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Open Letter To Norway’s Sovereign Wealth Fund: Target Lions Gate Entertainment

Norway’s Sovereign Wealth Fund’s CEO Yngve Slyngstad recently told the Financial Times that the fund is looking to restructure compensations plans at certain companies in its portfolio. “We have so far looked at this in a way that has focused on pay structures rather than pay levels…We think, due to the way the issue of executive remuneration has developed, that we will have to look at what an appropriate level of executive remuneration is as well.” As the fund looks for a company it can target, we offer a candidate: Lions Gate Entertainment (NYSE: LGF ). How Reforming Executive Compensation Creates Value For Investors We applaud the fund for looking at both the structure and the size of executive compensation packages. Many of the fund’s 9,000 holdings overpay their executives for hitting targets that don’t create shareholder value. Over the past several months, we’ve written a number of articles about the risks that excessive and misaligned executive compensation plans pose to investors. We’ve dissected examples of poor compensation plans leading to significant shareholder value destruction, from Valeant (NYSE: VRX ) to Men’s Wearhouse (NYSE: TLRD ). When boards of directors pay executives based on misleading and easily manipulated performance metrics, they harm investors in two ways. Immediate wasted money: the compensation going to executives, in the form of cash or equity, decreases the amount of cash flows available to investors. Long-term value destruction: poorly designed compensation plans incentivize behavior that leads to poor operational and strategic decisions with respect to the long-term interests of shareholders. For more evidence of the outsized impact of compensation plans on a business, look no further than Home Depot (NYSE: HD ). From 2001-2006, CEO Robert Nardelli earned $240 million in compensation. For comparison, his counterpart at Lowe’s (NYSE: LOW ) made around $30 million over that same time, about 1/8th of Nardelli’s compensation despite Lowe’s being between 1/4th to 1/3rd Home Depot’s size. In addition, Nardelli’s compensation was heavily tied to EPS-which he boosted by buying back billions of dollars of shares every year-and sales growth, which he accomplished by investing heavily in the company’s low margin, low return on invested capital ( ROIC ) wholesale business. These moves helped Nardelli’s bonus, but they created little value for investors. During Nardelli’s tenure, Home Depot’s stock was essentially flat. In the midst of a bull market and a housing bubble, Home Depot delivered almost no returns to shareholders! In 2006, activist Ralph Whitworth took a 1.2% stake in Home Depot and began agitating for a change to the company’s executive compensation practices. He was able to force Nardelli out, significantly reduce CEO pay to less than $10 million a year, and institute a compensation plan with long-term incentives for increasing ROIC. Figure 1: Stock Prices Move In Line With Return On Invested Capital Click to enlarge Sources: New Constructs, LLC and company filings Figure 1 shows how Home Depot significantly underperformed Lowe’s stock during Nardelli’s tenure. It also shows how it significantly outperformed after Whitworth’s reforms, gaining more than 200%. This link between stock prices and ROIC is intuitive and well-known among more diligent investors. Increasing ROIC is the best way to create long-term value for shareholders . Linking executive compensation to ROIC has helped companies such as AutoZone (NYSE: AZO ) outperform the market for many years. Don’t just take our word for it either. S&P Capital IQ recently released a study showing a significant statistical link between ROIC improvement and outperformance. Finding A Target: Lions Gate Entertainment Lions Gate turned heads when it handed CEO Jon Feltheimer over $60 million in equity awards as part of a new five-year contract. The board lauded the company’s strong performance in 2014 as justification for the large stock award, but our numbers show that ROIC actually fell from 12.1% to 11.1% that year. As Figure 2 shows, the problem goes far beyond just 2014. Over the past five years, Lions Gate has spent a larger portion of its enterprise value on executive compensation than any of the companies in its self-identified peer group for which we have five years of data. Figure 2: High Executive Compensation + Poor Return On Invested Capital = Bad News For Investors Click to enlarge Sources: New Constructs, LLC and company filings. “TTM” = Trailing Twelve Months. Figure 2 also shows that Lions Gate’s ROIC has dropped to just 2.3%, putting it near the bottom of its peer group. That’s due in part to disappointing results from several films this year. It also reflects a compensation plan that does a poor job aligning executive incentives with shareholder interests. Both annual and long-term incentive bonuses are tied to a non-GAAP metric called “adjusted EBITDA.” This metric does a poor job of measuring shareholder value creation for several reasons: Excluding depreciation and amortization means that executives are not held accountable for capital allocation. They can boost adjusted EBITDA by investing heavily in low return projects and excluding the costs. Adjusted EBITDA excludes stock-based compensation, which is a real expense and should be accounted for. Since executives are largely paid in stock, they get to largely exclude their own compensation when calculating profitability. Adjusted EBITDA makes a number of adjustments for purchase accounting, start-up losses, and backstopped expenses. These are real costs, and executives have a high degree of discretion when it comes to calculating these numbers so they can hit their targets. Tying executive compensation to such a flawed metric is a recipe for low ROIC and significant shareholder dilution. Sure enough, going back to 2005 Lions Gate has earned an ROIC below its cost of capital ( WACC ) in every year except 2013-2015, when it was buoyed by the success of the (now-ended) Hunger Games franchise. Over that time, its share count increased by 47%. Succeeding through creating original content is tough. It’s even tougher when management is not a responsible steward of capital. It should come as no surprise that the most successful company in the industry, Disney (NYSE: DIS ), is also one of the few that links executive compensation directly to ROIC. If Lions Gate wants to have any hope of creating long-term value for shareholders, it needs to cut back on executive compensation and better align compensation incentives with investors’ best interests. Norway’s Sovereign Wealth Fund should consider Lions Gate as its first target in its campaign against excessive executive compensation. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Matthews Asia: Q&A With Robert Horrocks, PhD

