Update No. 86 – 16/11/12

I came across an article in the Sydney Morning Herald a few weeks ago by a fund manager, which discussed the alignment of shareholders with management via management holding a large stake in the business.  Specifically they looked at situations where the CEO derives more than his/her annual salaried remuneration in dividends, from the article:

Remuneration data available for the completed 2012 financial year (using S&P Capital IQ's database) shows that 38 companies with a chief executive entitled to a larger annual dividend than their reported remuneration have achieved a total return of 72 per cent over the past three years – while the S&P/ASX All Ordinaries Index delivered only 5.2 per cent.

It is very clear that there are meaningful benefits in having the leaders of your company own an economically meaningful stake.  The ability to participate in equity upside ensure that even if they are paid ‘generous’ salaries that their primary interest will still be capital appreciation and dividends.  I have always subscribed to large management interests, when I penned the basics of this post (1 month ago on 18/10/12) I did a calculation as to the proportion of stock held by CEO’s within EGP Fund.  I knew the figure would be very high.  On a weighted average basis, the CEO held 44.7% of the stock in our portfolio of holdings.  When we add in the holdings of the rest of the board, the figure is over 60%.  I do love to align our interests with the interests of the CEO and his/her team, this idea has worked very well historically, and I expect will continue to do so into the future.  I should add there are risks in this.  When the CEO controls virtually completely the direction of the company, they can occasionally make moves which aren’t necessarily in the interests of all shareholders. 

One example, mentioned last week was the recent buyout of Mesbon China Nylon  – conducted below any reasonable estimate of ‘fair value’ and achieved primarily through the ‘brute-force’ of the controlling shareholder and CEO’s holding.

Another example in a firm we own has been occasional offerings of substantial portions of the executive remuneration as stock options, which invariably seem to coincide with depressed stock prices. The remuneration levels are sensible though and the depressed price is controlled by the auction-market, which does get pricing wrong from time to time. Given the remuneration is not excessive, despite the dilution that occurs, when an executive takes up 50% of their pay in stock, it is usually a solid indicator of good future growth (given they could have taken cash had they preferred).  A recent article in Harvard Business Review questioned whether removing insiders from the board really improves governance.  The benefits are at best marginal of such a removal in my view, but removing an insider with a stake of greater than say 5% will in the majority of cases probably detract from performance.

In any case, it is absolutely my preference to have a large insider ownership and this will likely remain a feature of our holdings for the foreseeable future – Tony Hansen 16/11/12

P.S. This week was a pretty harsh one for both the fund and our benchmark.  The 2.27% drop in our holding, however should not be viewed entirely in a negative light by holders as it enabled us to augment some existing holdings at prices we are pleased with.  It is probably a cold comfort, but the benchmark fell even further with a 2.78% drop.

EGP Fund No. 1 Pty Ltd. Up by 13.31%, leading the benchmark by 4.96% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 16.7%, leading the benchmark by 19.68% all-time (April 1^st 2011).