24 Jun 2016

Good Corporate Governance

Castle Point does not normally seek to be an ‘activist’ shareholder, very rarely would we presume that we know better when it comes to the management of a company. That being said, we do have internal guidelines as to what to look for, and what to be wary of, when it comes to management structures and boards of directors.

Our Quality investment candidates fall into two sub-categories:

  1. Moats, which have high barriers to entry, and can earn higher returns than the market expect for longer, and
  2. Growth, which have the potential to grow further, and faster, than the market expects.

The latter, growth companies, require excellence at all levels of management in order to fully capitalise on the size of the opportunity ahead of them. With the former, it of course helps if a Moat company is well run, but a Buffettism is also relevant for the more cynically minded: “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Our Value candidates have often become value because of management mistakes, poor practice, or because they have an ineffective board. One of the catalysts, in the longer term, for an underperforming unloved company turning around is a change in management and/or the board.

So what do we look for? At the board level we of course need to see a majority of Independent Directors. However, we do also have our own, sometimes more demanding, definition of independence and what makes a suitable board.

We believe independence declines with length of tenure. After 10 years on a board a director has become too engrained into the management systems to properly fulfil his or her role. This becomes a challenge where in some companies and industries a degree of knowledge is required, although we do not believe all directors need to be intimately knowledgeable of the industry.

We spend some time looking into director’s professional relationships. Who has served with who on other company’s boards? Did they work together previously? Was the team successful? For shareholders, or only for management?

A director who founded or used to have an executive role with the company can have useful insights. They can also spend a lot of time looking in the rear view mirror, are psychologically biased against change, or even worse, actively cover up previous mistakes.

A director who has any association with a competitor is a clear red flag.

Related party transactions and ‘finders fees’ for any M&A activity are also clear red flags requiring further investigation.

Politically appointed directors are reviewed with caution.

There is a role for an executive on the board, normally the CEO, but rarely for more than one.

The CEO should never be the Chair of the board.

Rather than the entire board having in depth industry experience we would rather see a board that is willing and able to seek technical or specialised advice, or further training, where required.

Whilst we acknowledge that the pool from which good quality directors can be drawn is not huge, we are very wary of directors who spread themselves too thinly. Some professional ‘independent’ directors have sat on the boards of 4 or more publically listed companies, and in addition 20 or more private companies. Attending a different board meeting every working day of the month makes it somewhat challenging to adequately prepare, engage, and above all deliver shareholder value. 

Depending on the circumstances of the company the Audit, Nominations, and Remuneration Committees can be much more important than otherwise. These especially need to be chaired by a high quality, truly independent director with the appropriate qualifications and experience.

At a management level our primary governance concern is the proper alignment of incentives. Modern reporting standards go to significant lengths to explain both the short and long term incentive structures made available to management. Incentives however should go further than the CEO or the executive team. In order for a firm to perform to the best of its potential, all employees need to be engaged, and motivated to improve profits. For example:

At the minimum, any customer facing activities should have compensation structured around gross margin. Rewarding sales staff on revenue alone can be damaging unless they have no influence on pricing strategies. If sales staff are not able to provide feedback and influence on their employer’s product pricing, one should be equally concerned.

Further to this, any management with influence over the cost structure needs to be compensated based on at least EBIT, or preferably metrics lower down the Income Statement. We disapprove of operating profit measures such as EBITDA (Earnings before costs), and tread warily in the murky world of ‘normalised’ numbers.

Most importantly anyone with influence over capital allocation should be monitored on a return on capital employed structure. In software and other ‘capital light’ industries this can be more difficult, but must be attempted.

In summary, it is important that a high performance culture is embedded throughout the organisation, and that ‘profit’ not be a dirty word at any level. It is hard to imagine a scenario where some degree of profit share amongst all employees creates improper incentives.

Granting executives options increases their motivation to increase the stock price, but can often be biased to short term performance, and has too little regard to the level of risk undertaken. Executive share ownership is a proper alignment, although sometimes expensive.

Whilst companies may not publish a senior management organisational chart the CEO should be willing and able to clearly articulate roles and responsibilities.

Companies traditionally organised themselves in a role specific manner with responsibilities for production, sales, R&D, and accounting at the Exec level. Others use a ‘business unit’ manner, with the CEO managing the overall coordination of the units. Either is fine, but if the two are mixed without clear direction there is ample opportunity for underperformers to hide, and even worse, for quality talent to go unnoticed.

Senior executives with roles such as ‘Commercial Manager’ or ‘Special Projects Manager’ highlight possible concerns regarding unorthodox structures. (Thankfully NZ and Australia are mostly immune to the practice of making anyone and everyone a Vice President.)

The appointment of a new executive to a role similar to an existing role may be a sign that the CEO, or the board, is unwilling to make the hard decisions.

A good CEO actively seeks to employ managers who are better than he or she is, who will challenge, and drive the business further. A CEO surrounded by ‘yes men’ is another situation to cause concern. We generally like to see a senior CFO working alongside a CEO.

The CEO will be the highest paid executive. If other senior executives are paid substantially less there is cause for two concerns; either the CEO has surrounded himself with lowly but appropriately compensated ‘yes men’, or quality talent is not being properly compensated , and is at risk. We call this CEO Pay Slice, and measure it as a % the CEO is paid out of the total pay to the exec team.

We also expect a company’s CEO to be solely focused on the running of the organisation he or she has been given charge of. For a CEO, or other senior executives, to accept directorships on other boards, the executive needs to be supremely confident that they have their own house in order before diverting their attention elsewhere.

Our Moat investment candidates have an especially high hurdle to meet in terms of their capital allocation policies. This hurdle is one they have set themselves, and the reason we have chosen to invest in them. A Castle Point Moat investment is an investment in a business with high barriers to entry, where excellent returns on invested capital can be made over a long time frame. A Peter Lynch quote summarises the proposition well: “In business, competition is never as healthy as total domination”.

The challenge for the Board of Moat companies is what to do with the free cash flow that is produced. Should it be re-invested, or returned to shareholders? Re-investment is fine, with the single proviso; the marginal investment must increase the strength of the Moat, the barrier to entry. Only that way can we, as shareholders, be confident that the long run high returns on invested capital we have identified will be preserved.

Recent market history is littered with the shipwrecks of grand ideas spun out of high performing assets: casino’s in Australian cities not conducive to gambling, secondary airports in highly competitive tourist destinations, and telecom assets scattered around the pacific to name but three. It is unfortunately an ever growing list, with offshore geothermal assets featuring previously, and it seems poised to appear for a second time.