As reporting season finished last week, we have been very busy over the month meeting with management teams from various companies and property trusts. In this piece, we are looking to shed some light on the role that these meetings play in the investment process.
A key part of our investment process is meeting with the management teams of companies at least once every six months, or when we are in the process of adding a position to get an understanding of the quality of the management team with whom we are entrusting our investors capital. Generally, we seek to meet with management teams just after they have released their semi-annual profit results, and at other times during the year when we have specific issues or concerns that we feel need to be addressed.
The content and tone of management meetings vary widely depending on the nature of the company and how far the results delivered by the management team deviate from our or the market’s expectations. As such, the meetings can vary from being quite convivial discussions running through dividend policy and debt maturities, to downright hostile conversations about poor acquisitions, asset write-offs or recapitalisations.
Why Meet with Management Teams?
The efficient market hypothesis developed by Fama in 1970 states that it is impossible to "beat the market" because stock market efficiency causes existing share prices always to incorporate and reflect all relevant information.
If we believed this to be true, investors should simply invest in an index fund, because it would be a waste of time for anyone in the market to meet with management, as we could learn nothing that was not already incorporated into every company’s current share price. Whilst this theory sounds elegant, in practice markets are inefficient due to the influence of human emotions and robotic trading algorithms trading off price momentum. Ironically, the current trend we are seeing of flows into index funds should deliver a long-term benefit to active management, as they cause market inefficiency by directing an increasing proportion of inflows into higher priced over-valued companies. After almost twenty years in the market it seems to me that the increasingly short-term focus of investors is creating more inefficiencies.
Further, I have previously worked at a fund’s management firm that had a fund with a strategy of deliberately avoiding meeting with management teams. This approach is based on the view that meeting management, cultivating a relationship, and understanding the business would distract from their investment strategy of profiting from the short-term price movements in a large number of companies. In my opinion, the weakness in this approach is that a company is more than a collection of cash flows, assets and liabilities contained in the financial accounts. The future direction of any company and its share price is determined by the skill and motivations of the individuals managing these assets. Also, management teams have incentives to present their financial results in the most favourable light and in some situations, this results in misleading financial accounts. Fund managers running index and quantitatively managed funds are unlikely to be able to detect these issues.
The press sometimes characterises the additional access to management that institutional investors have over casual mum and dad investors as being unfair or bordering on inside information. In practice, these management meetings don’t provide us with inside information, but rather are used by the fund manager as additional pieces to build up a mosaic of information to determine the underlying value of a company and its prospects for the future.
In the past, some of the most useful information on a company has been obtained not from management itself, but rather from meetings with that company’s direct competitors and clients. Often a company may be a little coy when asked the more difficult questions about issues facing their business, but that same company may enthusiastically discuss problems facing their listed competitors. Relevant issues include lost contracts or aggressive accounting measures being used to boost profits (that the company being interviewed inevitably no longer uses).
Two years ago, RIO and BHP were discussing their plans to cut significantly their cost base by reducing their reliance on contractors and indeed renegotiate existing contracts. At the same results season, the contractors were confident that margins and contracts would be maintained despite falling commodity prices hurting their customers. Coming out of these meetings it was clear that there was a disconnect between the guidance being given by the suppliers (Downer, United Group and Leighton) and their customers (BHP and RIO).
See the Colour of their Eyes
Before investing in a company, it is a critical part of the Atlas process to meet with the company’s management team. When meeting with management teams you are also looking to gauge management’s response and interpret body language when they are answering difficult questions. These can range from refinancing debt to achieving stated profit guidance targets which look excessively optimistic.
By purchasing securities listed on the ASX we are effectively entrusting our clients’ capital to the management teams of various companies and must therefore trust that these management teams are going to act in the best interests of our clients.
For example, a number of years ago we met with management of Lihir Gold (now part of Newcrest) to question them about their meagre dividend payout policy, despite ounces of gold finally starting to flow out of the mine on Lihir Island in Papua New Guinea. Management (former engineers) said that returns for shareholders would not increase, but rather they were going to invest the profits in building a new mine in war-torn Côte d’Ivoire, which would require building a 100km rail line through the jungle. From this meeting, it was clear that management’s primary instincts as former engineers were to build beautiful mines, rather than reward the owners of the company. We took the view that our clients’ interests would be served better by receiving dividends now, rather than vesting that cash flow in a new, quite risky development; hence the position was sold shortly after the meeting.
Similarly, we left a meeting with a company’s CFO last year with the view that there was a disconnect between the profits outlook presented to us and the structural headwinds from deteriorating conditions in the company’s industry. As a result, we sold the position shortly after. Whilst the stock price had been drifting downwards prior to our selling, it fell sharply 4 months later on a large profit downgrade.
Not a one-way street
It would be wrong to think that these meetings are mostly adversarial competitions for information between fund managers and company management. From the perspective of the company, these meetings can be a forum for the CEO to gauge large sophisticated investors’ appetite to back potential acquisitions, changes in strategy, or capital management initiatives The advantage of doing this behind closed doors is that a company can avoid the potential embarrassment or loss of goodwill that comes with presenting an acquisition with a dilutive equity raising to a hostile group of institutional shareholders, some of whom may decline to support it.
Over the last month we met with a smaller company that was performing well, yet had only attracted research coverage from two investment banks. As their management’s focus was on running their assets efficiently and bedding down a large acquisition, they were uncertain about how to engage with the research departments of investment banks to encourage them to research their company. As the Fund is invested in this company, we are incentivised to assist the company in this area to increase research coverage that may assist in pushing its share price closer towards our valuation.
One of the benefits of having your portfolio managed professionally is that it is constructed and managed by individuals whose sole focus is to select and blend listed companies into a portfolio designed to deliver higher returns with lower volatility. To execute this strategy effectively, professionals prioritize meeting with management teams and going through their financial results in detail. Another advantage for investors of institutional management is that fund manager tends to have access and opportunities to ask questions of senior management in investee companies that are unavailable to most retail investors.