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James Montier - Maximizing Shareholder Value is Stupid


merkhet
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I like Montier, but...WOW.

 

1. How can you possibly compare IBM and JNJ? A technology company that has had to reinvent itself every ten years versus a "wonderful" business that has raised its dividend every year since the Civil War?

 

2. The "operating principles" espoused by JNJ are in fact designed to boost shareholder value, not supercede it. You think JNJ wants its doctor base to be as happy as possible because they care about them as human beings? Of course not - the happier the docs are, the stickier the demand base; and the stickier the demand base, the greater pricing power JNJ has over time. Buffett basics 101. Buffett himself would say JNJ should focus on its customer base "over" shareholder value...because that's what creates shareholder value!!!!

 

3. Montier is more than two-faced here: he rants for years about LIRP and elevated profit margins, yet now blames SVM for a lack of private investment. A) LIRP creates a disincentive to save, which we all know is the core to investment - SO, low interest rates = low savings rate = low investment rate (look no further than China as an example.......); and B) elevated profit margins as a result of low investment is the reason for excess cash return to shareholders!!!!! If margins reverted to the mean as GMO says they should, does anyone seriously think payout levels as a % of market cap would stay where they are? 

 

 

Very, very disappointing from Montier. Perhaps he is just bored from a perpetually "elevated" market.

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I liked this one, actually.

 

I don't think that he'd disagree with #2. It's just about Kleig-light syndrome. People have an intense focus on their goals to the exclusion of other things. Customer-orientation (or in the case of Costco, employee-orientation) leads to increased shareholder value -- whereas SVM leads to short-termism that defeats its own purpose.

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I could not disagree with this paper more. The return by era chart is just downright silly. Even if one could say there was some sort of dramatic shift in perspective around 1990, there are just a few other variables at play  ::) The J&J vs IBM comparison is equally misleading. He just cherry picked two companies to make his point. Why doesn't the pro-shareholder value side get Berkshire Hathaway? Montier's side should get a non-profit.

 

The right way to look at business, in my opinion, is that it exists to make money for the owner. Long term value creation is the fundamental goal that every employee in the business acts to achieve. It's the standard by which every action is evaluated, both of employees and the company. It's because of this standard that an owner of a business can judge as good the attempt to treat customers well. At the end of the day, every interaction with a business is voluntary. Customers have to voluntarily choose to purchase the product or service and so by the standard of maximizing shareholder wealth, treating customers, suppliers, and everyone in the value chain well is good. It's the path to making money. Every interaction between individuals in a free society has to be win-win, otherwise one side will not be party to the interaction for long (that true for personal relationships as well as economic relationships). If J&J had really held, in principle, that customer satisfaction is the standard, why would they make any money at all? Those products could have been sold to the doctors, nurses, patients, and mothers much cheaper. So apparently in practice, that constituency DID NOT come first. The fact is that no business could survive if it acted this way.

 

There's such a thing as giving away too much to your customers. Double Your Profits (a 3G Capital favorite) makes this point from a practical perspective. From a theoretical perspective, profit ought to be viewed as a measure of value creation. Anything less than the maximum achievable represents potential value that was destroyed. If you want to give away value, that's what charity is for.

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I liked this one, actually.

 

I don't think that he'd disagree with #2. It's just about Kleig-light syndrome. People have an intense focus on their goals to the exclusion of other things. Customer-orientation (or in the case of Costco, employee-orientation) leads to increased shareholder value -- whereas SVM leads to short-termism that defeats its own purpose.

 

Caveat: Haven't read the article yet..

 

Your point is one that should be blindingly obvious to investors, yet somehow it isn't.  If a company is entirely focused on serving their customers then shareholder value should follow.

 

Companies that are naturally maximizing shareholder value aren't doing it explicitly, they're fulfilling their main purpose which is to deliver a product or service that satisfies a vital customer need.  If a company can do this profitably then shareholder value follows.  Where the chain is broken is when companies can't satisfy customers and management starts to pull financial engineering levers to fake this.

 

Look at all of the lauded companies, consumers either love them, or they fill an essential need.

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Agree that it should be blindingly obvious.

 

I think the problem is that things that are blindingly obvious to some are not blindingly obvious to others. I mean, look at Costco -- they have a pretty good secret sauce in the whole "treat employees well" strategy, and yet no one copies them.