Q&A With Robert Horrocks, PhD by Matthews Asia Chief Investment Officer and Lead Manager, Matthews Asia Dividend Fund Matthews Asia: How do you view the market environment for Asian economies? Robert Horrocks: The biggest negative in the short term is the U.S. Federal Reserve raising interest rates, meaning potential currency weakness and capital outflows for Asian markets. The main question is whether growth will pick up in an environment where markets are weak. In the short term, we are also seeing aggressive monetary stimulus across Asia: in China, India, Taiwan and Korea. The long-term outlook is, however, more upbeat. First, current accounts in Asia are generally positive: Asian countries are saving more domestically than they invest and are relatively less reliant on foreign capital. Asia has a higher share of manufacturing as a percentage of GDP and higher productivity growth, compared with the rest of the world. This started from a low base and has improved significantly over the past 20-30 years. Matthews Asia: How do you mitigate volatility? Robert Horrocks: The behavior of a dividend portfolio tends to be less volatile than the market: the security of receiving a dividend yield enables us to pursue a reasonable level of total return without chasing faster-growing, but more volatile investments. That is a double-edged sword, however: if the market goes up, we do not necessarily follow at the same pace. But in down times, we may have an element of protection. Matthews Asia: How is the Matthews Asia Dividend portfolio structured? Robert Horrocks: We take an all-cap approach, meaning we can invest in anything from small to mega caps. What is nice about Asia is that you see companies right down the market cap paying dividends. In small and mid-caps, you tend to find more entrepreneurial companies, family-owned commercial businesses, while large companies in Asia are often less commercially run and connected to governments. The market capitalisation of companies we invest in depends on the liquidity of underlying stocks in a particular market. For some markets, a liquid stock would have to be $1 billion, for others, only a few hundred million. But one thing this Fund will not do is morph into a blue-chip yield portfolio. Matthews Asia: What differentiates the Matthews Asia Dividend Fund from other Asia income funds? Robert Horrocks: We believe it is important to focus on the sustainability of the dividend stream. Many Asian equity income portfolios are built with a lot of emphasis on yield, containing stocks of Chinese and Australian banks and commodities, for example, which can be difficult underlying businesses. In our long-term total return approach, we use dividends as an indicator of core earnings growth and strength of the company. The companies we seek to invest in range from small and mid-caps that may be yielding 2% to solid businesses that may yield 4-5% but potentially growing their dividends at a 15% rate. This balanced approach seeks to create a portfolio that can benefit from an attractive dividend yield without giving up on growth. We have a lot of flexibility: If the market is hot, the natural thing for us is to take a step back and look in the other direction. If everyone is looking for yield, we would look for growth; if they start paying more for growth, we would move the portfolio back towards yield. We have a dedicated team of investment professionals that have 2,500 company meetings every year, looking at all businesses through the Asian dividends framework. We also meet with companies’ competitors and suppliers to gauge their outlook. Matthews Asia: Where are you currently wary of investing? Robert Horrocks: The Fund has currently no allocation in Australia. A lot of the time, the Australian banks or the material sectors are quite cyclical and exposed to shocks, both internally and externally. There are some countries that are more fertile ground than others. In India, for example, it is difficult to find high-quality companies, which are giving you a particularly high current yield. Now the reason for that is capital is quite scarce in India – after you have reinvested it into the business, there is less to pay out. Also, valuations there tend to be a little bit higher than in the rest of the region, so that is where the valuation discipline of the Fund comes in. In places like Korea, there is a lot of capital that can be shared with minority shareholders, but historically, the attitudes of management teams there has been less favorable to shareholders. That is where the corporate governance side of the discipline of our framework comes in. Matthews Asia: What are some of the most prevalent investment themes in Asia? Robert Horrocks: Looking at the past 30 years, inequality across the world has been decreasing (although it could be increasing within certain individual countries). This development has resulted in the rise of the middle class, so an opportunity for us is to find companies that will facilitate that middle-class life. This is an ongoing trend, likely to continue for the next 30 years. According to the Organization for Economic Co-operation and Development’s estimations, by 2060, Asia will account for two-thirds of middle-class spending in the world. Companies that should gain from that spending include businesses in industries as varied as retail, consumer staples and goods, consumer discretionaries, autos, media, leisure, entertainment, tourism, insurance and wealth management. Consumer and auto loan businesses of banks as well as healthcare are also expected to benefit – whether it is a high-street establishment or a more sophisticated business, such as a healthcare equipment manufacturer, a private hospital or a drugs company. Click to enlarge Robert Horrocks – Image source: Matthews Asia See full PDF below. Disclosure: None