This is the fourth part in a series titled "Beyond Buffettology," written by Portfolio Manager George Kurian, CFA.
You can read part 1, part 2, part 3 here.
Question: What could Investment firms learn from Democracies?
Answer: Division of Power into Legislature, Executive & Judiciary.
In the previous episode, we saw how positive politics added shareholder value at a great US investment firm. Now let us see some examples where negative politics subtracts value. Many asset managers attempt to solve the ‘key man’ risk, by making the ‘key man’ a ‘no man’. They achieve this by creating an investment committee with multiple Portfolio Managers for the same portfolio without objectively tracking the alpha created by the individual PMs. However, such a setup is the unwitting hand maiden for negative politics. First, great investment ideas are usually contrarian and not obvious. So, ideas that would have provided the best returns are first laughed at by the committee. If that is not enough to demoralize you, ‘prudently’ is rejected as ‘high risk’. Finally, if everything fails, you are shouted down. Second, such an arrangement also facilitates ‘internal barter’, where PM2 would vote for PM1’s idea only if he is supported in turn. Third, a PM committee creates an ownership problem, when the committee could modify the original idea to such an extent that the ownership of the idea itself comes into question. Finally, as individual accountability is darkened, committee ‘freeloaders’ mushroom. In many committee cultures, successful political PMs even become the management itself, often through backroom manoeuvres, as was seen in a large Sydney money manager only a couple of years ago. In these hyper-political organizations, ‘Marketing PMs in Investment Clothes’ grace the investment committees for multiple products and capture exorbitant compensation at the expense of genuine PMs, upcoming analysts, and the shareholders of the firm. This eventually increases the probability of the destruction of the firm itself as the good PMs leave and bad PMs stay creating a ‘metastatic’ organization where corporate life is, to borrow from Thomas Hobbes, ‘nasty brutish and short’. Hence, teams could be creatively destructive or destructively creative depending on the type of politics fostered by the management.
Every man has a price. What is yours, Sir? - Widely attributed to a late Indian billionaire.
As told in Genesis, Adam and Eve couldn’t resist that one forbidden fruit in the plentiful garden of Eden, even after a warning from the almighty Lord himself. Similarly, while a plethora of investment literature warns, and a gush of sour experiences confirm the value destruction caused by Mergers & Acquisitions (M&A); many CEOs still find it very hard not to drive in this no-speed limit Richtgeschwindigkeit Autobahn to corporate hara-kiri.
‘Many shall be restored that now are fallen, and many shall fall that are now in honour’, so wrote Benjamin Graham in his magnum opus Security Analysis, quoting Roman poet Horace. One could be forgiven for thinking that this American professor was forewarning about a high-flying Australian. Perpetual (ASX:PPT), founded in 1886 and ASX listed since 1964, was honoured for generations as ‘the bluest of blue’ Aussie fund manager, and was the training ground for some of the greatest fund managers Australia has ever seen. However, in more recent times, it was less of a star stock market runner but rather a ‘reverse walker’. Perpetual’s revenues peaked just before the GFC in the July 2008 fiscal. Over the 10 financial years since, the sales by declined about 1.3% p.a. and EPS declined by about 2% p.a. However, these sluggish numbers must be seen in the context of the industrywide decline in active funds management, thanks to the trifecta of underperformance, overpricing and star substitutes like Index funds. In short, while the elephant-sized Perpetual had long stopped dancing to Foxtrot, no one was questioning its pulse.
However, now the giant is being dismembered as if in a Deceased Estate Sale. Its greatest asset, the asset management division, has become its Prodigal Son with years of fund outflows and fee compressions. The bridesmaid divisions of Perpetual like Wealth Management and Corporate Trust, which are renowned for their stable cashflows, are now being sold to an LBO artist (Leveraged Buyout), who would almost surely fire the employees and load these pristine businesses with junk debt. And if that is not even enough, a century plus old heritage Aussie name would now adorn an American abode, and the so-called perpetual fund manager would now be a mere memory. The key question for us to analyse as investors is: what was the proximate cause of this epic disaster? The knockout blow? The coup de grace? In two words: M&A Fever.
To expand the fund's management division, over the last 5 years Perpetual paid about A$3bn for three major acquisitions (A$2.5bn for Pendal, USD$319m for Barrow & Hanley and US$36m for Trillium). As a result of these deals, the FUMs increased from about $30.8bn to $225bn over the last six years or so. However, the current market cap of Perpetual? Only about A$2.2bn, which is lower than what it paid for these so-called ‘compelling’ deals. Over FY18-24, Perpetual stock returned negative 26.9% compared to the positive 63.1% total return for S&P ASX100. Who are the winners here? Investment bankers pocketed several hundred million in acquisition expenses which perpetually disfigured the income statement over these binge years.
The question is why so many CEOs consistently fall for this M&A siren song. Once again one could see the impact of Corporate Politics. First, CEOs are tempted over time by sleep-deprived investment bankers, who like real estate agents are only focussed on the immediate transactions and not on the long-term interests of the owners. Second, creating value for shareholders is a long hard journey that involves high-quality strategic thinking, building and nourishing high-quality teams, developing a great corporate culture, and waiting patiently (often for several years) for value to blossom. Given this context, many average CEOs who are rated by the investment community quarterly (half yearly in Australia), can’t resist the ‘spiked Kool-Aid’ of buying revenues, firing people and showing ‘accretive earnings growth’, especially as the inducement for such mischiefs is high with low cost of debt. Third, there is an asymmetry of information between corporate buyers and sellers, so the probability of the seller withholding key information and making the buyer pay gold for fool’s gold is very high. Finally, there is a personal incentive issue as the size of a company is positively correlated with the CEO compensation but does not correlate whatsoever with the shareholder returns. Hence, with some honourable exceptions, M&A is the banker’s friend and the investor’s enemy.
In Part V, we will look at another version of negative politics – Corporeal politics, and how that destroys shareholder value.
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