Tag Archives: investing
Maximising Shareholder Value Has Nothing To Do With Maximising The Share Price
The idea that directors should seek to maximise shareholder value has come in for a lot of flak in recent years. James Montier of GMO even wrote a piece on it called ‘ The World’s Dumbest Idea ‘. One of the most prominent criticisms of maximising shareholder value is that it causes directors to focus too much on their company’s share price, which leads them to underinvest in the company’s long-term future in order to boost short-term profits (and therefore, the share price). This is not so much a failing of the concept of shareholder value maximisation as it is a failure to understand what shareholder value is and what directors can do in their attempts to maximise it. True shareholder value is a measure of long-term value The value of a company is essentially the value of all the cash it will return to shareholders over its remaining lifetime. Let’s assume that Sainsbury ( OTCQX:JSAIY ) ( OTCQX:JSNSF ) will survive another 100 years before closing its doors for the last time. In that case, the value of the company today is the value of all dividends paid out over the next 100 years plus any cash returned to shareholders, when the company is wound up (which we can ignore because it is usually zero). A dividend today is preferable to a dividend in 50 years’ time, so future dividends are usually “discounted” by an annual discount rate. If you want a 10% annual return on your Sainsbury investment, then you would discount the value of future dividends by 10% each year, in which case a 100p dividend 10 years from now would have a “present value” of about 42p. Add up those discounted future dividends and hey presto, you have the present “shareholder value” of Sainsbury, at least according to an investor who wants a 10% rate of return. A different discount rate would provide a different shareholder value. Because the company’s shareholder value is the discounted sum of 100 years of dividends, only a fraction of Sainsbury’s value today comes from dividends paid in the next 10 years. Most of its shareholder value comes from dividends that are expected to be paid more than 10 years in the future, as is the case for most mature companies. This is the true meaning of shareholder value; a multi-decade stream of dividends, which directors should be attempting to maximise, without taking unnecessary risk. True shareholder value maximisation should be much more about working to improve and expand the business for the next 10 years and the 10 years after that, rather than hitting short-term profit expectations. Share prices have almost nothing to do with shareholder value Those who believe in the wisdom of crowds might say that yes, the true shareholder value of a company is indeed the discounted value of its future cash returns to shareholders, but we can never know those cash flows and therefore can never calculate an accurate figure for shareholder value. They might go on to say that our best estimate of shareholder value is the market value or share price of a company, and so it is entirely sensible for directors to pay attention to share price and to be paid according to its performance. Utter drivel, is what I would say to that. The share price or market value of a company is, at most, a combined “best guess” by investors as to what a company’s shareholder value really is. However, calling it a “best guess” is wildly optimistic as a large portion of equity trades are carried out by traders who don’t even know the names of the companies whose shares they are buying and selling (especially the computer-driven High Frequency Traders who own shares for thousandths of a second). Even if all market participants were long-term dividend-focused investors, they still wouldn’t have the faintest idea what dividend Sainsbury will be paying 10, 20 or 30 years from now, and therefore no idea what its shareholder value is (and the same would be true for pretty much all companies). Rather than an estimate of shareholder value, share prices are more closely connected to factors like current dividends, current earnings and any and all combinations of news, noise, expectations and emotions; none of which have anything to do with true shareholder value. So the idea that maximising shareholder value means maximising the share price is a joke, which means that compensating executives with one-way bets on the share price (otherwise known as stock options) is equally daft. If executive directors are to be compensated by share price movements at all, it should be by insisting that they invest a significant amount of their own money into the company and to keep it invested for as long as they are on the board. In addition, they should be encouraged to focus on maximising true shareholder value rather than the company’s market value. As Lawrence Cunningham describes in the introduction to his book, The Essays of Warren Buffett : “The CEO’s at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their businesses as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies.”
