Tag Archives: john-kingham

Maximising Shareholder Value Has Nothing To Do With Maximising The Share Price

The idea that directors should seek to maximise shareholder value has come in for a lot of flak in recent years. James Montier of GMO even wrote a piece on it called ‘ The World’s Dumbest Idea ‘. One of the most prominent criticisms of maximising shareholder value is that it causes directors to focus too much on their company’s share price, which leads them to underinvest in the company’s long-term future in order to boost short-term profits (and therefore, the share price). This is not so much a failing of the concept of shareholder value maximisation as it is a failure to understand what shareholder value is and what directors can do in their attempts to maximise it. True shareholder value is a measure of long-term value The value of a company is essentially the value of all the cash it will return to shareholders over its remaining lifetime. Let’s assume that Sainsbury ( OTCQX:JSAIY ) ( OTCQX:JSNSF ) will survive another 100 years before closing its doors for the last time. In that case, the value of the company today is the value of all dividends paid out over the next 100 years plus any cash returned to shareholders, when the company is wound up (which we can ignore because it is usually zero). A dividend today is preferable to a dividend in 50 years’ time, so future dividends are usually “discounted” by an annual discount rate. If you want a 10% annual return on your Sainsbury investment, then you would discount the value of future dividends by 10% each year, in which case a 100p dividend 10 years from now would have a “present value” of about 42p. Add up those discounted future dividends and hey presto, you have the present “shareholder value” of Sainsbury, at least according to an investor who wants a 10% rate of return. A different discount rate would provide a different shareholder value. Because the company’s shareholder value is the discounted sum of 100 years of dividends, only a fraction of Sainsbury’s value today comes from dividends paid in the next 10 years. Most of its shareholder value comes from dividends that are expected to be paid more than 10 years in the future, as is the case for most mature companies. This is the true meaning of shareholder value; a multi-decade stream of dividends, which directors should be attempting to maximise, without taking unnecessary risk. True shareholder value maximisation should be much more about working to improve and expand the business for the next 10 years and the 10 years after that, rather than hitting short-term profit expectations. Share prices have almost nothing to do with shareholder value Those who believe in the wisdom of crowds might say that yes, the true shareholder value of a company is indeed the discounted value of its future cash returns to shareholders, but we can never know those cash flows and therefore can never calculate an accurate figure for shareholder value. They might go on to say that our best estimate of shareholder value is the market value or share price of a company, and so it is entirely sensible for directors to pay attention to share price and to be paid according to its performance. Utter drivel, is what I would say to that. The share price or market value of a company is, at most, a combined “best guess” by investors as to what a company’s shareholder value really is. However, calling it a “best guess” is wildly optimistic as a large portion of equity trades are carried out by traders who don’t even know the names of the companies whose shares they are buying and selling (especially the computer-driven High Frequency Traders who own shares for thousandths of a second). Even if all market participants were long-term dividend-focused investors, they still wouldn’t have the faintest idea what dividend Sainsbury will be paying 10, 20 or 30 years from now, and therefore no idea what its shareholder value is (and the same would be true for pretty much all companies). Rather than an estimate of shareholder value, share prices are more closely connected to factors like current dividends, current earnings and any and all combinations of news, noise, expectations and emotions; none of which have anything to do with true shareholder value. So the idea that maximising shareholder value means maximising the share price is a joke, which means that compensating executives with one-way bets on the share price (otherwise known as stock options) is equally daft. If executive directors are to be compensated by share price movements at all, it should be by insisting that they invest a significant amount of their own money into the company and to keep it invested for as long as they are on the board. In addition, they should be encouraged to focus on maximising true shareholder value rather than the company’s market value. As Lawrence Cunningham describes in the introduction to his book, The Essays of Warren Buffett : “The CEO’s at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their businesses as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies.”

