"Is the company shareholder friendly? Does it pay a high dividend? Does it buy a lot of its shares?" I had been hearing such statements because some investors and others think returning cash is the most important tenet to judge a company and/or to make an investment. I am skeptical here.
A company is like a four-legged stool that stands on the health of its Customers, Employees, Suppliers, and Shareholders' legs. If one of those legs goes haywire, the business, including shareholders, usually lose.
Let's delve into each of the "legs", and see some examples of what happens if those legs are broken.
Customers
Every company provides a service or a product. However, if the company fails to properly satisfy its customers, it is on the path to destruction. Unfortunately, such companies allure investors because they are usually earning higher returns at the expense of their customers. Consider CompuCredit that was preying on its low-income customers by charging so many fees that the effective credit limit was cut more than in half. The result: the company lost almost 90% of its value from 2007 until the end of 2008.
The extent to which providing customer value proposition sounds simple, to the same degree it is difficult to implement and maintain. I believe the latter (maintain) is even a more difficult task. If I were to ask you for a list of five companies that have either maintained or increased their customer service in the previous ten years, how many can you think of with high certainty?
To find a sustainable customer friendly company, look at a long history of the product's value proposition for a given business. If you encounter a company whose product or service value you can't justify, simply move on.
Employees
These are the people that get work done in a business. They not only generate the return on capital invested by the company but also the return on incremental capital for new projects. If the company's top management fails to appropriately compensate, improve working conditions, and establish an appropriate culture, employees will leave resulting in poor customer service and shareholder returns eventually. Remember there is no cookie-cutter culture. Different cultural attributes are relevant to different industries.
Consider the case of Texas Air in the 1980s. The company saw a spectacular rise in its stock price from cutting costs and the turnaround of its key subsidiary Continental Airlines. However, the reality was different. Employees became increasingly impatient with management on the matters of salaries and benefits. Customer service went south with increased flight delays and lost luggage. All of that resulted in the company's market value tanking roughly 80% in 1987 alone.
Before investing in a company, I read the company's proxy statement and scrutinize employee satisfaction from various sources such as local news and Glassdoor reviews. I want to see how the management treats themselves and their employees. When you study performance criteria, security ownership, option
grants, and bonuses, consider whether you’re comfortable with the
numbers given the level of employee satisfaction.
Suppliers
Would you like to have your lender extend your payment due date without penalty? Let's say by 30-days or even better 60-days? That sounds good but who is on the other side? Suppliers. For some companies, suppliers have become the new lender!
“Extending our payment terms allows us to better align with industry practice and ensures we compete on a level playing field, while simultaneously improving transparency and predictability of payment processes,”
- Valerie Moens, a spokeswoman for Mondelez.
Just because everybody is doing something bad, doesn't mean you have to do it. Squeezing suppliers to generate short-term cash or reduce business capital needs is not a sustainable way, a company can prosper in the long-run. In addition, various practices have plagued suppliers such as unreasonable delivery timelines, and hefty fines. The cost of these practices is huge such as lower profitability, supplier bankruptcies, and bad relationships.
“Ford, General Motors, FCA US and Nissan collectively would have earned $2 billion more in operating profit last year [2014] had their supplier relations improved as much as Toyota’s and Honda’s did during the year,”
- John Henke, Ph.D. president and CEO of Planning Perspectives INC.
So, to avoid the above fate in a potential investment, look for a company that takes a partnership approach with suppliers. For example: I look for clues everywhere - qualitative and quantitative. I listen to earning calls of both the company and its suppliers (sometimes listening is better than reading the transcript as that helps to gauge the management inclination from their body language). How truthful is the management when describing the supplier relationships comes out when you hear from the supplier management? I talk directly to suppliers by cold calling them. After all the work, if I feel good about the company's relationship with its suppliers, I'll move forward.
Shareholders
I started this post by questioning whether a shareholder-friendly company is a good thing. As you might have noted, it is not the only leg that makes a company successful. But, it is important just as the prior three legs because shareholders provide the capital to the company to make investments, and grow.
A company's management can destroy shareholder value in numerous ways. Some examples include not giving back excess cash, reinvesting capital in lower returning projects or acquisitions, and buying the stock at above intrinsic value. While these are common ways, there are other subtle ways in which a company can destroy or lower shareholder value.
Consider the case of CRT properties going private in 2005. The company was financed by loans, preferred stock, and common equity. The preferred stock had a healthy 8.5% dividend that didn't change post the transaction. However, the security was less valuable given the increased risk from the absence of both common stock, and a public market. Such behavior by management should be questioned and monitored.
It is worth studying the capital allocation policies of the management and important to see what the management does compare to what they say they would do. I want to see a rationale approach. When you smell questionable behavior, consider whether you’re comfortable with that given the available options management has for capital deployment.
To summarize, if the four legs are not even, I don’t invest. Reading and learning about these four legs is simple, but not necessarily easy. It takes hard work, determination, and discipline on the investor's part.
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