Executive Behaviour

In a classic, “Investing with the Grand Masters” there is a brilliant interview of Colin McLean of Scottish Value Management which makes for interesting reading

““For the smaller companies, I like to look at the executive behaviour, too, in terms of what’s motivating them and whether they are drawing most of their reward from the company through its growth and through the share performance in the same way as we are. I would differ from those that just tend to look at whether directors are buying or selling, because I think you need to be more subtle about it than that. There are close periods where directors can’t buy and sell; there are some directors who have more money than others, some that are older and some that are younger. I think that an important question is whether a chief executive has other interests outside the company, and whether he has a significant proportion of his own wealth tied up in the company.

“Behaviour goes beyond simply saying whether there is an absolutely large sum. I can think of one very large company where a chairman has an investment valued at ₤3 million, but he is quite senior, and the sum invested is a lot less than his salary and bonuses drawn out over the last few years. The same man has a lot of other outside interests, so I would not regard ₤3 million as being particularly material in motivating him. It is interesting to recall that Gerald Ratner had relatively little of his own money invested in Ratner’s. You can see this, sometimes, with long standing family management, and directors who may have very little personal wealth at risk in the businesses they run. That lack of financial involvement concerns me.

“Sometimes executives, particularly in smaller companies, will have quite a large stake that may have been achieved through floating something for which they actually put in very little cash, and their behaviour may not be someone who actually has 20 per cent of a ₤50m company. It may still be the behaviour of someone who actually only spent ₤20,000 and mainly used debt, or other people’s money, in developing the business. You might find by the time they have actually listed the company they have taken out more net than they have put in. The executive behaviour after that is not of someone who has got large amount at risk.

“You have to include, as well, whether they have been buying or selling and what other things they are doing. There is a whole mosaic of information to collect. Take the compensation of executives. The average person in the street would be quite right to look askance at Cedric Brown type salaries. Sometimes these can cause real problems, either operationally, in terms of leadership of others paid less, or financially, in terms of hidden implications for pensions. I feel a lot more comfortable where senior people are drawing most of their long-term reward the same way as the shareholder.”

And it’s not just how the directors behave towards their own investment, but what they know about the business they are running on behalf of their shareholders, which leads McLean to make decisions on whether to invest or not. He has several tests which he has found useful in weeding out the good from the bad management.

“I’ve met a few who seem to know a lot about their share price, and are more concerned about that than they are about their product prices! Certainly there are company chairmen who sometimes struggle to give a price of their main products, but know what the price of the stock was that morning. On the other hand, it’s very easy to be impressed by management who seem to know a lot, technically, about the business, and to be swayed by their apparent knowledge of technical detail within the industry. One company, which collapsed in 1993, had brought in a chap who gave a great presentation on what they were doing in their building division and how they were bucking the recession by putting up modular buildings in Moscow and things like that. I know very little about building and nothing about modular units, so there’s no way I can verify what is going on a Moscow. The Russian profits turned out to be fiction at the end of the day but, during the meeting, they were unable to answer the accounting questions that I had, so I stayed out. In verifying what companies say – the main thing is to stand back and spend more time looking at the numbers. You have to let the accounts and the balance sheet speak for themselves and then do your own calculations as to whether the stock market has got the price correct.”

Which is the perfect lead in to point out that basic analysis is the foundation stone for McLean. Here, too, he takes a somewhat different stance. He lays less emphasis on P/E ratios, ROE and EPS, indicators still at the forefront of the thinking of many fund managers. His antennae are more sensitive to the nuances to be gleaned from looking at organic sales growth, operating margins, and return on capital employed (ROCE). McLean has become convinced, over 15 years of searching for the hold grail, that there are no easy ratios, no short cuts, not even a single complex formula that can lead you to investment nirvana. Instead, he concentrates on certain investment themes to find the investments which yield superior returns.

1. Temporary misrating of a business or sector

McLean is looking to find a fundamentally sound business where the price of the stock is depressed due to factors which will not last. In this category with true contrarian spirit McLean cites the Lloyds linked trusts. In CLM Insurance, which he owns, you can purchase assets linked to the market index at a discount and the good underwriting results for 1994 and 1995 are in for nothing.

He also highlights Utility Cable as a business with specialist contracting skills lowly rated because of excessive concerns that it will have no business left once cable systems cover all the UK. In reality they have other skills and are already establishing themselves in the utility industry as well as expanding onto the continent.

2. Alignment of shareholders and management

Are the interests of these two critical constituencies identical or potentially in conflict? What is more important to management – today’s pay cheque or the share value long-term? It’s fascinating to see how salaries start to rise more rapidly once managers cash in their share options.

“I can remember one occasion when Distillers’ management came round and were trying to defend against the bid from Guinness. They talked about the potential for change in the company. I think we pointed out that the group of fairly young investment managers sitting round the table opposite together actually owned more Distillers’ shares personally than the three directors facing us. The comparison was interesting.”

3. Takeover candidates

Here we have one of those themes which everyone likes to talk about, but where few people actually understand how to make money, other than on an opportunistic basis. Rarely are predators simple. What really motivates acquirers or triggers a bid at a particular time is not often obvious.

McLean does not spend his time speculating on Tompkin’s likely next target. Instead, he sets his mind to thinking through the logical consequences of change in an industry sector. In this respect, he is consistent in trying put himself in the position of an industrialist, just as he does when it comes time to value a particular property. Industries go through waves of consolidation. One of the earliest shares McLean ever bought was called Glass and Metal, which disappeared into another building materials company around 1977 at a time when a number of takeovers occurred in the sector where there are economic imperatives is step one. Sifting through likely buyers to identify those businesses that are likely to be snapped up requires different skills. Here Mclean tried to find companies which have some unique capability which a bigger buyer needs and will pay up for. A leader in some particular niche which is relatively small but strategic is likely to disappear sooner or later. So McLean was a holder of Devenish, which was swallowed up by Greenalls in 1993 after a failed bid from Boddington. Devenish owned a well located group of pubs which were always going to be attractive to larger operators looking for suitable scale acquisitions in the turmoil of the restructuring between brewers and the pub industry in the UK.

The takeover theme was one which McLean latched onto while still at FS Assurance. Of the 24 holdings in the portfolio, as of 30 September 1984, three were taken over at higher prices by that year end. Others, like Imperial, the tobacco company, and Pleasurama, the casino group, were taken over subsequently.

4. Companies which are misunderstood

McLean is always on the look-out for a pattern of neglect by the institutions which can leave the field open to someone not so worried to make sure the right names crop up on the list of holdings at year end.

“We have, over the last year, in just over a year, almost doubled our money in Asda. People are waking up to the fact that it is one of the biggest food retailers. In fact, it was never that much smaller than the others, despite what people thought. They were stuck looking at a small market capitalization and judging by what they saw on the stock market, rather than looking at its franchise as represented by its turnover and the potential for improving its margins.

“Distillers was a classic. You could walk round the West End and evaluate half a dozen separate management teams and all that cash tied up in their property value. The board lacked focus, and didn’t seem to have a good grasp of the business. You could ask them questions about why they didn’t promote Lagavulin more because they didn’t seem to be making very much of it, and make the suggestion that they might price such luxury malts a bit higher, or ask why they did not pursue opportunities in single malts or mixers with whiskey/gin etc. They didn’t seem to have good answers”.”