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Bram de Haas
Bram de Haas
Articles (454)  | Author's Website |

Daniel Loeb's Lessons on Corporate Governance

In his 1st-quarter letter, the guru explains what he looks for in management's long-term incentive plans

Daniel Loeb (Trades, Portfolio) of Third Point focuses on activist investing.The firm employs an event-driven, value investment style. The Offshore Fund just published its first-quarter report. It gained 8.8%, driven primarily by activist positions Nestlé (XSWX:NESN), Baxter International (NYSE:BAX), United Technologies (UTX) and Campbell Soup (CPB).

Third Point also had hedges and shorts in place that held back its performance. This letter was extremely interesting because Loeb talked about some research the firm is doing into long-term executive compensation with some conclusions that are somewhat counterintuitive.

To start, Loeb explains the firm's activist strategy:

"Sometimes, we see discrepancies between a company and its competitors in areas like growth rates, margins, or capital allocation practices. Most management teams are aware of where they are falling behind and work toward closing these gaps. In a small number of companies, management teams seem satisfied with the status quo and are unwilling or unable to make changes. There are many reasons for such recalcitrance: sometimes the CEO's incentives are misaligned with shareholders because of an incentive plan based on revenue growth irrespective of returns; or a CEO is most interested in status and perquisites, or most enjoys hobnobbing on the world stage in Davos or pontificating on TV; while some CEOs may simply find themselves in over their heads and without the managerial skills to effectuate change and improvement. In all these cases, the company's board must be held accountable for allowing such antics to persist."

It almost seems as if Loeb and Third Point are sweet, nice and purely constructive activists that come in peace. In reality, the guru has a reputation for some of the most virilous activist letters that have ever seen the light of day. Here's a short quote from Loeb's letter to Stargas:

"Sadly, your ineptitude is not limited to your failure to communicate with bond and unit holders. A review of your record reveals years of value destruction and strategic blunders which have led us to dub you one of the most dangerous and incompetent executives in America. (I was amused to learn, in the course of our investigation, that at  Cornell University there is an 'Irik Sevin Scholarship.' One can only pity the poor student who suffers the indignity of attaching your name to his academic record.)"

Loeb can be pretty vicious, but admittedly very effective.

"Boards of poorly performing companies have their own reasons for inaction but generally, they can be traced back to a lack of alignment of interests with shareholders or incompetence. Few board members have much 'skin in the game,' having been awarded free stock and a nice stipend simply for joining the board. As a result, they often make decisions to preserve their status and income stream rather than to drive shareholder value."

This part wasn't entirely new to me and I actually actively look to own companies with major insider ownership. Looking for CEOs with seven times their annual salary in stock will help them outperform. The same goes for board members, though these rarely have that much stock unless they are also executives.

"Most directors have little actual experience in capital allocation, yet are asked to make decisions on the topic at virtually every board meeting. Each activist investment we engage in begins as constructive and many end there, with collaborative idea-sharing with management."

This can be a big problem. It matters in particular to value investors where a lot of free cash flow is generated on an annual basis. This needs to be redeployed and if that's botched, it will ultimately hurt total shareholder returns. This is what makes Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) so great. It throws off enormous free cash flow that is reinvested. Therefore, the company has been enormously successful over time. Most companies don't have a Warren Buffett (Trades, Portfolio) and, as a result, never reach Berkshire's size.

"A focus on financial returns (e.g. ROIC, ROCE) is what we look for in the long-term incentive plans ('LTIPs') of management. LTIPs have become increasingly core to many large US companies, however, not all LTIPs are created equal. Our analysis shows a material difference in excess annual stock price performance over a rolling medium-term horizon (e.g. three years) when the focus in LTIPs includes a form of Return of Capital metric versus other incentives like Total Shareholder Return ('TSR') (+150 bps), EPS (+180bps), and revenue targeting (+215bps). Among others, we also look at factors like: a) the amount of stock owned by the CEO and, if holdings are substantial, whether TSRs become double counted; b) if TSR is an incentive metric, is R&D or Capex spending stunted?; and, c) will a management team paid on ROE be more likely to buy stock than one tied to TSR, who would rather issue a dividend? Whether as passive investors in high-quality companies or activists in companies that can improve, we want corporate management to solve for value creation, not security price. We believe certain governance factors and incentives are useful to evaluate management skill and thus, company quality. More carefully and systematically studying governance is giving."

I did not realize companies that incentivize return on invested capital and return on capital employed outperform those that incentivize total shareholder returns. Total shareholder returns seem to be an okay second.

I've seen the power of these LTIPs in practice with Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B). First, the company incentivized growing the resource base and it gradually got bigger and bigger, but total shareholder return lagged Exxon (XOM) and Chevron (CVX). Then, current CEO Ben van Beurden was installed and the company started to rival gold standard Exxon on the very metrics incentivized like ROIC. This improved shareholder returns greatly, even though it has been operating in a tough environment. Now Royal Dutch is diluting its incentive plan by including environmental metrics. I think this will have a noticeable adverse effect on total shareholder return.

Something very interesting Loeb suggested is that companies that incentivize management by total shareholder returns are underinvesting in research and development and capital expenditures because management is trying to hit short-term targets.

What it all comes down to is picking the management teams that, in the words of Loeb, "solve for value creation." Value creation will drive share prices in the long term. In the short term, solving for value creation can definitely take away from share prices. True value investors are okay with that.

Disclosure: No positions.

About the author:

Bram de Haas
Bram de Haas is managing editor of The Special Situations Report and Founder of Starshot Capital B.V.

Visit Bram de Haas's Website

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