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Management behaving badly

17 May 2016

John Wood of J O Hambro believes that too many companies emphasise short-term earnings at the expense of compounding returns.

What companies pay out has made plenty of headlines in recent weeks, whether it’s eye-watering bonuses for senior executives or beefy dividends for shareholders.

Many shareholders have used their voting rights to complain about the scale of recent executive pay deals, especially if the company concerned had seen its profits slide.

The problem is one of mismatch. If a company has had a bad year, it seems inappropriate to increase the size of the CEO’s bonus. It is not simply a question of fairness either; the business should be addressing its shortcomings by putting its reduced profits to more productive ends.

John Wood of J O Hambro believes many businesses are making a similar mistake when it comes to dividends. Instead of reflecting the recent fortunes of the business in the size of the dividend, a high number of companies have opted instead to maintain or even increase the level of dividend pay-outs even as business slumps.

The aim, of course, is to please their shareholders, but Wood believes that the business ends up paying too high a price for its largesse. Because such practices have become more common, Wood believes it is harder than it should be to find good companies to invest in.

“What we are finding is that management is behaving badly,” says Wood. “As investors we require management to look after the capital on our behalf; to invest, and to grow the businesses they look after.”

Instead, many companies choose to put their capital to other uses that seem more appealing in the short term. Wood, who has 26 years of experience in the industry, believes that tends to make them bad investments in the long run.

“What we are finding is that the demands of other investors are leading management to prioritise special dividends, buybacks, ordinary dividends and acquisition activity,” says Wood. “We generally find this to be value-damaging to shareholders.”

Wood believes that numerous listed companies are starving themselves of investment for the sake of buybacks and big dividends. (A buyback occurs when a company uses excess cash to buy back some of its own shares from investors.) In doing so, companies leave themselves no margin to manage short-term challenges or to reinvest when the time is right.

On the other hand, companies are much too willing to make deals that involve heavy borrowing and to step into business areas in which they lack experience. Often this is because the management team is incentivised to pursue mergers and acquisitions – and that team may not be around for very long, especially once managers have met their targets, and so picked up their rewards.

Capital allocation

Wood is therefore interested in companies that are focused on their core operations, and that put the needs of those operations above maximising the remuneration of managers or of short-term dividend investors.

“We like businesses to invest – we are investors in the cash flow of a business,” says Wood. “We are not short-term speculators in the movement of an asset price or an equity price. We want companies to commit capital to make that business grow, so that there is a virtuous circle of strong cash flow being invested [in the business].”

One company Wood believes knows how to behave is Travis Perkins, a builders’ merchant and home improvements chain listed in the FTSE 100. The company was founded in 1797, is based in Northampton, and runs some 1,900 outlets. This distribution is one reason that Wood is so keen on the company, as is the fact it can offer competitive prices. But he also likes the fact that it invests for future growth – not to meet the short-term aspirations of shareholders.

In short, it takes its role seriously as a custodian of capital.

 

J O Hambro is a fund manager for St. James’s Place.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

The opinions expressed are those of John Wood and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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