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Yes, I think it was in a Pabrai talk where he discussed this.  He said you can tell a competitor exactly what makes you different and special and they won't copy it.  That there is no point in being secretive because people just don't copy, that's what makes copying so powerful.

 

I know the 'not invented here' mentality is strong, I've seen it daily.  People would rather do something themselves however flawed verses copying something that works somewhere else.

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In my opinion SVM is right, but only in theory… In practice different time frames always leave it subject to criticism. I try to explain what I mean:

 

Just as we know that maximization of earnings this year and the next might require actions that won’t necessarily maximize earnings 20 years from now, maximization of earnings 20 years from now might require actions that won’t maximize earnings 50 years from now, and so on…

 

Grantham showed this perfectly in a former letter of his, in which he explains why our use of agricultural land might not be sustainable, and he says SVM cannot explain nor support a sustainable use of agricultural land…

 

Well, I don’t quite agree: SVM might very well explain and support a sustainable use of land… It just requires a time frame of 100 years to do so… Therefore, both us and our children should be willing to accept lower earnings, in order to devise strategies that maximize our grandchildren’s earnings… Strategies that anyway might not be the best ones to maximize their children’s earnings… And so on…

 

Gio

 

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i think there is some confusion between the forest and the trees here.

 

think of it this way: Buffett has said that the best business is one that can re-invest its capital in itself at high rates of return for long periods of time. Similarly, everyone on this board would agree with Buffetts statements on the advantages of permanent capital.

 

Montier is saying that the culture of shareholder value makes it more difficult for companies to reinvest in themselves because investors want immediate results (ie not willing to take a short term hit to GAAP earnings in order to maximize future earnings potential), which is akin to CEOs not having access to permanent capital.

 

Now, as with anything else, there is a continuum here. 

 

On one end of the spectrum, companies that are unable to re-invest in themselves at obviously acceptable rates of return should clearly return capital to shareholders.

 

On the other hand, companies that are able to re-invest in themselves at obviously acceptable rates of return should quite obviously re-invest in themselves.

 

However, where it gets tricky is in the middle.  there is a lot of gray area here between what is a wise re-investment and what is not.  it depends on your assumptions and hurdle rates etc.  As investors we should of course demand a margin of safety and expect management to require one when making investment decisions, and thus err on the side of caution. The problem however lies in the fact that as we all know (and as Montier has written about extensively) human beings have a hard time placing the future in context. 

 

Is it worth it to pursue a project that has a negative impact on EPS for 5 years before turning into a massive success? 

 

Mathematically answering that question is a simple IRR calculation.

 

But what Montier is saying is that in the real world, its not simple math. The math is clouded by human elements such as a CEO who is likely to have a short tenure and thus must drive profits and earnings now.  This CEO is thus incentivized to violate a decision that may make sense economically in the long term in order to focus on the short term.

 

for more on this google Tom Russo, Capacity to suffer... he gave a speech in Omaha in 2013 i think about the best companies over time having the capacity to suffer, meaning invest for the future at the expense of short term profits.

 

it is one of the reasons that owner operator companies perform better over time... they're not afraid to take the short term pain for the long term benefit.  Modern CEOs don't have that luxury.

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I really like Montier's work but it is intellectually dishonest to compare IBM and JNJ. Burroughs or DEC might be a better comparison for IBM. Pfizer, Merck, or Bristol-Myers would be a better comparison for JNJ.

 

I'm not convinced "Maximizing Shareholder Value" is the problem. "Maximizing CEO's Wealth" and rewarding short-term shareholders is a bigger problem.

 

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James Montier: The Stock Market is Hideously Expensive

(see attached article)

 

It says they are selling out of high quality equities like JNJ.  But get this...  they did so in order to write index puts, among other things.

 

They might have just written calls on their stocks.

 

I wonder why they prefer the downside of the hideously expensive index over the downside of their high quality names?

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selling equity vol, over time, has a different return profile than owning stocks, be they of the "high quality" sort or index sort; it's more akin to being long credit or long merger arbs (which they advocate).

 

Also, there probably isn't too much liquidity to sell puts on individual quality stocks in a big way (writing covered calls on the high quality would be equivalent to selling puts on them).

 

They prefer, for better or worse, to be opportunistic sellers of downside vol, rather than business owners, in order to shorten their duration. there just aren't that many months where the S&P just jumps down 20% ( October 1987/2008, the type of month that hurts this strategy, even though that allows for some juicy vol selling thereafter) so they are making a bet that the probability of that type of scenario is lower than the probability of  a scenario where equities grind lower or are flat. 

