IQ, IP and 8 Commandments of Corporate Governance

By: Chris Tell

Recent dealings with a company led me to think about the relationship between corporate governance, creativity, innovation and what it takes to create or indeed wreck a successful enterprise.

A result of having been involved in well over 100 private equity transactions (I’ve long ago stopped counting), Mark no doubt a similar number, has been a lot of lessons learned and a particular methodology for choosing investments. Each day I learn more and I’m far from perfect. I only hope that I keep getting better.

One of our pillars of investment methodology has always been to focus very heavily on management in any company we invest our capital into. I’ve seen fabulous ideas run by idiots and they have a near 100% failure rate. I’ve also seen mediocre ideas run by very talented smart people succeed beyond all expectations. Clearly we need to work with good people, period.

Albert Einstein famously commented that “Creativity is intelligence having fun”.

But what exactly is creativity?

I’d define it as an ability to create meaningful ideas. These ideas brought to fruition bring value to peoples lives and people pay for value. In monetary terms this is known as intellectual property or IP. It is a critical element worth mentioning as the vast amount of value in today’s world resides in intellectual property. Additionally, IP is mobile. Governments, organizations and individuals who try to trap IP by force are facing a tough challenge in our modern world. IP can move across borders in minutes without an individual leaving their sofa.

Mark and I own some businesses which are 100% mobile. They are domiciled where it is most attractive for them to be domiciled and this can be changed in a matter of weeks if not days should the need arise. These businesses are driven by IP and are far from abnormal. They are, in fact, becoming the norm.

Consider companies such as Apple, Google or even Glaxosmithkline. What and where is the value in Apple? I’d suggest it is in the IP the company has built. The products are assembled in China anyway and that certainly isn’t where the value lies. Apple’s products could be assembled in any number of countries which provide competitive labour costs. The IP, however, can move anywhere.

For any company their challenge is to attract talent, creativity and skill. They do this by creating an environment of openness, fairness and opportunity. A company therefore needs strong values and good governance. Without good governance talented people will soon leave as their skills will not be allowed to flourish. What is needed is an environment conducive to flourishing ideas. Ideas die when they’re not put to use. Ideas die if there is no sustenance for them to grow and flourish. This sustenance is what is provided by investors in the form of capital and corporate infrastructure in the form of governance.

Corporate governance is a favourite topic of Richard Chandler. If you’re not familiar with the Chandler Brothers you’re likely not alone. These two Kiwi gentlemen are my heroes. Extremely secretive, contrarian, driven, principled investors who invest their own capital and don’t care for the limelight or what others think. They are at heart value investors often focusing on turnaround opportunities.

Over a span of some 20 years the Chandler brothers took a $10 million sum of capital and have parleyed that into over $5 billion. They are amongst the most successful investors in history yet they are virtually unheard of by the mainstream. My kinda guys.

I could discuss the Chandler brothers all day long but suffice to say their influence on me was one of the many catalytic reasons for the formation of Seraph, a syndicate of High Net Worth investors who together with Mark and I, invest in early stage proprietary private equity opportunities.

Suffice to say the Chandlers focus a lot of attention on management and though they’ve often invested in companies with poor management they’ve done so in order to replace those management teams, turn the companies around and reap the rewards. They are probably THE most successful strategic narrow focused private equity investors I know of.

Richard Chandler has a list of principles of good corporate governance and I’d like to share them with you today.

The Chandler Corporation’s Principles of Good Corporate Governance:

  1. Commerce and capital are based on trust. Capital will naturally flow to markets where there is a fair and impartial application of just laws. Governments have a responsibility to create a trust-based economy that protects investor property rights through the rule of law being applied without discrimination.
  2. Good corporate governance rests on the Cardinal Principles of integrity, transparency, and accountability.
  3. Prosperity flows from a partnership among shareholders, management, customers, and regulators. Management’s role is to create long-term shareholder value as well as social value through the productive use of capital and resources in an ethical manner.
  4. Management has a social responsibility to respect and nurture the physical, economic, moral, and social environment within which the company operates.
  5. Shareholders are owners. They must have the attendant rights and responsibilities of ownership. A company’s structure should be based on the principle of “one share equals one vote.” Shareholders are responsible for electing the board of directors which, in turn, appoints the company’s management. Responsible shareholders provide oversight of management’s performance.
  6. Good regulations support the Cardinal Principles. They enable shareholders to exercise their oversight responsibilities without burdensome and impractical rules and procedures.
  7. Management is accountable to shareholders for the productive use of the capital entrusted to them and for their financial and ethical performance.
  8. Capital is a valuable resource which must be prudently managed. When management cannot deploy capital productively in the business, it should be returned to shareholders.

I think good corporate governance is a bedrock on which a company can let its intellectual creativity and innovation flourish. I liken it to the compost my wife is putting into our vegetable patch for the coming spring planting.

