Being skeptical of insiders' incentives

Perverse incentives that affect the average investor

The stock market can be regarded as a transfer of wealth mechanism from minority shareholders and investor to company promoters and managers. What has caught my mind recently is three different examples.

Pershing Square

The first is Pershing Square one of the most high-profile hedge funds in the world led by its enigmatic CEO and founder William (Bill) Ackman.

Pershing Square had an impressive track record compounding its returns between 17.6% - 20.8% p.a. net of fees depending on the structure between 2004/5 and first half 2014. This performance enabled Pershing Square to launch a large Listed Investment Company in the Netherlands raising $2.7B USD. This raising provided Ackman with permanent capital to invest and a guaranteed fee income stream. Pershing Square employee numbers also swelled as can be seen in the graph below.

What precipitated was a series of poor returns from investments including Valeant, Herbalife and Mondelez. This blog post is not questioning the merits of these investments but what has subsequently resulted is a significant amount of lost money. However, Pershing still likes to focus on its long-term compounding record as Pershing Square. What is more important though is Pershing Square’s money weighted return. These returns take account of how much $ return was generated. As Pershing generated most of its positive return when it was managing relatively smaller; amounts of money and generated negative return when it was managing larger amounts the money weighted return would be far lower than its time weighted return.

 

The other fund management trick that Pershing Square has pulled is that Bill Ackman has reincarnated himself as a fund manager but conveniently forgotten his past track record. Previously he was managing Gotham Partners where the funds shuttered due to redemptions from poor performance.

Investors must be cautious when investors raise large amounts of money off the back of a historical track record obtained under different conditions. Many fund managers right now are trying to raise as much permanent capital as possible as they have strong track records from the bull-market in equities due to compressed interest rates. Investors should beware the incentives of the managers behind such actions.

CBL Insurance

CBL recently listed in 2014. It has a great run as a recent IPO increasing from $1.55 to $4.00. CBL is an insurance company which specialises in niche insurance predominately in France.

CBL exceeded its prospectus forecasts, however it made a number of acquisitions which were not forecast in the prospectus forecasts. Adjusting for these acquisitions CBL still beat prospectus forecasts by $5.2m PBT or 8.2%. However, looking further into the result the FY16 result was aided by a release of provisions of $5.8m.

This would be fine, however the events that subsequently followed suggest that the timing of the release reserve to ensure prospectus forecasts were met was extremely convenient.

In April 17, little over 1 month post the FY16 result was released 20m shares were sold at $3.26 to NZ and Australian investors. This realised $65.2m for the Directors and Management. On August 18^th CBL came out with a surprise announcement, shortly before it was due to release its 1H17 results, that it would miss its internal operating profit expectations by $17.5m due to a $16.5m strengthening of its insurance reserves. This seemed strange given the reserves were released only 6 months prior. The stock subsequently fell from $3.75 to a closing low of $2.80. To add salt to the wounds CBL has recently updated the market again in February 2018 and has remained suspended from trading as it expects to make a future claims reserve strengthening adjustment of $100m to the reserves, it will also take a $44m write-down of receivables arising from SFS, a business that it acquired in 2016.

The observation is in businesses where significant accounting adjustments can be made which significantly affect the profitability of the business such as finance and insurance companies in situations where management have an incentive to produce a favourable result it is necessary to exercise increasing skepticism towards the results produced.

ITL Healthcare

ITL healthcare conducted a suspicious share buy-back which was announced on the 25^th of October. The company began buying back shares at 40.5c and purchased aggressively right up to December 29. Prior to this buy-back the previous buyback was conducted at less than half the price being 20c on 8 February 2016.

ITL purchased 4.11m shares in November at prices between 0.40 to 0.47 which was 72.5% of all volume traded in that month.

ITL purchased 7.99m shares in December at prices between 0.415 to 0.475 which was 71.3% of all volume traded in that month. The volume that wasn’t bought by ITL consisted of two director sales, conveniently at the high share-price of the month of 0.47. Andrew Turnbull sold 990,000 shares and William Mobbs sold 2,343,543 shares. Adjusting for these director sales ITL purchased 100% of all shares during the month and effectively pushed the share-price to a level that allowed the directors to sell down. The buy-back has now stopped and the share-price has fallen 22%.

