Tuesday, January 28, 2014

Perspectives on management

The relationship between corporate management and portfolio management.

The previous postings about managing an equity portfolio (starting with “2013 Was a Very Educational Year”) intentionally minimized references to the financial analysis or technical analysis that supported the portfolio adjustments discussed in the postings (especially in “What is to be learned about stock acquisition?”).  The purpose of that approach was to demonstrate that investing can be done without extensive sophisticated analysis. 

Lest that comment be misunderstood, the point is not that one should throw darts at the financial page in order to construct a portfolio.   Once one has identified what looks like an appealing adjustment, additional analysis can be used to confirm that it is legitimate.  The amount of additional analysis one requires is really a matter of taste and there are numerous scores of guidance from textbooks to websites.

The approach works because the widows’ and orphans’ portfolio has a logic and an objective.  An important component of the logic behind the portfolio is to restrict portfolio holdings to well-respected companies that produce well-respected products.  One can learn a lot about the quality of a company from an analysis of the reputation of its products.

Another important criterion for inclusion in the widows’ and orphans’ portfolio is what for lack of a better term might be called robustness.  Robustness implies companies with reputations for conservative financial management and market leadership.  Buffett likes to say that he likes to invest in businesses that are so simple that they could be run by idiots, because sooner or later they will be.  Robustness does not have to originate from simplicity.  Robustness may originate from an ingrained corporate culture, unique assets, natural monopolies, strong brands, exceptional management or a variety of other factors.

Among those factors that contribute to robustness, the most fleeting is exceptional management, especially senior management.  It is easy to over-emphasize senior management's role.  They get paid a lot, so one might assume they must be doing something important.  The media likes stars, so they focus on senior management.  Most investors do not get exposure to other than the most senior managers.  However, the corporations in the widows’ and orphans’ portfolio are huge.  Any senior manager’s impact on the company is a lot like the impact of the helmsman of the supertanker.  Changes in the fortunes of the company only occur slowly.  Consequently, monitoring the quality of senior managers provides an opportunity for the long-run investor. 

The investor’s greatest challenge associated with using judgments about the quality senior management is deciding whether senior management's impact will be lasting.  In most cases, the portfolio is designed to include firms that can outlast weak management.  But, weak management provides an alternative opportunity.

Johnson and Johnson provided an example when it was run by Weldon.  He made a series of mistakes including ill-advised acquisitions that resulted in some embarrassing product recalls.  It was clear that he was overly focused on empire building to the detriment of the company's reputation for quality products.  At the time, a decision had to be made as to whether to abandon Johnson & Johnson as an investment or hang on in the belief that it would survive Weldon's mistakes.  If one judged that Johnson & Johnson would survive Weldon, when he was finally replaced it bdecame an excellent opportunity to acquire additional Johnson & Johnson stock.

If one felt that his management would have lasting impact, the response could been to shift to an alternative drug company.  Somewhere in between, there is a strategy that involves buying a different drug company with the intention of shifting the capital into Johnson & Johnson when Weldon was replaced.  One could also just accumulate the Johnson & Johnson dividends and wait for the opportunity to invest them.  If the widows’ and orphans’ portfolio is as well-designed as intended, the alternative was to hold onto Johnson & Johnson stock, and to use the dividends from the stock to purchase an alternative drug company.  Then, when Weldon left, some of the stock in the alternative drug company could be sold to purchase Johnson & Johnson shares. 

One should not misinterpret these comments about Johnson & Johnson during Weldon's management term.  Weldon did not achieve his position by chance.  He is a capable executive with a lot to contribute.  However, his talents were not what Johnson & Johnson needed at the time of his term.  Further, one suspects that some of the mistakes that were made could not have occurred without substantial support, perhaps encouragement, from some members of the Board of Directors.

That example is looking backward.  Looking forward, a review of the portfolio reveals that currently there may be similar opportunities among the holdings.  Empire building is not the only vice that sometimes afflicts bright people.  Very talented managers may just have the wrong skills for the particular challenges the company is facing.  One of the most dangerous situations is when a very talented senior manager cannot recognize his or her own managerial limitations.  That can originate from a variety of motivations from hubris to an evangelical commitment to a particular object.  It is extremely rare for it to be incompetence.  More often than not, it is a failure of senior managers to structure their environment in a way that capitalizes on their talents.  That structuring can be anything from delegation to divestitures.

