As a long-only investor in public equities, Cedar Rock focuses on identifying high-quality businesses with the ability to sustain a high unleveraged return on capital. We seek businesses that have easy-to-understand opportunities to grow while generating high returns on the capital required for growth. If we’re satisfied that a business is sound and that its managers share our enthusiasm for returns as well as growth, this can give us the confidence to invest for the long term.
Our preferred combination of quality, value and managerial skill and probity is difficult to find; we only own about 20 stocks around the world at any moment, and our average annual rate of portfolio turnover has been well under 10% for nearly two decades. In effect, we subcontract our capital to the boards and managers of the companies in which we invest. For our portfolio to compound in value over the long term, our companies must continue to find ways to grow while generating high unleveraged returns on capital.
It helps to start with great businesses and talented managers we know and trust. It helps also to check that their financial incentives are consistent with the potential compounding of our wealth. Three principles on incentive pay underpin our investment philosophy.
- Managers should act like owners.
- Managers should be encouraged to balance growth and returns.
- Managers should be paid for what they manage.
These principles, or something like them, are rarely the norm when it comes to remuneration practices in public companies. In fact, taken together, they collide with key features of just about every remuneration policy we’ve come across. Despite this, we remain disciplined in our approach to identifying businesses with these characteristics. We use these principles to try and align managers’ incentives and remuneration committees’ methods and measures with our desire for sustainable compounding of investment returns. We believe, in the long run, return on capital is an important component of shareholder value creation. As stated, we think sustainable compounding comes from the pursuit of both growth and high rates of return on capital (or growth not at the expense of return on capital).
Principle #1: Managers Should Act Like Owners
At Cedar Rock, we seek companies that require senior managers to acquire over a reasonable period – and retain until at least a few years after leaving – a shareholding whose value is large in relation to the annual bonus they might receive in any year.
(We mean fully vested shares, rather than stock options. Options give management an incentive to do whatever it takes to get the share price above the strike price, within the life of the option. This may or may not coincide with the long-term interest of actual shareholders. In addition, options are expensive for long-term shareholders when, each year, more of an investment’s upside – but none of the downside – gets reallocated from shareholders to employees.)
While each case will have its own unique circumstances, and we don’t want to be overly prescriptive, why shouldn’t a 20% move in the market value of a manager’s shareholding be equivalent to a year’s bonus?
Owner-managers of private businesses understand that cash is cash, regardless of how it’s accounted for, and that cash should be invested for high returns or removed from the business. Some managers of public companies may become overly focused on the differing accounting treatments of cash expended on operating activities in the profit and loss (P&L) account and cash applied to capital expenditures that appear on the balance sheet.
Corporate expenditures on research, product development, advertising and marketing often are the lifeblood of long-term sustainable growth. However, these P&L expenditures reduce reported profits in the accounting period in which they are incurred. Corporate expenditures of a capital nature, such as acquisitions, also may fuel growth, but they often come at such a high price that they generate only modest returns on the capital spent. Managers who also have significant shareholdings will have an incentive to understand and manage these trade-offs.
Principle #2: Managers Should Be Encouraged to Balance Growth and Returns
An unnecessary, but commonplace, shortcoming of many public companies is that they present managers with financial incentives that reward growth in profits as presented in the P&L account, but take little or no account of the returns on the capital required to produce that growth.
In our opinion, a business run exclusively for growth will destroy its return on capital, and one run to maximize return on capital will deprive itself of the ability to grow. At Cedar Rock, we seek both growth and returns, and we need managers to balance the two. In our view, long-term incentives should reward profit growth over a rolling three-year period (or preferably, a rolling five-year period) and reward maintaining a high return on capital (or improving a depressed return) over the same period.
Our preferred profit measure is an unleveraged one: earnings before interest, rent, tax and before any amortization expenses that will not result in future cash outflows. We are not fans of the far more popular growth measure earnings per share (EPS) because it is leveraged. The amount of debt in a company’s capital structure is a decision for the board of directors, rather than management. We believe in rewarding managers for their particular responsibility, which is their companies’ unleveraged operating performance.
