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 18th 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 25th 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%.
