP metric called “adjusted EBITDA.” This metric does a poor job of measuring shareholder value creation for several reasons: Excluding depreciation and amortization means that executives are not held accountable for capital allocation. They can boost adjusted EBITDA by investing heavily in low return projects and excluding the costs. Adjusted EBITDA excludes stock-based compensation, which is a real expense and should be accounted for. Since executives are largely paid in stock, they get to largely exclude their own compensation when calculating profitability. Adjusted EBITDA makes a number of adjustments for purchase accounting, start-up losses, and backstopped expenses. These are real costs, and executives have a high degree of discretion when it comes to calculating these numbers so they can hit their targets. Tying executive compensation to such a flawed metric is a recipe for low ROIC and significant shareholder dilution. Sure enough, going back to 2005 Lions Gate has earned an ROIC below its cost of capital ( WACC ) in every year except 2013-2015, when it was buoyed by the success of the (now-ended) Hunger Games franchise. Over that time, its share count increased by 47%. Succeeding through creating original content is tough. It’s even tougher when management is not a responsible steward of capital. It should come as no surprise that the most successful company in the industry, Disney (NYSE: DIS ), is also one of the few that links executive compensation directly to ROIC. If Lions Gate wants to have any hope of creating long-term value for shareholders, it needs to cut back on executive compensation and better align compensation incentives with investors’ best interests. Norway’s Sovereign Wealth Fund should consider Lions Gate as its first target in its campaign against excessive executive compensation. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Best And Worst Q2’16: Information Technology ETFs, Mutual Funds And Key Holdings

The Information Technology sector ranks fourth out of the ten sectors as detailed in our Q2’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Information Technology sector ranked third. It gets our Neutral rating, which is based on aggregation of ratings of 29 ETFs and 122 mutual funds in the Information Technology sector as of April 18, 2016. See a recap of our Q1’16 Sector Ratings here . Figures 1 and 2 show the five best and worst rated ETFs and mutual funds in the sector. Not all Information Technology sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 384). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Information Technology sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Five mutual funds are excluded from Figure 2 because their total net assets are below $100 million and do not meet our liquidity minimums. The Van Eck Market Vectors Semiconductor ETF (NYSEARCA: SMH ) is the top-rated Information Technology ETF and the Fidelity Select Communications Equipment Portfolio (MUTF: FSDCX ) is the top-rated Information Technology mutual fund. Both earn a Very Attractive rating. The First Trust Dow Jones Internet Index Fund (NYSEARCA: FDN ) is the worst rated Information Technology ETF and the Invesco Technology Sector Fund (MUTF: IFOAX ) is the worst rated Information Technology mutual fund. FDN earns a Dangerous rating and IFOAX earns a Very Dangerous rating. 506 stocks of the 3000+ we cover are classified as Information Technology stocks. Cisco Systems (NASDAQ: CSCO ) is one of our favorite stocks held by FSDCX and earns a Very Attractive rating. Over the past decade, Cisco has grown after-tax profits ( NOPAT ) by 7% compounded annually. Cisco has improved its return on invested capital ( ROIC ) from 14% in 2005 to a top-quintile 17% in 2015. The company has generated a cumulative $32 billion in free cash flow ( FCF ) over the past five fiscal years. However, in spite of the operational strength exhibited by Cisco, CSCO is undervalued and presents an excellent buying opportunity. At its current price of $28/share, Cisco has a price-to-economic book value ( PEBV ) ratio of 0.8. This ratio means that the market expects Cisco’s NOPAT to permanently decline by 20%. If Cisco can grow NOPAT by just 6% compounded annually for the next decade , the stock is worth $43/share today – a 54% upside. ServiceNow (NYSE: NOW ) remains one of our least favorite stocks held by IFOAX and earns a Dangerous rating. ServiceNow was placed in the Danger Zone in December 2015. Since going public in 2012, ServiceNow’s NOPAT has declined from -$29 million to -$154 million while its ROIC declined from -29% to -41% over the same time frame. The drastic decline in profits and profitability is in stark contrast to ServiceNow’s revenue growth, as the company adopted a “grow revenue at all costs strategy,” which clearly ignores profits. Making matters worse, when we placed NOW in the Danger Zone, its valuation implied significant profit growth and despite NOW falling 21% since the publish date of our report, those expectations remain unrealistically high. To justify its current price of $63/share, ServiceNow must grow immediately achieve 15% pre-tax margins (-15% in 2015) and grow revenue by 23% compounded annually for 13 years . In this scenario, 13 years from now, ServiceNow would be generating over $14 billion in revenue, slightly below Facebook’s (NASDAQ: FB ) 2015 revenue. It’s clear how the expectations embedded in NOW remain overly optimistic. Figures 3 and 4 show the rating landscape of all Information Technology ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Best And Worst Q2’16: Energy ETFs, Mutual Funds And Key Holdings

The Energy sector ranks last out of the ten sectors as detailed in our Q2’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Energy sector ranked ninth. It gets our Very Dangerous rating, which is based on aggregation of ratings of 22 ETFs and 100 mutual funds in the Energy sector. See a recap of our Q1’16 Sector Ratings here . Figures 1 and 2 show the five best and worst rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 144). This variation creates drastically different investment implications and, therefore, ratings. Investors should not buy any Energy ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Four ETFs are excluded from Figure 1 because their total net assets are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Rydex Series Energy Service Portfolio (MUTF: RYVIX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. Market Vectors Oil Services ETF (NYSEARCA: OIH ) is the top-rated Energy ETF and MainStay Cushing Renaissance Advantage Fund (MUTF: CRZZX ) is the top-rated Energy mutual fund. Both earn a Neutral rating. iShares US Oil & Gas Exploration & Production ETF (NYSEARCA: IEO ) is the worst rated Energy ETF and Saratoga Advantage Energy and Basic Materials Portfolio (MUTF: SBMBX ) is the worst rated Energy mutual fund. Both earn a Very Dangerous rating. 178 stocks of the 3000+ we cover are classified as Energy stocks. LyondellBasell Industries (NYSE: LYB ) is one of our favorite stocks held by CRZZX and earns a Very Attractive rating. Over the past five years, LYB has grown after-tax profit ( NOPAT ) by 10% compounded annually. Over the same time period, Lyondell’s return on invested capital ( ROIC ) has improved from 17% to a top-quintile 22%. Additionally, over the past four years, LYB has generated a cumulative $14.8 billion in free cash flow . Despite the strength of the business, LYB is undervalued. At its current price of $88/share, LYB has a price-to-economic book value ( PEBV ) ratio of 0.8. This ratio means that the market expects LYB’s NOPAT to permanently decline by 20% from current levels. If LYB can grow NOPAT by just 4% compounded annually for the next decade , the stock is worth $139/share today – a 58% upside. Hess Corporation (NYSE: HES ) is one of our least favorite stocks held by IEO and earns a Dangerous rating. Contrary to GAAP net income, which has fluctuated wildly over the past decade, Hess’ NOPAT has only worsened by declining from $1.7 billion in 2005 to -$859 million in 2015. Over the same time period, Hess’ ROIC has fallen from 11% to -2%. In a large disconnect from reality, HES has risen over 50% over the past three months, which has made shares more overvalued. In order to justify its current price of $57/share, Hess must immediately achieve positive pre-tax margins (from -22% in 2015) and grow revenue by 20% compounded annually for the next 20 years . In this scenario, 20 years from now Hess would be generating $254 billion in revenue, which would nearly equal oil giant Exxon’s 2015 revenue. The expectations already embedded in HES are unrealistically high. Figures 3 and 4 show the rating landscape of all Energy ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.