Reasons For Us Not To Invest

The following is a list of red-flag factors that will cause us to walk away from making an investment in a company:

Poor capital allocation decisions
Misguided dividend policy
Improper use of share buybacks
LTIPs and SBC plans which misalign interests of shareholders and management

More detail of our views on each of these factors is set out below, but first it is important to explain why corporate CEOs often make poor commercial decisions .

Why Do CEOs Make Poor Decisions?

A well managed company makes for a great investment, and this of course requires a certain type of CEO. The problem is that great CEOs are few and far between.

There are two separate issues to consider here. The first involves CEOs that find themselves running a public company as a matter of circumstance without prior experience to draw upon. The second relates to problems that flow from the misalignment of interests as between shareholders and career CEOs.

We shall look at each in turn.

1. Circumstantial CEOs

Building a startup is an exercise in innovation; but running a successful public company is an exercise in capital allocation. The key issue is that the skill set that enabled the founder/CEO to create a successful company in the first instance, and to list it at the stock exchange in order to raise growth capital, is rarely the same skill set that is required to drive a public company forward and to effectively allocate that capital.

Consider a software engineer who develops a wonderful computer application that goes viral, or a sales person with the ability to proverbially sell ice to the Eskimos. These people are skilled at what they do and so are able to establish a successful private business, but do they understand anything about the effective allocation of capital within a public company? The answer is, invariably, “no”.

As soon as a business is listed on the stock exchange the CEO inherits a new responsibility – a fiduciary duty to act in the best interests of the company’s public shareholders. This is a new duty for which the CEO has received absolutely no training, so it ought to come as no surprise that the discharge of this duty usually falls far below the standards demanded by intelligent investors.

2. Career CEOs

At the other end of the spectrum from Circumstantial CEOs is a person who acts as a CEO professionally and moves from one company to another every few years (the equivalent of a football manager in the corporate world).

Allow me to throw out two rhetorical questions for you to consider.

If the average tenure of a career chief executive is four years, are they motivated to make decisions to benefit the company and its shareholders for decades to come?
In the alternative, are they motivated by what needs to be done to earn a big bonus by meeting short-term performance targets?

I’ll leave you to decide!

Businesses evolve and grow over the long term and most of the higher returning capital deployment opportunities require patience. But if you are a CEO, mid-term with only two years left in office, the last thing you have is patience.

Additionally, short term CEOs rarely, if ever, use their own money to buy shares in the company that they manage. Instead they receive “Stock Based Compensation” (SBC) which they cash-out as soon as the vesting period has passed.

Against this backdrop, is it any surprise that the interests of shareholders and those of the career CEO are misaligned?

Key Decisions For CEOs

Capital Allocation

Capital allocation is the most important task of any business leader, but in a public company there are more levers available for allocating capital and they are often not pulled in the correct order.

There are four ways in which capital is usually allocated:

Reinvestment in the growth of the business at marginal returns above the cost of capital
Building cash surpluses for future investment (perhaps a strategic acquisition) and/or repayment of debt
Repurchases of shares
Dividends

The decision about which of these levers to pull ought to be determined based on opportunity cost. Generally it requires a waterfall approach whereby option 1 is preferred if available, but if not then option 2, failing that option 3 and finally, as a last resort, option 4.

Dividends should always be a last resort mechanism for returning capital to shareholders. Paying a dividend is tantamount to the company stating, “Management have no commercially viable options for the allocation of corporate capital, so we have decided to share it out amongst our shareholders instead.”

This is not our opinion. This is fact. Many of the best managed companies in the world do not pay dividends and the results speak for themselves. The table below compares dividend payers to non-dividend payers. You will see that these are very different types of companies. Non-dividend paying companies grow rapidly and have rewarded their shareholders with huge capital gains. By contrast, dividend paying companies are limited in terms of growth opportunities (some are in declining industries) and so the distribution of capital to shareholders by way of dividend is the only game in town.

By way of explanation, if the company is very profitable and growing rapidly then reinvestment in the business will invariably result in the best outcome for the shareholder. This is all about compounded growth over time. Levers one and two must therefore be preferred over all other options.