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selling equity vol, over time, has a different return profile than owning stocks...

 

...

...

 

 

They prefer, for better or worse, to be opportunistic sellers of downside vol, rather than business owners,

 

Owning the stock and writing the call has the same profile as selling the downside volatility.

 

That's a truth.

 

Your point though sounds right that there may be a more liquid option market for the index vs individual names.

 

They could own the index and sell calls, or hold cash and write puts -- whether or not they want to be business owners is irrelevant.

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it isn't irrelevant. the owner of index in a given year receives the total return of the index. whereas the seller of short term downside  volatility protection receives (premiums received - negative returns of index). there are lots of scenarios where selling downside vol will outperform owning the index. they are two different payoff profiles and GMO states they like one rather than the other.

 

just to be absurd let's say in 2015 the S&P goes down 0.5% every month after divvies and GMO gets paid 0.5% every month to insure downside. GMO ends up flat, the index holder ends up down 5.6%. GMO wins.

 

Of course, one may wish to point out that they both have the same downside risks and GMO has very limited upside (and i'd agree), but they don't see a lot of upside in the index so they don't care. they just want to get paid regularly and quickly (shorten their duration)  and accept the "jump risk".

 

I know you know this and understand it better than i ever could.

 

 

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we agree that shorting puts and buywritecall is the same thing.

 

i'm just comparing the return profiles of an index owner (no options) and a putwriter/buywriter.

 

You asked why they prefer the downside of the hideously expensive index versus that of the high quality co's. I offer the explanation that

 

1) liquidity in the single stock options market is not large enough to sell puts on a massive scale in daily liquidity commingled funds

 

2) the payoff profile of selling downside protection systematically is different than owning index and even if the index is overvalued, selling vol at the right price may make sense

 

I'm not advocating for doing what GMO is doing and in fact think it's a sign of the times that they are venturing into short vol positive carry yieldpig pennys in front of steamroller strategies like merger arb (which is selling an event put) and index put selling. But I understand why they are. And I think you do to.

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They don't seem to care about the client's tax bill either. 

 

They expect the index to plunge or go nowhere, so they stick a capital gains tax bill on the client to free up cash for pursuing their pennies in front of steamroller play.

 

It's highly questionable.

 

Also, the put option premiums are taxed at ordinary income rates.

 

Further, the benefit of selling calls on an index (instead of writing puts) is that if the index goes up, you have deferral of taxes as the option can perhaps be rolled without taxes.

 

Oh well. 

 

 

 

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The majority of their clients don't pay taxes.

 

 

GMO is a global investment management firm committed to providing sophisticated clients with superior asset management solutions and services. We offer a broad range of investment products, including equity and fixed income strategies across global developed and emerging markets, as well as absolute return strategies. Our client base includes endowments, pension funds, public funds, foundations and cultural institutions.

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I think this is a little bit silly.

 

My thoughts on the matter have always been that the aggressive proponents of Conscious Capitalism miss the point... if you can create shareholder value by treating customers well and providing them great service, good. Of course that can create a lot of shareholder value.

 

But if you have a largely unregulated monopoly, as Malone did at one point, you can also create a lot of value by taking your customers to the cleaners and returning gobs of cash to shareholders. Both work, they just work in different situations.

 

I think it's better to have a nuanced view here, rather than take anecdotes and correlations - as if you could really prove a causal relationship... people with agendas try to pull the wool over our eyes with fallacious interpretations of data all the time - and coming to strong conclusions either way. Much of the world does not lend itself to analysis by spreadsheet.

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I think this is a little bit silly.

 

My thoughts on the matter have always been that the aggressive proponents of Conscious Capitalism miss the point... if you can create shareholder value by treating customers well and providing them great service, good. Of course that can create a lot of shareholder value.

 

But if you have a largely unregulated monopoly, as Malone did at one point, you can also create a lot of value by taking your customers to the cleaners and returning gobs of cash to shareholders. Both work, they just work in different situations.

 

I think it's better to have a nuanced view here, rather than take anecdotes and correlations - as if you could really prove a causal relationship... people with agendas try to pull the wool over our eyes with fallacious interpretations of data all the time - and coming to strong conclusions either way. Much of the world does not lend itself to analysis by spreadsheet.

 

+1 So true. Having a nuanced view is almost always the way to go, I guess.

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