How to hold businesses accountable for what they do with your money
Shareholders own public companies and appoint managers to lead them. It should make you feel pretty powerful. In theory!
In reality, many business leaders behave as if they own the business and shareholders need to be addressed, but not consulted, and only when they have finished speaking to regulators, politicians, staff and the government. hurry.
Shareholders with perhaps less than 3% of a company’s equity are often faced with blank stares and impertinent suggestions when trying to hold management to account.
Larger shareholders, more common in smaller companies, may be allowed a more substantial dialogue, but usually only in private.
Much has been written about companies questioning their environmental, social and governance standards, but how should shareholders hold companies to account for how they spend the profits they make – your money. ?
Companies have three things to do with these profits: invest in growth, buy back stocks, or pay dividends.
Invest in growth
Earnings retained in a business and reinvested are not taxed. Indeed, large American digital companies like Amazon pay little tax. Amazon has spent more than $ 70 billion on capital expenditures over the past three calendar years.
Fans of Jeff Bezos and his team are happy to see these huge sums invested for growth. They believe Amazon management will make better use of it than it could.
They are probably right. Amazon has averaged a return on capital employed of more than 10.5% per year over the past five years (until the end of 2020), according to Bloomberg. Returning the money would require a corporation tax payment, so you would need a return of around 13 percent to match it. And if you’re paying income tax, you need almost 18 percent. Meanwhile, over five years, the Amazon share price has risen 320% (vs. 178% for the Nasdaq).
Another way for businesses to spend (your) money is through expensive acquisitions. They claim this is another path to growth, but university studies put the failure rate of M&A activities at 70 to 90 percent.
There are many empire-building managers who believe they should be paid based on the size of the business they run rather than how profitable it is. Only the largest shareholders are consulted before a deal is announced, and while they can ask tough questions, their objections are usually ignored.
When a company feels it has excess cash to return to shareholders, share buybacks are often preferred, especially in the United States. This is where a company uses its accumulated cash to buy its own stock.
Buyouts can benefit shareholders if your company trades below its book value – that is, at a steep discount, as some investment trusts, small Japanese companies, and European banks sometimes do. . If management buys its own shares and cancels them, it leaves all the remaining shareholders with a higher book value per share (but also with a lower balance sheet, as cash has been spent).
Investors should be more skeptical of buyouts than they are. Too often, companies buy back stocks when conditions are bullish and prices far exceed book value.
It’s remarkable how many companies stopped buying back stocks when they fell sharply during the pandemic. One might ask tech companies, in particular, why they halted buybacks in March 2020 only to buy large amounts now at much higher stock prices.
Another aspect to consider is the strategy (particularly popular in the US) of using buybacks to pay for management.
PayPal, for example, spent around $ 3.4 billion to buy back shares between 2018 and 2020, but the number of shares outstanding has changed little. Indeed, PayPal remunerates its management and staff mainly in shares, worth $ 3.3 billion over the same period. Good job if you can get it.
Because less salaries are paid to management, the profit numbers appear higher, which makes profits look better and increases the price of the stock. This, in turn, makes the management look great, so they may demand even more pay!
Money spent on buyouts has been deducted from corporate tax, while money spent on normal compensation would come from pre-tax income, so it’s not even tax efficient ( except for executives who pay less income tax through this form of compensation).
Buybacks don’t usually stop us as fund managers from buying companies, but we’re looking at the numbers carefully to make sure we’re not overpaying. We treat all executive stock option grants as an expense and deduct them from the cash flows we use to value the stocks. Our view is that if this looks like compensation, it is probably compensation and should show up as compensation in our assessment.
That said, we surprised the management of a US science equipment company last year when we sold our stake after announcing a major share buyback.
In this case, it was because it indicated that the company was running out of good growth opportunities to exploit on the back of its technology, despite the strong growth in the sector. We switched to one of its competitors.
We have a similar view on companies that pay generously in dividends. We are growth investors. The returns of UK pharmaceutical companies GlaxoSmithKline (5.6%) and AstraZeneca (2.4%) may look attractive compared to the zero return for Moderna, but to us this is a sign that they are struggling to invest. and to develop.
This is strange, given the range of new genomic discoveries in recent years and the preeminence of UK scientists and universities in many of these fields. It seems now is the time to invest rather than paying high dividends. Moderna, meanwhile, is investing in growth, making as many vaccines as possible, leaving no surplus to return to shareholders.
High dividends are also often a sign of companies in declining industries. Think of the British tobacco and petroleum companies. A 10 percent return is attractive, but not if the company’s stock price drops from £ 1 to 89 pence within a year.
A healthy, growing business invests as opportunities arise, maintains a strong balance sheet, and returns excess cash in the form of a dividend.
So what makes a sound dividend policy for a high quality business? A good benchmark is to expect dividends to be less than half of profits each year – this would show that your business is investing most of its profits in growth opportunities while still being able to return a clearly affordable portion of the profits. cash profits to its owners – you the shareholder.
This approach tends to produce average market returns of around 1% in our portfolios, but healthy dividend growth. Of course, some investors prefer funds with higher starting yields and reject larger dividend checks.
What difference did it make to invest for income versus total return? In recent years, quite a lot. The Investment Association carefully divides global equity funds into income-oriented and growth-oriented funds. Over the past five years, the “global” industry has generated 81 percent and the “global equity income” 51.5 percent.
This may be due to unusual recent conditions and imply that income stocks are currently cheap, or it may suggest that an income preference is costing investors. You decide.
Most individual shareholders have little control over how management uses their earnings other than to buy and sell stocks. You may not be able to hold management to account, but you can account for its performance in the way you build and manage your portfolio, so that you, the business owner, get the optimal balance of advantages for your needs.
Simon Edelsten is co-manager of Mid Wynd Investment Trust and Artemis Global Select Fund