Book review: Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance: Value Investing with Confidence for a Lifetime of Stock Market Outperformance by Marshall, Kenneth Jeffrey

Book review: Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance: Value Investing with Confidence for a Lifetime of Stock Market Outperformance by Marshall, Kenneth Jeffrey

Finished reading: 1 January 2018

https://www.amazon.com/Good-Stocks-Cheap-Confidence.../dp/125983607X

The book covers the investing basics focussing on value investing which, as an experienced investor, I skimmed over, however I found it instructed in the structure how to think about investments.

1. 1. Do you understand the business and what it does?
2. 2. Is it a high quality business. Quantitatively measured from the past?
3. 3. Is it likely to continue to be a high quality business going forward? This requires a strategic analysis.
4. 4. Management
5. 5. Is this business undervalued?
6. 6. Are the decision being made being influenced by cognitive biases.

1. 1. Define the business along six parameters: 1.   Products      2.   Customers      3.   Industry      4.   Form      5.   Geography      6.   Status
2. 2. Various financial ratios are discussed.
3. 3. The second discipline, strategy, shows which companies with successful pasts promise to have successful futures. It’s qualitative. It involves thinking about what sets a company apart from its peers, and picturing it years onward. The first is what I call breadth analysis. It asks two questions. One, is the company’s customer base broad, and unlikely to consolidate? And two, is the company’s supplier base broad, and unlikely to consolidate? The business isn’t good unless the answer to both is yes. I define a broad customer base as one where no single customer accounts for over a tenth of revenue. Similarly, I define a broad supplier base as one where no single supplier accounts for over a tenth of cost of goods sold or operating expenses. A second qualitative tool is forces analysis. It’s my cheap rendition of the five forces model introduced by business school professor Michael E. Porter in 1979.

A third qualitative tool is what I call moat identification. A moat is a barrier that protects a business from competition. It’s a defense that lasts.

The first is government.

A second source of moat is network. Network is an accumulation of users or customers. It constitutes a moat if it yields a product benefit derived from the other users of a product.

A third source of moat is cost. Sometimes a company has a low cost structure that enables it to produce a product for less than competitors.

A fourth source of moat is brand. Some brands are so strong that customers rarely consider substitutes.

A fifth source of moat is switching costs

A fourth qualitative tool is market growth assessment. This is a straightforward view on whether a company’s market is growing or not. It’s important because a business with an expanding market—everything else being equal—has a brighter future than one that doesn’t.

4. 4. The first indicator is compensation and ownership. What executives and board members earn and own shapes their incentives. We’d like these incentives to be as aligned with ours as possible.
5. 5. Generally a business trading over 25x EV/Operating Earnings is considered expensive.
6. 6. The third, psychology, is about the restraint necessary to reject the misjudgments that naturally arise from one’s inborn biases. Humans think funny. It’s not that we’re silly or wrong. It’s just that we’re people. To be mindful of the bad calls we’re likely to make is to maximize the chance that we’ll catch them before they hurt us.
7. 
   

1.   Affinity         2.   Reciprocity         3.   Anchoring         4.   Authority         5.   Availability         6.   Cleverness         7.   Incomprehensibility         8.   Consensus         9.   Peculiarity       10.   Intermixing       11.   Consistency       12.   Confirmation       13.   Hope       14.   Lossophobia       15.   Scarcity       16.   Hotness       17.   Miscontrast       18.   Windfallapathy. Investor misaction is caused by one of two forms of akrasia:      1.   Impetuosity      2.   Weakness

The book provides a lot of commonsense  observations such as the below:

Stated differently, value investors know what’s going to happen, but they don’t know when.

The first three steps of the value investing model—do I understand it? is it good? and is it inexpensive?—form a row.

To do it is to decisively take action when it’s time to do so. It means, for example, to buy when an understood, good business is underpriced. This turns out to be impossible for most people. It requires one to commit capital to a stock at the precise moment when everyone else seems to be selling it.

It’s absurd to insist that lousy operating results from a cyclical company in a down cycle are permanent.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period.

Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

Above subsistence and below gluttony, there’s little correlation between net worth and happiness. Money just doesn’t produce life’s great joys. Those come from those loved ones, from health, and from other sources that don’t care much about geometric means, depreciation schedules, or enterprise values. But an absence of money can keep one from the great joys.

Conclusion

Although the books stazrted off with basic concepts the second half of the book I took value from the simple and concise approach to thinking about investments using material originated from other thinkers. I will incorporate some of the thoughts to my own investment process going forward.