Reinvesting capital may take the form of OPEX (customer acquisition through increased ‘sales & marketing‘ or the development of proprietary intellectual property via ‘research & development‘). Alternatively, it may take the form of CAPEX (growing organically or by way of acquisition). Either way, this kind of expenditure is tax deductible and so highly efficient.

If reinvestment in the business is not an option and if the shares of the company are considered to be trading at a price which implies a significant discount to the intrinsic value of the business, then the return on repurchasing stock will be accretive for shareholders. This option will not aid the business in growing and it will neither help to increase a company’s market share nor give it any form of competitive advantage – for this reason it must never be preferred over options 1 and 2.

In the absence of all other options, a dividend payout ought to be considered as a default last-resort mechanism for returning capital to shareholders.

Dividends

Most of the time the payment of dividends is entirely inappropriate and misguided.

Know this – dividends are exceptionally tax inefficient. Consider that dividends are paid out of net profits after deduction of corporation tax and are then subject to income tax when received by the investor. So dividends are effectively taxed twice.

To make matters worse, dividend payouts invariably need to be reinvested by their recipient and so they incur transaction fees.

So a company that pays 25% corporation tax will have every $1 of Profit Before Tax (PBT) shaved by the tax man down to 75 cents. A higher rate tax payer may then be subject to 40% income tax on dividends, so the 75 cents becomes 45 cents. Then the recipient reinvests the money received, crosses the bid/offer spread in the market and pays brokerage fees. That $1 of PBT has now eroded to about 43 cents of value to the shareholder!

No intelligent investor would opt for dividends if there was any viable alternative available.

Rock and Turner would rather that the full $1 of profit be reinvested in the business for growth on a tax deductible basis, so enhancing the capital value of the shareholding. If the company were to generate a return on invested capital of 15% then the choice is effectively between watching $1 of reinvested capital grow to $1.15 of additional value by this time next year, or else receiving a 43 cent dividend. Which would you prefer?

Inexperienced management will often argue that institutional investors demand dividends and that it is necessary to adopt a progressive dividend policy in order to attract institutional capital. This is nonsense. Great companies become strong by reinvesting for growth rather than paying dividends. Amazon, Adobe, AMD, eBay, Google, Facebook and Berkshire Hathaway are perfect examples. All are cash generating machines, none of them pays a dividend and none has any trouble attracting institutional investors.

The most nonsensical thing that we see, which is a huge red flag for investment purposes, is where management pay out dividends to shareholders and then raise money to grow by either issuing more equity (diluting shareholders) or increasing debt levels. This is equivalent to raising cash from the capital markets in order to pay dividends! Why would any right minded CEO pursue such a ludicrous policy? It smacks of incompetence.

Even worse than paying dividends for the sake of paying dividends is a commitment to a rigid dividend policy (perhaps paying 20% of net income as dividends). Given that dividends ought to always be used as the method of last resort for returning cash to shareholders, why would any company bind its hands in advance by making such a commitment? The CEO has no way of knowing what investment opportunities may arise in the future and so rigid dividend policies that limit the ability to capitalize on future opportunities (options 1, 2 or 3 above) are sheer madness.

It is for these reasons that the Rock and Turner Partnership prefers investing in businesses that pay no dividends and which demonstrate a need for capital to fuel growth. These are the companies that will most likely best reward the investor. That is not to say that we don’t invest in dividend paying companies (mining companies are one such exception), but the dividends need to be paid from surplus capital for which there is absolutely no other economically viable use. Young and fast growing companies should, in our professional opinion, never pay dividends.

Our view is best expressed metaphorically. Some investors like cows while others like race horses. If you invest in a race horse then you want to get from A to B quickly (growth), but don’t try to milk it!

Share buybacks have become commonplace in the market and while these are sometimes well intentioned and beneficial for the shareholder, all too often they are not.

Share repurchases are among the most misunderstood and also the most abused aspects of modern capitalism. A repurchase operation will be presented as a means of returning value to the shareholders.