We define capital employed as total assets plus the capitalized value of operating leases minus noninterest-bearing current liabilities. We do not use shareholders’ equity as a measure of capital because it, like EPS, is leveraged.
We believe that only the senior managers who sign off on major investment decisions should be accountable for the corporate return on capital. Managers down the line with operating, rather than strategic, responsibilities should be accountable for the return on operating capital employed, which excludes such nonoperating assets as goodwill and acquired intangible assets.
Beyond this, a focus on return on capital should make boards and senior managers accountable for decisions about capital distributions. Conventional accounting subtracts both dividends and share repurchases from shareholders’ equity as if both were distributions of capital. We find this misleading; dividends genuinely shrink a company’s capital, while share repurchases merely redirect capital from one asset (cash) to an investment in another asset (repurchased shares). We believe such investments, like any corporate investment, should be capitalized and carried on the balance sheet.
This supports the common notion that share repurchases make sense – that is, they contribute to the corporate return on capital – when they can be done cheaply. As prices rise, share repurchases stop making economic sense well before they stop contributing to EPS. Dividends, by contrast, boost the return on capital for companies with high unleveraged returns until the cost of debt becomes extremely high.
Principle #3: Managers Should Be Paid for What They Manage
We think incentives should be aimed at what managers get out of bed to do each day: expand the business, beat the competition, invest for the future and make balanced choices between growth and returns.
We do not agree with the current trend among public companies of making long-term incentive pay contingent upon so-called “relative TSR” – that is, a company’s total shareholder return (TSR) relative to the TSR of a stock market index (such as the FTSE 100 or the S&P 500), an industry sector index, a hand-picked peer group or some combination thereof.
We think holding managers accountable for phenomena they do not remotely influence, let alone control, is a missed opportunity to encourage good managerial behavior. If relative TSR is intended somehow to put managers in their shareholders’ shoes, what better way than simply to require managers to own shares outright and participate directly in their companies’ actual TSR?
How We Judge the Output of Remuneration Committees
We measure the mechanisms and measures proposed by remuneration committees against the three principles described. Here’s an abbreviated list of winners and losers.
Sound Performance Criteria
We would be happy to see some combination of the following criteria for the calculation of annual bonuses or the vesting of longer-term incentives:
- Organic volume growth
- Organic revenue growth (at constant rates of foreign exchange, if appropriate)
- Operating margin (excluding rent, if significant)
- Operating return on capital (including capitalized operating leases, if significant)
- Conversion of operating profit to operating cash flow
- Competitive performance (market share, for example)
- Customer satisfaction
Unsound Performance Criteria
- EPS growth: This fails our test because it is a leveraged, post-tax measure, easily influenced by nonoperational factors
- Return on equity (ROE): Like EPS, a leveraged, rather than operating, measure
- Relative TSR: A lottery ticket that fails to motivate
Good Delivery Methods
- Cash (for annual bonuses)
- Performance shares
- High personal shareholding requirements (extending beyond employment at the company)
- Clawbacks (in the event of managerial misbehavior)
Poor Delivery Methods
- Stock options: These reward capital appreciation within the life of the option, rather than long-term TSR, and can be expensive for long-term shareholders; options can make managers reluctant to recommend paying ordinary or special dividends, which reduce the capital value of the underlying shares, and encourage them to hoard capital through share repurchases, even at uneconomic valuations
- Time-based vesting: Paying managers simply for showing up is what base salaries are for
We are continually reminded that we are unusual in being an investment institution with a single investment philosophy that we translate directly into the voting decisions we make at annual general shareholder meetings. Far more commonplace is for large investment institutions with multiple strategies to hand over voting decisions to external proxy advisors or in-house corporate governance specialists. Such advisors and specialists often insist on measures, like relative TSR, that we find simplistic or irrelevant, and they usually control far more votes than we do.
It’s a jungle out there.
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