Sunday, November 13, 2005

Conflict of Interest

"The officers of large corporations constitute a group of men above the average in probity as well as in ability. But this does not mean that they should be given carte blanche in all matter affecting their own interets. A private employer hires only men he can trust, but he does not let these men fix their own salaries or decide how much capital he should place or leave in the business"--Ben Graham.

Recently Prof. Sanjay Bakshi screened the movie, "Other People's Money" in his class to demonstrate why, usually, managements don't realise that their company may be going down the tube and keep on evading the reality by taking irrational decisions, thereby causing huge losses to owners(ie) shareholders. I will quote Ben Graham extensively, among others, from his Security Analysis(1934) throughout this post while discussing the issues where there is conflict of interests between management & shareholders.

Worth more dead than alive:
"We're dead all right. We are just not broke. And do you know what is the surest way to go broke? To get an increasing share of a shrinking market. Down the tube. Slow but sure"--Larry the liquidator (Danny Devito in the movie) on the consequences of management not facing up with the reality.

Management don't realise it, even if they realise they just don't act. Why?

"Complete liquidation means loss of the job itself. It is scarcely to be expected, therefore, that the paid officers will consider the question of continuing or winding up the business from the standpoint solely of what is in the best interest of the owners"--Ben Graham

Though a retail shareholder is rightfully the owner of a business, he cannot in anyway alter the way management work. So it will be much more prudent to try and avoid management that don't adapt to changing times

Capital Allocation:
This is one of the most important decision that a management makes. Generally capital can be allocated to 2 activities:
  • Expansion (organic or inorganic)
  • Buybacks
"Management are naturally loath to return any part of the capital to its owners, even though this capital may be far more useful-and therefore valuable-outside of the business than in it. Returning a portion of the capital means curtailing the resources of the enterpirse, perhaps creating financial problems later on, and certainly reducing prestige of the officer."--Ben Graham.

The problem is not expansion but unwise expansion as Warren Buffett explains:

“We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely. We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can't create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”

Yet managers having committed themselves to a losing project keep on pushing it. This is quite similar to an investor holding onto his losers. Peter Bernstein explains this in Against the Gods: The remarkable story of risk as follows,

"Investors(Managers) hate to take losses because a loss taken is acknowledgment of error. Loss-aversion combined with ego(reputation) leads investors to gamble by clinging to their mistakes in the fond hope that some day the market will vindicate their judgment & make them whole"


One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?” – Warren Buffett.

But the desire to acquire the stock at lowest possible level, sometimes, pushes the management to manipulate the price to bottom out before announcing the buybacks. This is generally done by reducing or passing out the dividends even when the free cash flow may be sufficient even to carry on with the dividends,

"The desire to buyback shares cheaply may lead to a determination to reduce or pass the dividend, especially in times of general uncertainty. Such conduct would be injurious to nearly all the shareholders, whether they sell or not"--Ben Graham

He further adds,

"If the reason for passing the dividend as a desire to preserve cash then it is not easy to see why, since there was money available to buy in stock, there was no money available to continue a dividend."

In general, not only what the management does is important but also how and when it is done.

"Human nature what it is, such(managerial compensation) developments are not in the least surprising. They do not really reflect upon the character of of corporate managements, but rather on the patent un wisdom of leaving such matters within the virtually uncontrolled discretion of those who are to benefit by their own decisions." - Ben Graham

Also Warren Buffett has been since long advocating against the stock options & bonuses as compensations to employees.

Role of Directors:
"The role of individual directors are frequently joined by many close ties to cheap executives. It may be said in fact that the officers choose the directors more often than the directors choose the officers. Hence the necessity remains for the stockholders to exercise critical and independent judgments on all matters where the personal advantage of the officers may conceivable be opposed to their own"-Ben Graham.

Keeping with the style of the post I would like to end the post with quotes, whatelse,

"By failing to prepare, you are preparing to fail"--Benjamin Franklin.

"We can evade reality, but we cannot evade the consequences of evading reality"--Ayn Rand.


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