Unfortunately the truth is that buybacks will likely destroy shareholder equity and are nothing more than a means of the management pursuing a self-serving agenda. Allow me to explain:

Buybacks will reduce the number of shares outstanding thereby increasing earnings per share (EPS) even though actual profits may in fact be unchanged or worse in decline. Similarly, when executed above intrinsic value (most of the time) they enhance the Return on Equity metrics by eroding the denominator even if earnings are unchanged or declining. This is a great way for management to give investors the impression that progress is being made when in fact it is not.

The buyback creates artificial demand for shares in the market which, all else being equal, temporarily pushes the share prices higher. But the value of the company is not being enhanced in any way, so this temporary share price inflation caused by the supply/demand imbalance of the repurchase operation is all smoke and mirrors.

Buybacks are commonly used to mask the dilution to shareholders that comes from executive compensation paid in shares.

Often, leveraged companies opt to repurchase shares rather than paying down debt. This is effectively a debt for equity swap which, in some circumstances may make sense but often does not. If the marginal cost of debt is greater than the earnings yield on the equity, then the swap is nonsensical (Would you borrow at 8% to invest at a 5% return? It may surprise you to learn that many CEOs do just that!)

The only time that a share buyback makes sense is when the shares are trading at a discount to intrinsic value as only then does the repurchase add real value to the business (see below, Lessons From The Master CEOs). Buybacks at a premium to the value of the business destroy shareholder equity, that’s a fact.

Ironically, share-buybacks usually occur when the company is doing well and awash with cash. Accordingly, the company buys back shares when its shares are trading at a premium. When the company subsequently needs to raise capital it will issue new shares, often when it is under duress (perhaps a downturn for a cyclical business), so it will sell equity at depressed prices. This is essentially a sell low, buy high strategy. Ouch!

Having said all of that, as highlighted in bold at the beginning of this section, buybacks are sometimes beneficial for shareholders. For this to be the case they need to occur at a market price that does not exceed, and preferably at a discount to, intrinsic value. To exemplify the point, Warren Buffett made the following statement in his 2022 letter to shareholders of Berkshire Hathaway having recently repurchased 9% of outstanding equity for $51.7 billion:

“I want to underscore that for Berkshire repurchases to make sense, our shares must offer appropriate value. We don’t want to overpay for the shares of other companies, and it would be value-destroying if we were to overpay when we are buying Berkshire.”
~ Warren Buffett

To conclude this section on buying back stock it is critically important to stress that this is not about trying to force the share price higher, although this may be an ancillary consequence of a stock repurchase program. A good CEO will not allow the share price, determined entirely by sentiment in the market, act as a distraction during the decision making process in relation to the allocation of capital.

Once shares have been issued in the capital markets for the purpose of raising capital to grow the business, the subsequent share price in the market is of no consequence to the company (unless it needs to raise further capital through issuance of new shares in future).

A share repurchase program is about allocating capital in a manner that achieves the best return for shareholders. Ergo, if the market sentiment (read: inefficiency) creates an opportunity to buy back stock at a price that implies a very attractive earnings yield, then that would be a sensible allocation of capital. Said differently, unless the senior executives or long term shareholders (the kind that companies ought to value most) intend to sell shares imminently, the share price in the market is inconsequential. Reducing the number of shares outstanding by buying back stock at a bargain price means that long term shareholders are rewarded as they own a larger part of a successful money making enterprise and so become entitled to a larger proportion of future profits. In this way shareholder value is enhanced and this will compound at a greater rate – the market price will eventually catch up (be reminded about Mr Market who we met in section two).

CEOs As Trustees

Sometimes it is easier to turn these things on their head and to take a different perspective in order to see them more clearly. Imagine, if you will, a company generating 15% return on equity with its shares trading at a market price of 20x operating earnings. On this multiple, every $1 invested will provide a shareholder with an entitlement to 5 cents of annual pre-tax profit (a 5% earnings yield).

The CEO of the company owes a fiduciary duty to the shareholders (acting as a de-facto trustee on behalf of the shareholders). As such, the choice of how to allocate that 5 cents of pre-tax profit ought to always be made in the best interests of shareholders in order to properly discharge that duty. So what are the options:

Option One is to reinvest the full 5 cents in the business at a 15% return on equity which will result in the equity of the company expanding on a compounded annual basis, its earnings increasing proportionately and its shares enhancing in value. All else being equal, in 10 years every $1 invested will be worth $4.0456. Additionally, the growth of the company may result in a larger market share, lower costs due to economies of scale and enhanced pricing power, all of which improve profit margins. So in all likelihood shareholder returns will be greater than that $4.0456 per $1 invested.