Why Diversification Is An Important Tool Of Managing Risk
Summary Even the famous investors sometimes get it wrong. Pershing Square and Herbalife and Valeant Pharmaceuticals. Greenlight Capital and CONSOL Energy. Casablanca and Cliffs Natural Resources. Icahn Capital and Chesapeake Energy and Transocean. Introduction Diversifying an investment portfolio is more than just buying stocks in unrelated industries. It can also mean portioning a portfolio between multiple asset types such as equities, bonds, real estate, currencies, etc. And then, there is another layer of diversifying within each asset type. Bonds can be diversified many ways: government versus corporate, investment grade versus high yield (otherwise known as junk), Treasuries versus municipals, and domestic versus foreign. On top of that, investors need to consider holding a variety of maturities that will meet income needs today and in the future. Think of laddering the bond portion of a portfolio as a key element to be considered. The point of this article is to encourage investors to consider diversifying to reduce the risk inherent in holding too large a percentage of any on assets. The secondary theme is that every investor needs to do some due diligence on their own to satisfy themselves that each investment made is appropriate for that investor. Some investors like to follow the investing decisions of high-profile investors that have successful track records. But even then, diversifying against risk is important. Even the famous investors sometimes get it wrong Some of the best-known and most knowledgeable investors can be wrong or way too early. Sometimes even the smartest investors outsmart themselves by taking a large position that they believe in and holding onto it well beyond a reasonable period of loss, unwilling to admit a mistake. It can be a matter of pride and ego. Those are terrible reasons to hold onto an investment. Here are a few examples of mistakes made recently by some high-profile investors in the hedge fund arena. Pershing Square ( OTCPK:PSHZF ) and Herbalife (NYSE: HLF ) and Valeant Pharmaceuticals (NYSE: VRX ) Pershing Square is led by Bill Ackman and has recorded some excellent returns in the past. Lately, though, things have not been going Mr. Ackman’s way. I wrote an article about another multi-level marketing (MLM) company and got slammed by some of Ackman’s disciples. Here is an example comment: “Do you even own a passport? BTW they are not but are receptive to good skin care products. MLM is scrutinized in China. Have you ever studied Amway and AVP? When the Ackman atom bomb burns HLF to ashes NUS USANA and the likes will be part of the inferno.” – LeMarJackson. The article was written in May 2014. HLF’s shares have not fully recovered from the public frontal assaults by Ackman, but the shares also have not tumbled. In the end, the Pershing Square hedge fund investors (and Mr. Ackman) have lost money; a lot of money being short in a concentrated bet. Valeant has also been a losing position for Ackman. Thus far, Pershing Square has lost about $2 billion on this one investment alone according to this Wall Street Journal article. That one investment accounted for nearly 20 percent of the fund’s assets at one point, and the stock fell in value by 65 percent. These are just two examples of why we need to keep our emotions out of our investment decision-making process, why we need to diversify our holdings, so that we do not risk losing too much on any one position, and why we all need to do some research to confirm the investment thesis of those whose leads we like to follow. Greenlight Capital (NASDAQ: GLRE ) and CONSOL Energy (NYSE: CNX ) Greenlight Capital is managed by David Einhorn, another admired billionaire hedge fund investor. He has also been right a lot, and made his investors a lot of money (but probably not as much as himself). According to this article from money.cnn.com, Greenlight Capital is down about 12 percent this year, primarily due to investments in energy. One of his large position, CNX, is down about 65 percent this year. Just another reason not to follow blindly and to not concentrate too much into one position. The effects can be devastating. Casablanca and Cliffs Natural Resources (NYSE: CLF ) Another activist investor who had done a lot of homework was Donald Drapkin, a former protégé of Ron Perelman and head of Casablanca. Casablanca purchased about 5.2 percent of CLF’s shares outstanding for an average price of about $25 per share. The plan was to oust senior management and replace the CEO with a veteran who had managed turnarounds before, cut costs and close unprofitable mines to improve margins. CLF’s stock now trades at about $2.34 per share. That is a loss of more than 90 percent so far. I am glad I did not follow Casablanca into this mess. Icahn Capital (NASDAQ: IEP ) and Chesapeake Energy (NYSE: CHK ) and Transocean (NYSE: RIG ) Carl Icahn has a net worth of over $20 billion the last time I checked. So, he must be doing something right. He also has a long enough time horizon and the wherewithal to withstand temporary setbacks. He has made significant investments in the energy sector. He may be right in the end, but so far, some of his large positions in that sector are sucking wind. CHK is down almost 70 percent this year while RIG is down only 21 percent since January 1st, but off more than 43 percent in the last 12 months. IEP is down in value over 24 percent since the beginning of the year. It has made some good investments that partially offset the blunders. This is the case with all of the above investors/funds. They did a lot of homework/analysis before making these investment, and still got it wrong. Conclusion Diversification may have saved the respective bacon of these outstanding investors keeping them alive to fight/invest another day. We may not all be able to avoid making mistakes over our investing lifetimes, but we can take precautions to minimize the risk when we are wrong. For those who might be interested, I published a series on Seeking Alpha recently that explains ” How I Created My Own Portfolio Over A Lifetime ” by that same name. I take a rather unique approach to investing that those who have already stumbled onto the series seemed to really like. Likewise, I also use an approach to hedging that is different but keeps costs low. It is not for everyone, but so far my experience has proven very favorable. I have captured gains of 600 to over 2,700 percent on some positions to help defray the cost and protect my core holding through the recent turbulence. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.