The great taskmaster

December 21st, 2017 by Brian Kantor

The success of any business enterprise is measured by the return realised on the capital entrusted to it. The managers of an enterprise will rationally direct the capital provided them to particular business purposes in the expectation of a return on the capital invested that exceeds its opportunity cost, that is greater than the expected return from the next best alternative project with similar risks of success or failure. The more risk of failure, the greater must be the required (breakeven) return.

Measuring the internal rates of return delivered by an operating enterprise in a consistent way over any short period of time, for example a year or six months, has its own accounting for performance complications. The fullness of time, or until the venture is sold or liquidated, may be necessary for calculating how well the owners have done with their capital. However calculating the risks of failure of any potential project is much more a matter of judgement and sound process, than any precise measurement.

The only returns that can be measured with accuracy are those realised for investors in listed and well-traded companies. Returns come explicitly in the form of capital gains or losses and dividends or capital repayments received. And risks to potential returns are measured by the variability of these (monthly) returns over time that hopefully have a consistent enough pattern. A consistency furthermore that identifies the returns from a company as more or less risky compared to the pattern of average returns realized on the stock market. These measures can then form the basis of a required risk-adjusted return for a company or an investor to aim at.

These so-called betas that compare returns on individual shares to market returns as above or below averagely risky may in fact be quite unstable variables when measured over different time periods. Furthermore, these equations that relate company returns to market returns may or may not explain a great deal of past realised returns. The alpha of the total return equation that reveals company specific influences on total returns may account for much of realised returns.

This may be as well when judging the competence of the managers deciding and executing on projects. If the share market returns are mostly alpha (under the control of manager) and not the result of market wide developments over which managers have no influence, then determining the contribution of managers to realised returns becomes a consistent process.

Those buying a share from a willing seller are mostly gaining a share in the established assets and liabilities of an operating company – a share that the seller is willingly giving up – at a price that satisfies both. They are not providing extra capital for the firm to employ.

By establishing a price for a share they are however providing information about the market value of the company’s operations and so by implication the terms on which the company could raise further share or debt capital, should they wish to do so to supplement the company’s own savings to be invested in ongoing projects. The additional capital invested by operating companies will mostly be funded through cash retained by the firm, that is from additional savings provided by established shareholders.

The secondary share market transactions, through their influence on share prices, converts the internal rates of return realised by and expected of an operating company, into expected market returns. The superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company. The higher (lower) the share price the lower (higher) must be the expected returns for any given operating outcomes.

In this way through share price action, higher costs of entry into the investment opportunity, companies and their managers that are expected to generate way above average returns on the capital they invest in on-going operations and projects, may in reality only provide market-related average returns to share owners over any reporting period, say the next year or two. The further implication of these market expectations, incorporated into share prices, is that only a surprisingly good or disappointing operating results will move the market. The expected will already be reflected be in the price of a share or loan.

The implications of these expectations and their influence on share market prices and share market returns for managers and their rewards, provided by shareholders, seems obvious. Managers should be rewarded for their ability to realise or exceed the required internally generated returns on capital invested: charged to exceed targets for internal rates of return that are set presumably and consistently by a board of directors, acting in the interest of their shareholders.

Better still, targets set for managers that are made public and well understood and can be defended when exceeded and managers who are then rewarded accordingly. By contrast, share market returns that anticipate good or poor performance, cannot reveal how well or poorly operating managers have done with capital entrusted to them. Rewarding operating managers on the basis of how their shares performed is not a good method. Excellent companies that are expected to maintain their excellence and perform as expected to very high standards may only generate average returns. And poor management can wrongly benefit from above normal returns if expectations and share prices are set low enough. The correct basis for recording the value of managers to their shareholders is to recognise as accurately as possible, the realised internal rates of return on the shareholders capital they have employed.

The managers of companies or agencies that invest in operating companies – be they investment holding companies or unit trusts or pension funds – can however be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments. They can do so anticipating the surprises that will move the market one way or another and allocating capital accordingly in advance of them.

The managers of a listed investment holding company, for example a Remgro or PSG or a Naspers, are endowed with permanent capital by original shareholders that cannot be recalled. This allows them to invest capital in operating companies for the long run. They, the managers of the holding company, when allocating capital to one or other purpose, must expect that the managers of these operating companies they invest in are capable of realising above average (internal) returns on the capital they invest. If indeed this proves so, they must hope that the share market comes to share this optimism and prices the holding company shares accordingly, to reflect the increased value of the assets it owns. Other things being equal, the greater the market value of their investments the greater will be the market value of the holding company.

But other things may nor remain the same. The market place is always a hard task master. Past performance, even good investment management performance, may only be a partial guide to expected performance. The capabilities of the holding companies’ managers to add value by the additional investment decisions they are expected to make today and tomorrow – not only the investments they made in the past – will also be reflected in the value attached to their shares.

These can stand at a discount or at a premium to the market value of the assets they own. The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its NAV – will reflect this pessimism about the expected value of their future investment decisions.

A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns. It is a market reproach that the managers of holding companies should always attempt to overcome, by making better investment decisions. And by exercising better management of their portfolios, including converting unlisted assets into potentially more valuable listed assets and also by indicating a willingness to unbundle successful listed assets to shareholders when these investments have matured. And be rewarded appropriately when they succeed in doing so.

21 December 2017

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