Option Two is the repayment of debt which must be judged on its merits. Financing costs are tax deductible, and so borrowing at 8% with a corporation tax rate of 25% is equivalent to borrowing at 6%. Paying down debt is value accretive if returns on capital exceed 6%. However, one certainly wouldn’t want to borrow at these levels to be repurchasing equity at a share price that implies only a 5% earnings yield.

Option Three is to repurchase shares, in which case the company forgoes the opportunity to generate 15% return on reinvested equity (a huge opportunity cost) in favour of a mere 5% earnings yield. Additionally, the buy back occurs out of post-taxed earnings, and so the 5 cents of operating earnings, at a 20% corporation tax rate, becomes 4 cents of net earnings for use to buy-back shares. This is even less accretive to shareholder value. In this instance, every $1 invested will only be worth $1.6134 after 10 years and this increase in share price is purely as a result of the reduced share count. In other words, the business will not have expanded at all in that time and it would not have gained any competitive advantage by pursuing this policy because there had been no reinvestment in the business itself. As a result it may have lost market share to another company in its industry that had wisely chosen to pursue the first option and so in all likelihood shareholder returns will be less than the £1.6134.

In the event of a market dip, perhaps caused by panic in the market due to a war or a pandemic, let us assume that momentarily the share price of this company drops to the point where it trades at a mere 5x earnings. Now every $1 invested will provide a shareholder with an entitlement to 20 cents of pre-tax profit (a 20% earnings yield). Now it makes sense for the company to repurchase shares because the 20% earnings yield exceeds the 15% return on equity.

Option Four is to pay out the 5 cents as dividends, which is even less beneficial for shareholders. Not only does it bestow no advantage on the company, but there is the double jeopardy taxation for the shareholder as explained above. The poor shareholder will see closer to 2.5 cents in value from the initial 5 cents after the deduction of corporation tax on profit, income tax on dividends and transaction fees on reinvestment. Even if the shareholder uses all of his dividend to purchase more shares in the company, the poor shareholder, after 10 years, will only see the original $1 invested grow to $1.2801 because compounding happens at a far lower rate due to the constant cash bleed to the tax man and in transaction fees on reinvestment.

It isn’t rocket-science, but so few CEOs get this right.

So it can be seen that a good CEO needs to be nimble in order to capitalize on opportunities as they arise from time to time. This isn’t possible if the company has dogmatically (read: foolishly) pre-committed to paying a fixed percentage of its profit as dividends each year under a rigid dividend policy!

Stock Based Compensation

Stock Based Compensation (SBC) was originally invented by young companies that were cash constrained. Cash flow issues are the single largest cause of corporate failures, particularly for start-ups and so paying employees in stock rather than cash solved this problem.

Back at the turn of the millennium SBC was a deferred cost that accounted for less than 5% of revenue. Fast forward twenty years and today SBC is one of the most abused aspects of corporate finance, particularly in tech stocks. It often amounts to a wealth transfer from shareholders to executives. By way of example, in 2020/21 Palantir Inc paid 117% of revenue in the form of SBC to its employees. In such circumstances, no matter how great the company may be, the investors are never going to see a return on investment.

Another great example is Facebook. It is neither a young company nor is it cash constrained. It could easily pay its employees in cash. So why in 2021 did Meta pay out $9.2 billion in stock-based compensation?

The chart below demonstrates how SBC has evolved to become the problem that it is today.

“There is no question in my mind that mediocre CEOs are getting incredibly overpaid. And the way it’s being done is through stock options.”
Warren Buffett

As you can see, there is all too often a misalignment of interests between the long term investors of the company and its executive management caused by misguided, or dare I say sometimes dishonest, incentive plans designed by executives for the benefit of executives. This is hugely problematic.

SBC should be used only where absolutely necessary and then only in moderation in a justifiable manner. This is why abusive SBC policies are a huge red flag when it comes to Rock and Turner investing in a company.