Pepsi is a good example.  The business has been unable to realize its full potential.  The entire food group has not performed spectacularly, but Pepsi seems to be suffering more from self-inflicted constraints than the overall performance of the industry.  This situation has been going on for a number of years and has reached the point where there are now calls for separating the beverage and snack food businesses.  Pepsi's market position and size pretty much guarantee that it can survive such underperformance.  Therefore, its problems did not justify abandoning the stock.  At the same time, those same factors eliminated any urgency to address the problems.

Under the circumstances, Pepsi can perform reasonably, but not well, for a long time.  It has done just that.  Over the last few years, Pepsi's lack of a catalyst for a performance improvement provided an incentive to delay any investment in Pepsi.  Such underperformance generates increasing pressure on management.  It may be that 2014 is the appropriate time to begin reinvesting dividends in anticipation that the pressure will force some change. 

Previously, investing dividends from Pepsi in other firms in the industry, or similar industries, made sense.  Pepsi's relatively poor performance within the portfolio means that some step had to be taken to restore an appropriate weighting to the food and beverage industry component of the portfolio.  In that respect, it provided an opportunity to diversify into a broader representation of the total industry.  One could acquire a non-snack food firm like General Mills.  One also might consider other beverage companies less heavily represented by sugary beverages.  It seemed like a perfect time to have a beer.  Once a catalyst for improvement in Pepsi's performance can be identified, those stocks and/or their dividends can be used to enhance the holding in Pepsi.

General Electric has represented even more of a problem for the portfolio.  Almost from his first day, it has been apparent that Immelt was unable to control GE's future.  He walked into a period when GE faced significant challenges from the events of 9/11 and then the financial crisis.  However, his willingness to blame those external events for GE's performance made it quite apparent that he was not up to the task of controlling GE's future and ensuring its success.

The rationale for including GE in the portfolio included the statement that the company is sufficiently robust to survive a bad manager.  Thus, there is no reason to abandon the company.  It will prosper and perhaps 2014 will be when that begins.  However, over the last few years there was no rationale for adding to the position in GE.  In presenting the widows’ and orphans’ portfolio, United Technologies was mentioned as an alternative.  Given the situation at GE, investing GE’s dividends in United Technologies has made sense for over a decade and may continue to be the case.

Procter & Gamble was mentioned as the consumer nondurables component of the widows’ and orphans’ portfolio.  However, as was noted, Kimberly-Clark, Colgate-Palmolive, and even Clorox provide alternatives.  Thus, Procter & Gamble's management problems and the consequent underperformance of the stock make the consumer nondurables component of the portfolio the natural place to diversify away from the core into other comparable companies.  For example, one opportunity to diversify was mentioned in a posting on March 30, 2010.  The posting, “Wall Street doesn’t run the world,” mentioned an opportunity in one of the alternatives, Kimberly-Clark.  It was not until last year that Procter & Gamble’s stock was able to keep pace with the companies peers.

The underlying philosophy behind the widows’ and orphans’ portfolio is that it will provide a core, but not the totality, of one's equity positions.  Adding new positions might occur in response to a change in one of the portfolio holdings.  For example, when Pepsi spun off Yum Brands, it made sense to hold Yum Brands’ or add exposure to replace Yum Brands business in fast foods. 

If the basic portfolio holdings are durable, management problems represent a different kind of opportunity.  They present an opportunity to acquire non-core holdings or accumulate the dividends. Those non-core holdings can be used to expand the industry coverage of the holdings.  An example would be adding a non-snack food producer to supplement Pepsi's snack food business or adding a paper company like Kimberly-Clark to the nondurables.  In some cases, the supplemental company will be a competitor of the core holdings for some or all of its lines of businesses.  For example, United Technologies competes with General Electric in some business lines.  But between them, the two companies represent more business lines than either alone. 

In most cases, the additional stocks can be selected so as to strengthen the overall portfolio and enhance the performance over the long run.  However, it is the long-run portfolio objective, industry mix, and emphasis on quality holdings characterized by the core holdings of the widows’ and orphans’ portfolio that stay the same.

As with the other postings in this series, this posting was done without any reference to the financial statements of the corporation or technical analysis of the stock.  One should not conclude that a review of the financial statement is irrelevant to an assessment of management.  That is hardly the case.  Financial statements, especially the balance sheet, but also the cash flow statement, say a lot about management.  The income statement, which seems to receive the most press, probably says the least about management of the company.  They were ignored in order to show that sophisticated financial analysis and technical analysis are not required in order to identify investment options. 

No comments:

Post a Comment