In the final instalment of our series we examine the last two of the eight key factors we have found help distinguish those truly successful businesses from the also-rans. All eight key factors have been distilled from the many and varied learnings of the UBS small caps team over a cumulative 75 years of investment industry experience. Before we get into that, let's briefly recap the first six key factors as discussed in prior notes. 1) Management are owners/founders or otherwise act as if they are. 2) High returns on capital will often dispense with the need for high debt. 3) Re-invest profits – don't perpetually raise new equity. 4) Stable management who often promote from within. 5) Do not needlessly diversify a good core business. 6) Earnings are all-inclusive, not "underlying".
Turning now to key factors #7 and # 8 of a successful business.
7) Do not rely on a "gifted moat" – it may fade.
Some companies have no obvious "moat" around their businesses to protect them from competition, yet they succeed nonetheless. Think ARB (bending bits of steel to make bull bars and other 4WD accessories and then selling these into a competitive global market), Domino's Pizza (pizza delivery business that has seen off most competitors including Eagle Boys and a much weakened Pizza Hut – and now doing the same in Europe and Japan), and Technology One (enterprise software company that is competing and winning against the likes of global powerhouses SAP and Oracle).
Yet other companies are gifted a strong moat and then watch it fade away. Think SAI with its standards and assurance business. It has relied on its monopoly position to diversify into lesser businesses only to see the standards moat weakened and threatened. Then there is Sky Network Television in New Zealand. Its previous monopoly on showing the New Zealand All Blacks games is being eroded by streaming technology.
Our many years of investing experience have taught us to look for businesses that are successful without, or perhaps despite, a strong moat. As Andy Groves, former CEO of Intel once said "Success breeds complacency. Complacency breeds failure. Only the paranoid survive." Those truly great businesses that persist and flourish are often those with paranoid management that don't take future success for granted. Conversely, we have found very few businesses with gifted moats that have paranoid management.
8) Remuneration aligned with shareholders
The last of our key factors of successful businesses, factor #8, deals with the same management agency issue as explored in factor #1 (i.e. management who are, or act as if they are owners).
Owners are always more interested in benefiting from a higher dividend and rising share price than they are from the stipend they can draw as CEO. A remuneration policy that closely aligns the amount that management are paid with the returns that shareholders receive will greatly enhance the management agency outcome.
At the risk of sounding repetitive, we do indeed find the same successful companies reappearing with the examination of each new factor. Roger Brown at ARB remains a large shareholder so it's no surprise he is modestly paid by industry standards (<$400k pa). The rising share price and strong dividends (including occasional large specials to pay out excess franking credits) provides him with the majority of his (very aligned) remuneration.
Adrian DiMarco at Technology One remains one of its largest shareholders. His fixed base pay of $470k is, therefore, modest by the standards of similar companies. It is only with performance-based and at-risk components that his total remuneration rises to a still reasonable $1.3m. If we compare this to his $4m annual franked dividend, it becomes clear where his loyalties lie.
On the other hand, a misaligned remuneration will not tie a CEO's rewards to shareholder returns. In these cases the temptation is to make short term decisions that are not in the longer term interests of shareholders. Such decisions are only made to maximise earnings and management rewards in the short term (often at the detriment of longer term shareholder outcomes).
The best recent example of misaligned remuneration leading to poor shareholder outcomes is the very sad case of Dick Smith. Management were highly incentivised to reach ambitious profit targets in the first year post-IPO (perhaps cynically so that their private equity masters could maximise their final exit from the business). The rewards for management's achievement of this target, as spelt out in the prospectus (at the top of p.101 for those who are interested) were generous short term incentive payments of up to $10m if certain 2014 stretched profit targets were met.
Unfortunately, we now discover that management only achieved their financial targets by favouring certain suppliers who paid them the highest short term rebates. Little consideration seems to have been given to whether buying from these suppliers was in the best long-term interests of the business (it wasn't).
The rebates were booked to profits and thus boosting the result for that year (even if the stock remained unsold). The ultimate failure of the business, partly due to such misaligned short-term management strategies illustrates in the clearest terms how a remuneration misalignment can destroy shareholder value.
Another illustration of the misalignment that sees high CEO remuneration exist despite poor shareholder returns is Automotive Holdings Group. AHG is a repeat offender in our series, in this case due to the pitiful shareholder returns delivered despite the recently retired CEO having been paid in the order of $2.5m–$3.5m pa over recent years. This situation reflects very poorly on the board of the company.
Read the earlier parts below:
Written by Victor Gomes, Portfolio Manager of the UBS Australian Small Companies Fund. Contributed by UBS Australia: (VIEW LINK)
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