Long Term Incentive Plans

The situation is not very different in respect of Long Term Incentive Plans (LTIPs). These are targets set for management which, if met, result in the payment of performance bonuses.

Examples of misguided LTIPs include those linked to share price because they put market sentiment (share price) at the centre of every decision made by the board. The share price must not be permitted to become a distraction for executives.

When an LTIP drives a wedge between the interests of shareholders and of the CEO then something has gone seriously wrong.

The following anecdote describes the problem perfectly. In the period from 1993 to 2002, the CEO of one of the largest computer companies in the world had his remuneration linked to share price. Unsurprisingly he did everything in his power to push the share price higher, even though it was at the expense of his shareholders. He took on huge amounts of debt to repurchase 25% of the company’s shares. A decline in the number of shares as a result of stock repurchases boosted earnings per share (EPS) even though dollar profits were in decline. Most investors failed to notice the difference and blindly took comfort in the EPS growth of 58%. As a result, between 1998 and 2001 sales fell consistently yet the share price doubled! This is a perfect example of share price and corporate fortunes being entirely out of kilter. Worse still as the share price increased the CEO continued buying at larger and larger premiums to intrinsic value. The result was a destruction of shareholder equity but again many investors didn’t notice. In fact, the reduction in equity made the Return on Equity numbers look better and better (all smoke and mirrors). The CEO financed customer purchases of hardware with low interest rate loans while booking 100% of the revenue upfront. All the while he disguised debt by moving as much of it as possible off the balance sheet. He capitalised expenditure to keep operating costs off the income statement to bolster short term earnings numbers plus he cut research and development expenditure at the expense of the long term prospects of the company. He retired having amassed a personal fortune of over $650m before investors realised that the last drop of blood had been extracted from the company! This is a true story.

So LTIPs should never be linked to share price. Using alternative metrics such as Operating Profit is equally problematic because operating costs such as research and development or marketing may be slashed to achieved targets at the expense of the long term interests of the business. Similarly, using metrics such as changes in free cash flow is equally troublesome because free cash flow numbers may be enhanced by cutting capital expenditures (infrastructure investment) or operating costs (such as advertising). Even using customer growth as a benchmark can be manipulated – the business can slash its prices to win new customers at the expense of profitability.

In short, designing a good LTIP is difficult, particularly since they are long term plans and most CEOs have a short term personal time horizon. The design needs to be very carefully thought through and multi-faceted in order to avoid the unintended consequences spelled out above.

A better approach may be to avoid LTIPs and SBC entirely. Constellation Software Inc, a Canadian company, appreciates this issue and has a very progressive approach. Senior members of staff are paid cash but required to invest a percentage of their remuneration in the business at a preferential price. This approach is far from perfect and also brings challenges (for example, compelling staff to buy stock even when it is vastly overpriced by the market), but it effectively turns employees into paying shareholders which solves the misalignment of interest issue.

Lessons From The Master CEOs

John Malone, former CEO of Tele-Communications Inc is an interesting case study and considered to be one of the best capital allocators ever.

Until Malone came along Wall Street had only ever focused on Earnings Per Share (EPS) as a metric for valuing a company. This is the route of price to earnings multiple. So, naturally, every CEO focused on optimising EPS.

Malone recognised that this was pure folly. He knew that he would be taxed on earnings and that corporation tax was an impediment to the growth prospects of his business. Instead he decided to reinvest heavily on a tax deductible basis in order to grow his company, rather than hand over a sizeable percentage of earnings to the tax man.

Mitigation of tax liability required earnings of the company to be kept to a minimum, so he invested heavily in both CAPEX and OPEX in a manner that would benefit the business. In this way EPS was always very low, his tax liability was very small and the company grew in size and value exponentially.

In his 25 year tenure from 1973 to 1998 he generated average compounded growth (CAGR) for his shareholders of a staggering 30.3% per year.

It is difficult to overstate the significance of his approach to management. He convinced Wall Street that EPS is a foolish measure of a company’s worth and that instead they ought to look further up the Income Statement at earnings before tax, interest, depreciation and amortisation – and this is how John Malone invented the concept of ‘EBITDA’ which we all use today.

