Why “Shareholder value” Is Often A Lie

“Shareholder” – The over-simplified Term

We often hear that businesses are supposed to maximize shareholder value. It certainly sounds reasonable to beginners, but once you get to know more about stocks, you will find shareholders are rarely a single group with some common interests.

Instead, we can usually identify 5 groups of shareholders:

1. Operators/Management.

Management are the operators of the business. They manage and control the business’s daily activities. Although they don’t have the ultimate control of the business, they have strong enough influence to the business and board of directors.

For sure, management are often shareholders as well, but their interests also come from being able to draw compensation on a long term basis. When they have enough influence to the board, they could also treat the company as an unlimited source of cash flows for themselves.

Besides getting long term compensation, there is also pride, love, and sense of power involved. The job itself might be rewarding enough, so much that it is beyond the financial interests a regular shareholder would have.

By nature, management are the ones who interact daily with employees, so they might have natural attachment to employees or at least try to avoid confrontation at a minimum.

For all these reasons, management rarely have the same interests as the other shareholders:

  • They don’t like to lose control. It is often a matter of pride and sense of power.
  • They like to draw as much compensation from the company as possible.
  • They don’t like to sell the company even when given a good offer.
  • They don’t like to do restructurings and lay off people, even when it is really needed.
  • They don’t like to liquidate an unprofitable business even when they believe it is hopeless (think Berkshire Hathaway’s textile mill)

2. Controlling Owners.

Controlling owners are the large shareholders who actually control the board. Some have close to majority shares, while others have different class of shares with more voting power (such as class B shares with 10 times voting power).

Controlling owners sometimes have more aligned interests with long term shareholders, but they are rarely the same. This is because controlling owners have both control and insider information.

Insider information covers the past and present status of a company, giving them more certainty to predict the future.

“Control” is even more powerful, since it gives them certainty about future actions and potential changes that could happen to the company.

Because of these two advantages, controlling owners could also play tricks against minority shareholders. For example, there are quite a few Hong Kong companies that play the same type of tricks over and over to dilute minority shareholders in a big way.

Just recently, Landing International (HK: 0582) announced a pro-rata share offering at HK$0.05 per share for 102 billion shares (yes, you read it right, it is not “million”). The current share base has 20 billion shares outstanding. So this is 500% dilution. To understand the offering price, I should mention that the share was traded at HK$0.10 just the day before the announcement and HK$0.20 just one month ago. The company’s book value is HK$0.50 per share.

The company also has HK$5.2 billion cash and about HK$4 billion debt. So it has net cash to begin with, why does it need so much dilution and so much capital (HK$5 billion capital injection)? The controlling owner declares this is to pay off the loan made by the controlling owner himself.

I should also mention that this is not the first time they dilute shareholders in such dramatic matter, it is the 3rd time they do it since they acquired control in 2013.

Some people might think this is a “fair” offer because it is pro-rata. In theory, it might sound right, but again, people tend to forget that it is the controlling owner who has the control and insider information here. If you are one of those minority shareholders, do you want to put more money into this apparently suspicious company? Do you know how many insider dealings they could have later on? Do you really trust their accounting books?

So the mere action and announcement would already scare away the minority shareholders, leaving them 500% diluted at unbelievably low prices relative to their costs and the company’s book value.

3. Short term shareholders.

Short term shareholders don’t intend to hold the shares for many years. They want to take a “free-ride” and prepared to jump off the wagon at any time.

To them, the so-called DCF value (discounted cash flow) is a joke. They only care about the market value and how much and how fast they can sell.

With this purpose in mind, they would like a company which can make numbers and produce a stable trend. They like companies which can tip them off at the expense of other shareholders. They like companies which will sell at a premium to the highest bidder tomorrow no matter if the bid is below or above the long term intrinsic value. They like companies which care about short term earnings than long term returns and don’t want to make any real long term investments (unless the investment could make the “story” more attractive). And they like the company to buy back shares no matter what the price is since it would boost the short term share prices.

Many activists are also in this type. Although they claim that they represent the shareholders’ interests, they tend to be short term oriented, and their solution could be conflicting with the company’s long term interests.

4. Long term shareholders.

For long term shareholders, DCF makes more sense, at least theoretically. Even in this case though, “value” is still only meaningful in a relative sense. For example, since nobody knows what discounted rate should be used, we can never tell whether someone should prefer $3 for 10 years later or $1 for now.

Also, how much cash a company should hold and how much leverage a company should use is really a subjective decision, which depends on the personality of the decision maker.

5. Options holder.

Since management and employees usually hold a lot of long term options, this type of shareholders is also important to consider. Since they only hold options without any cash flow needed to excise them until many years later, their downside is practically zero at the moment they get the options, and their upside is infinite.

Naturally, options would encourage them to be very aggressive to pursuit growth and leverage regardless of the risk and downside. The limited time window of options would also encourage them to be more short term oriented.

When it comes to paying dividend vs. buying back stocks, options holder would by all means favor buybacks, no matter how high the stock price is. After all, dividends have nothing to do with them.

Implications

To be fair, there are a lot of common interests among all the shareholders too, but as you can see, the real picture is much more complicated than what you would usually read in the news media. It is also hard to argue what is right and what is wrong, plus what can you do even if you could tell? (unless you are the regulators)

Therefore, for investors, it is critical to understand who you are and what role you play, and try to find a shareholder base that meets your needs.

For example, if you are one of those long term shareholders, you would want to partner with some good controlling owners or a management who has long term shareholder’s interests in mind, those who would treat other minority shareholders fairly, and think about the company’s long term future.

On the other hand, if you are one of the short term investors, you might want to find a management that knows how to do promotions and tries their best to make the wall street happy.

Overall, people of the same type can usually get along. If a stock is dominated by short term investors, the absence of a long term oriented CEO or controlling owner can be a good thing, but collectively, they might lead the company to do something harmful to the long term performance.

On the other hand, a long term oriented company with long term investors as its shareholder base could be “unfriendly” to short term investors who have no patience for long term fundamental returns.

In any case, no matter whether you are a long term or short term investor, you have to be careful about any powerful management or controlling owners who behaved unfriendly to minority shareholders. Studying their history and the company’s history is an important part of due diligence. To do that, just reading all the past annual reports is far from enough, since that material is too official and strongly biased. Instead, you should look at the cash flows, value returned to shareholders, online reviews and investors’ past discussions.

Conclusion

Just as “value” is an over-simplified term, “shareholder” is also an over-simplified term. Experienced investors know what to look for beneath the surface. So next time when you hear people talking about “maximizing shareholder value”, you might want to silently ask yourself: which shareholder are they talking about?

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