We attended the Value Investor Conference in London, which took place on May 22nd 2014. Below are notes from the presentation by Mason Morfit of ValueAct (note: These notes are what the presenter said to the best of our knowledge, but there may be some inaccuracies). For some more great coverage, check out Dan Mccrum of FT – articles Also see: Andrew Cormie At London Value Conference: Value in Asia and Mason Hawkins on The Importance of Terrific Partners
- Valueact was founded in 2000 and it was very difficult for activist shareholders to access boards.
- Scandals of 2002/2003, such as Enron & Worldcom showed that boards didn’t always have all the answers and could benefit from outside help.
- Have built a team with a very deep circle of experience.
- They look to access boards without a fight – 37 board seats, only one from a proxy contest, the other 36 from invitation.
- Underlying religious principle is that they only invest in what they call great businesses – IP, high barriers to entry, high ROC, generating lots of CF etc.
- Best projects of all are when they take something that is defensive in nature and eventually move it to offensive.
- 2 degrees of separation have access to the boards of ~4,000 public US companies versus ~5,000 listed companies, through network and relationships they’ve built since inception.
- Rome wasn’t built in a day and neither was this – is the result of 14 years of hard work inside of companies.
- One of the pillars in how they work inside of company’s boardrooms, even if it requires tough decisions like the removal of a CEO, is that they do it the right way – with integrity and discretion. Won’t see them in the newspapers claiming victory in an investment; credit goes to the management who they worked as a team with to achieve the success.
- Over time they have developed and grown their capabilities through a feedback loop, versus traditional investing where you don’t gain the experience or skills to actively influence shareholder value from within the company.
- This feedback loop that comes from serving on company boards helps them to be better stock pickers.
- Framework – the US air force uses a 4 step process to analyze their own decision making. The point being that they iterate over and over and get feedback by seeing the reactions on the ground.
- Most investors have a set of passive observations about a co. that leads to a limited set of actions – buy or sell.
- Valueact are enriched with a set of observations which are fairly proprietary to them having experience on boards and deep understanding of the personal relationships and human dynamics within boards – how they react under stress, how they react in a hostile takeover, what types of advice they get from external council in various situations……which help them make better buy/sell decisions on co.s in parallel situations.
- They also have a much broader spectrum of actions they can take versus a passive investor, in addition to buy/sell, e.g. restructure exec compensation, guide cptl allocation, get involved in strategy.
- Have made many mistakes, which have made them better.
- An example of one of their sets of observations has been executive compensation and the power of incentives to create shareholder value.
- Extremely controversial topic over many years.
- There was an article last year in the WSJ called “CEO Pay More Closely Matches Firms’ Results”.
- Value Act did their own analysis on the same co.s and their conclusion was “Really?” Not based on their analysis of TSR (Total Shareholder Return). Found almost no correlation between the level of the CEO’s pay and share price returns.
- Mason put up some funny slides which showed performance targets that CEO’s needed to hit to receive performance based equity compensation. The previous year’s metric or guidance that the performance targets were based on, were hidden. When unhidden it was revealed that CEO’s would meet the performance targets in some cases by hitting the bottom of a pretty wide guidance range or for delivering worse performance year on year. His favorite example – a technology co. which could under perform the NASDAQ Composite (INDEXNASDAQ:.IXIC) by a mind boggling 24% and still meet its performance targets. If this was a money manager, they would be out of a job.
- So while co.s were following the letter of the law in terms of setting “performance targets” for equity compensation, the targets themselves were hard to miss.
- Valueact tried to do differently, using lessons learned from being inside boardrooms.
- They constructed a scheme – in simple terms think of it as a bar chart, the bottom part of the bar is the compensation you get for getting a 10% TSR, next the compensation level for getting a TSR of 15%…….up to compensation for a 45% TSR.
- The optimal structure was v low pay at ~10% TSR, v good pay moving higher – i.e. there needs to be a stick to drive some minimum level of good performance and a carrot to incentivise really good performance.
- A good example is their best investment to date was Valeant Pharmaceuticals Intl Inc (NYSE:VRX) (TSE:VRX):
o The new CEO was made to borrow to buy a significant amount of the company’s stock
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o The TSR performance targets were set aggressively. Net net – unless the CEO created enough shareholder value (15% TSR over 3 years) then they would be one of the worst paid CEOs, and if they did really well (+45% TSR) they would be one of the best paid.
o This created a powerful incentive that better aligned shareholders and the CEO and subsequently the stock (the shareholders) and the CEO did very well…….delivered ~85% TSR compounded and kept that up for over 7 years.
o So by setting up incentives with risk to the downside but rewards to the upside got results.
- Another example was C.R. Bard:
o Had exec compensation purely focused on EPS growth
o When top line slowed in the medical devices industry kept meeting EPS targets – lower sales and marketing, and R&D spend causing a death spiral
o Cuts were l-t value destructive on the health of the co.
o Changed and refocused on TSR
o Sacrificed s-t EPS growth for l-t health and stock price reacted positively
o This was an exciting thing to be involved with and contrary to the stereotype of a s-t focused activist
- Adobe Systems Incorporated (NASDAQ:ADBE) is recent example of an investment they are currently involved with:
o Pushed fwd with a complete reinvention of the business model taking it from a licence sale to a recurring subscription sale, taking recurring revenue from ~24% of revenues to ~65% revenues
o In order to do this there was severe accounting consequences and EPS fell ~40% from ~$2.34, in order to build it back up to +$5
o Visa Inc (NYSE:V) interesting case study:
- When invested in 2011 co. was describing their creative solutions business as mature and were focused on building document services and digital marketing.
- Worked with the co. to re-evaluate this premise and refocus energy on what they could do to the creative solutions business…..opportunities with cloud computing etc. to make a service with rich rendering, collaboration…..
- There were so many problems to be solved that you could demand an annual fee rather than launching a new product every 3 years or so and have a large amount of their customer base skip it.
- Mgmt executed very well and attracted +2m creative subscribers over the last couple of years.
- TSR is the catch all that encapsulates all value drivers
o Irresolvable when you tie compensation to other financial output/metrics, for example
- Sales: what if you want to sell half the company?
- ROIC: your current ROIC is 25% & you want to buy a good business that has a 18% ROIC, yet this takes down your ROIC?
Mason Morfit on if he prefers relative TSR or absolute TSR
Q: Does he prefer Relative TSR or Absolute TSR?
- Personally prefers absolute.
- They tend to invest in companies that control their own destiny.
- Having a relative bogey can distract focus on own business and how to double it.
Mason Morfit on Activist opportunities
Q: Activist opportunities in the US versus Europe?
- Activism activity in the US is at all-time high. However, see themselves as different/more boring than activists making headlines (looking to make l-t change/creation of shareholder value) and rarely bump into other investors (exception – Icahn with Ebay).
- UK much easier for activists to do business in as easier to talk to shareholders, less aggressive defensive tactics by companies etc.
- Still trying to figure out the continent in Europe.
Mason Morfit on value accretion
Q: Which levers provide the most value accretion?
- Try to find investments with all levers.
- Move from defence (taking out costs/selling assets) to offense (improving margins etc)
- Valeant – 1st ~100% was taking out costs etc, next ~800% was smart capital allocation, smart acquisitions.
Mason Morfit on preferred lifecycles of products
Q: Preferred lifecycles of products for co.s they invest in?
- Businesses they like tend to have long product cycles. Eg. Microsoft Office, Adobe Photoshop
- Allows a margin of safety that isn’t there when a product needs to be replaced every few years. (e.g. hardware)