Model Portfolio Update: Beating The Market By 14% Year To Date

My defensive value model portfolio is ahead of the market by just under 14% so far this year. The reasons are: 1) a sensible strategy and 2) some luck. To be honest, the FTSE 100 and FTSE All-Share are not providing much in the way of competition at the moment, because both of them have fallen in value this year. However, I can’t be blamed for that; all I can do is focus on the model portfolio’s goals, which are: High yield – A higher dividend yield than the FTSE All-Share at all times High growth – Higher total return that the FTSE All-Share over any 5-year period Low risk – Lower risk than the FTSE All-Share over any 5-year period The chart below shows the performance from inception of the model portfolio and its FTSE All-Share benchmark, the Aberdeen UK Tracker Trust . Both the model portfolio and the All-Share tracker are virtual portfolios which started with £50,000 in March 2011. They both reinvest all dividends and take account of broker fees and bid/ask spreads. I have basically all of my family’s long-term savings invested in the same stocks as the model portfolio. Ahead on a total return basis Clearly, the All-Share portfolio has not done well lately. At the start of October, it was down 3.7% relative to its value in January. In contrast, the model portfolio gained 10% in the same period, producing a relative outperformance of 13.7% year to date. The gap between the two portfolios is now £13,370, which is 27% of their original value. In annualised terms, the All-Share portfolio has generated a return of 5.9% per year (including dividends), while the model portfolio has returned 10.3%. One of my goals for the model portfolio is to beat the market’s total return by 3% per year, and that goal is still firmly on track. Ahead on dividend yield and (probably) dividend growth Another of the model portfolio’s goals is to have a high dividend yield at all times. This goal has always been met since 2011, and the portfolio’s current yield is 4.2%, which compares well with the All-Share tracker’s yield of 3.7%. Dividend growth has been relatively good too. The All-Share tracker has paid out the full 2015 dividend already (of £2,384), while the model portfolio’s cumulative dividend is ahead so far (at £2,650) and still has three months of dividends to go. I fully expect its total dividend to far surpass the All-Share’s by the end of 2015. Success with Cranswick ends a bad run In terms of individual investments, 2015 has been a bit of an up and down year. Although I realise that a sensible investor must expect some individual investments to perform badly, I was somewhat peeved after a string of underperforming holdings during the first half of the year. As you may know, I sell one holding every other month and replace it the following month. The idea is to repeatedly replace the “weakest” holding in the portfolio with a stock that has a better combination of defensiveness and/or value. Following that approach, I sold ICAP ( OTCPK:IAPLY ) in February for an annualised return of 15%, which, while not spectacular, was more than satisfactory. But after that, things took a turn for the worse. In April, I sold Balfour Beatty ( OTC:BAFBF , OTCQX:BAFYY ) – after three years of profit warnings – for an annualised return of 2.6%, which is obviously below par. After that came the sale of Serco ( OTCPK:SECCY ) in June, which was my worst investment to date and returned a loss of 50%. Next up was August and the sale of RSA ( OTCPK:RSNAY ), which returned a just-about-acceptable 6% per year. Even that result was largely down to luck and a well-timed exit during a brief share price peak, thanks to the now withdrawn Zurich takeover bid. However, such doom and gloom ended with October’s sale of Cranswick ( OTC:CRWCY ), which you may have read about last week. It produced a record result for the model portfolio, returning 135% in just under three years, for an annual return of 35.3%. And so it continues to be true that some you win, and some you lose. The lesson here is that it is a portfolio’s overall result that matters, and not the performance of any one investment. A couple of winners drive performance In addition to Cranswick, there have been a couple of really standout holdings this year whose performance has been, quite frankly, bordering on the ridiculous. The first outstanding performer is JD Sport , which is up by about 90% from the start of the year. The second is Telecom Plus ( OTC:TLPLY ) (trading as The Utility Warehouse ), which is up by about 50% from where I bought it in May. After these impressive results, the share prices of both companies have reached levels that I would no longer consider attractive. In fact, I am more likely to trim their positions back a bit if their share prices keep going up as they have done recently. Wide diversification helps reduce risk The model portfolio is a defensive value portfolio, so risk reduction is as important to me as performance. My main weapon in the war on risk is diversification, diversification and yet more diversification. I mention diversification three times not just for effect (although it’s partly that), but also because there are three dimensions to the portfolio’s diversification strategy: Company diversification – The portfolio holds 30 companies, with no more than 6% in any one holding. This protects it from problems in any one company. Industry diversification – The portfolio holds no more than three companies in any one FTSE Sector. This protects it from problems in any one industry. Geographic diversification – The portfolio generates no more than 50% of its revenues from the UK. This helps to protect it against problems in the UK economy. One additional line of defence against risk is the portfolio’s focus on defensive sectors . My rule of thumb (which it currently meets) is that the portfolio should always be at least 50% invested in defensive sectors. This focus on defensive sectors helps me to reduce the impact of economic and industry cycles on the portfolio’s capital value and dividend output. Expectations for the future Currently, the FTSE 100 (and therefore, the FTSE All-Share) is attractively valued, relative to both its own historical norms and the current valuations of international indices such as the S&P 500. The fact that the FTSE 100 has recently had a dividend yield of over 4% is a clear indication of this, although the CAPE ratio is my preferred measure of value. With these low valuations, I think above average returns are likely from here on out, which means more than 7% a year or thereabouts. Of course, that expectation is a long-term expectation, measured over the next five or ten years rather than the next five or ten months. The model portfolio’s goal over that period will be the same as it always is: To beat whatever income and growth the market produces, with less risk.