- Chris

“I think Asia is the best place to be for the next 20 years.” – Richard Chandler

The Bubble is in Cash, Not Stocks…

Consumer Confidence Index

By: Brad Thomas

We are repeatedly reminded by many so-called “experts” that the stock market is in a bubble, and that when central bank quantitative easing programs end stock markets will “crash.”

However, it would appear that the only bubble is people’s uncertainty of the future and their desire to hold large sums of cash. These high cash levels equate to a huge pool of marginal buyers, rather than sellers, for stocks and other “real” assets.

With more buyers than sellers the most likely next big move for stocks is up, not down. This will be the case until equity markets are overbought. Thus, until that time we should not concern ourselves with any material downside.

One of my guiding “mantras” is a quote from the famous value investor John B. Templeton:

Bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria.

If one can simply identify where we are on this continuum then everything else falls in place! Yes, it does seem simple, but the hard part is interpreting the data and sentiment to discover where we are. In order to do this one needs to have been through a few market cycles to know what conditions of optimism and euphoria are all about.

I started trading in the mid 1980s and I have been through everything between now and then. Yes, it has been one hell of a ride. However, courtesy of this “journey” I know what optimism/euphoria is all about (thank the TMT bubble for that) and what all previous market tops had in common.

Contrary to popular belief the common trait wasn’t that they were expensive, rather it was that too many people owned stocks. Markets reach stages where they quite literally run out of buyers and that is when they are prone to significant downside movements.

So let’s have a look at a few indicators which will shed light on how the market is positioned – i.e. the “ratio of weak to strong hands”. Previous market tops were characterized by high levels of consumer confidence. Granted no one indicator is perfect and free of “noise”, however, it does seem that once the Conference Board Consumer Confidence Index reaches the 110 level the market is in danger of serious downside and investors should be very cautious of being over invested in stocks. Note where the index currently sits – right bang in “neutral” territory.

Consumer Confidence Index

Yes, it is difficult to comprehend but, if consumer confidence is anything to go by, we are probably only half way through the current bull market! This may seem a wild assertion but it is backed up by what investors are doing with their savings.

When optimism is high people feel certain about the future and as a consequence they invest a high proportion of their savings in the stock market. High levels of fear/uncertainty or a lack of confidence is associated with a high proportion of peoples’ savings in cash or equivalents.

This week I couldn’t help but notice the following article in the Washington Post on 18 July:

Washington Post

The first paragraph of the article reads:

Americans are holding more cash in their bank accounts than they have at any other point over the last two decades, a new study found. The average checking account balance reached $4,436 at the end of last year, nearly double the average balance of $2,100 seen over the last 25 years, according to a new report from Moebs Services, an economic research firm. Prior to 2003, checking account balances pretty much hovered around $2,000, according to the report.

Cash levels more or less the highest in a generation! This isn’t “typically” the sort of condition that occurs anywhere near the end of an equity bull market! The same tone of this article was echoed by the following on Yahoo Finance on 21 July:

Yahoo Finance

However one looks at it – cash is still a way more popular investment alternative than stocks: released the results of a new survey about how secure Americans feel about their personal finances compared with 12 months ago. According to the results, Americans overall chose cash as their favourite long-term investment. In fact, 1 in 4 Americans prefer cash investments for money they will not need for at least 10 years. Stocks came in third with 19% of the vote.

Nearly 40% of 18-29 year-olds say cash is their preferred way to invest money they don’t need for at least 10 years, despite the fact that the S&P 500 has gained 17% over the past year while the yield on cash investments is below 1%.

Getting back to Templeton’s quote “bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria” – if these articles and the Consumer Confidence index are anything to go by then we are nowhere near a condition of optimism perhaps at best we are still in skepticism!

Yes, it is very hard to comprehend this given that the S&P is up well over 100% in some 5 years but we should be very careful of jumping to the conclusion that the stock market and sentiment move in a lockstep or linear fashion. I think that many investors are under the mistaken belief that the performance of the stock market translates directly to sentiment.

You might be asking – how has the stock market managed to advance as dramatically as it has over the last 5 years? I think to a large extent this has been driven by corporate buybacks. Many companies have been aggressively buying back their own stocks over the last 5 years which has dramatically reduced the liquidity of stocks to trade. So with liquidity in shares being dramatically reduced it doesn’t take much in the way of buying pressure to push prices higher.

This leads us to a very interesting situation and looming disaster for those who aren’t invested in stocks! Consumers (who are ultimately the buyers of stocks) have the highest cash levels in a generation, combined with the liquidity of stocks that is probably the lowest in a generation and you have the recipe for the best is yet to come in the stock market. Yes, the rally in stocks is likely to continue for many months and the performance may well rival what we have seen over the last 5 years!

- Brad

“Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart.” – Alan Greenspan

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