Henry Singleton founded Teledyne in 1960. It grew by acquisition into a large highly successful conglomerate and Teledyne’s shares rose substantially as a result. However, it was the manner in which Singleton achieved this growth that is remarkable

In 1966, at the stock market peak, Teledyne shares were trading between 50x and 75x earnings which Singleton knew was way too high. So what did he do?

Singleton excelled when it came to allocation of capital and Teledyne began using its overvalued shares as currency for acquiring over 100 companies. He was exploiting a temporary pricing inefficiency in the market by converting imaginary value into real tangible value for Teledyne. It was a brilliant move.

This was not the only time that Singleton capitalised upon market pricing inefficiency. In the bear market of 1973 to 1974 the entire market collapsed and the Teledyne shares price was pulled down with the rest of the market. The share price fell 75% from its high. At this point Singleton knew that his company was being undervalued and so this time he bought back his own company’s shares at bargain-basement prices. Over the decade that followed Teledyne bought back approximately 90% of its outstanding shares at prices averaging 10x earnings.

The moral of this story is that the best corporate management teams are those that are adept at capital allocation. Singleton was the best. If you have not read Singleton’s biography, “Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It” then you really ought to seek it out. You could not ask for a better book on great corporate management and capital allocation.

Over Singleton’s tenure from 1961 to 1996, some 35 years, he delivered average compounded growth (CAGR) for his investors of over 23% per year.

Warren Buffett , CEO of Berkshire Hathaway is another awesome allocator of capital. He invests capital only when opportunities arise that are accretive to shareholders, even if this means building large cash balances on the balance sheet in the interim. He continually looks for acquisitions or investments to enhance the earnings power of Berkshire Hathaway. He only engages in stock repurchases when he is in possession of surplus cash and, more particularly, when the market price of the stock falls below his calculation of the intrinsic value of the business – again something that is accretive to shareholders. Finally, he never pays dividends.

Buffett pays himself a meager salary of $100,000 USD despite presiding over the company that, in 2019, generated the largest profit in US corporate history of $80 billion USD. He has no LTIP, despite being a long term CEO (over 55 years in office), he receives no stock based compensation and he is fully invested (his own wealth) alongside his shareholders and his interests are perfectly aligned with theirs.

Buffet writes to his shareholders in an annual letter and stated, “Our directors have a major portion of their net worth invested in the company. We eat our own cooking. We can guarantee that your financial fortunes will move in lock step with ours. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when you do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.”

Since taking control of Berkshire Hathaway in 1965, Buffett has delivered over 20% compounded annualised returns (CAGR) for his shareholders. To put that in context, $10,000 invested on day one would be worth a little short of $500 million today.

Conclusion

In summing up, there are three types of corporate management: (1) deceitful and self serving; (2) honest but incompetent; and (3) highly proficient and aligned with shareholders. Rock and Turner looks to invest over the long term in companies that fall into the third category.

The references to the Master CEOs was included for a very good reason. They all have much in common. You will note that all generated outstanding commercial success that translated into extraordinary returns for their shareholders. None was transitory and all served over the long term, so their interests were very well aligned with those of both the business and its shareholders. All were personally invested in the business that they ran with the lions share of their wealth held as corporate equity, not by virtue of awarding themselves unconscionable levels of stock based compensation. Accordingly, they all had long term incentives without the need for artificially creating them by way of LTIP. All favoured reinvestment of capital above all else and none favoured the payment of dividends. Share buybacks were only used strategically where accretive to shareholder value. These similarities in approach are no coincidence. These factors combine to work exceptionally well. Jeff Bezos of Amazon follows a very similar approach and $10,000 invested in Amazon at its IPO in 1997 would have been worth $23 million in 2021.

As explained at the opening of this chapter, Rock and Turner will walk away from making an investment in a company that makes poor decisions in relation to capital allocation, dividend policy, share repurchases, LTIPs or SBC.

Rock and Turner actively engages with CEOs in attempting to procure the making of better management decisions. It introduces constructive challenges to the board as a shareholder and/or by providing an independent perspective either in the capacity of a non-executive director or on a business consultancy basis.

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