Spotlight on governance
The decisions a company’s leadership team makes are clearly critical to its success – but how can potential investors tell if a company is well run? Environmental, social and governance (ESG) factors can be powerful indicators. They are important inputs into the equity valuation model used by Manulife Investment Management’s Fundamental Equity Team, which is led by Patrick Blais and responsible for the Canadian Core Equity strategies.
ESG analysis complements the team’s focus on tangible cash flow (see “Get to know real cash flow” in the summer 2019 issue of Advisor Focus). Integrated into the team’s fundamental analysis of individual stocks, it seeks to identify ESG factors that are quantifiable, material and may affect future free cash flow generation and cash flow return on investment.
“We’ve got a unique way of looking at companies, and we think you need to be unique,” says Blais. “There’s a lot of smart people out there and a lot of the traditional metrics will be competed away – so we’re looking for that unique perspective.”
The team’s work in this area aligns with Manulife Investment Management’s ESG policy, which states the firm’s belief that “well-managed companies will create long-term shareholder value, and, therefore, it is important for a company to have quality management with appropriate supervision through balanced controls.”
Specifically, the ESG policy continues, “good governance practices mean that the company has a strong and effective board, honors appropriate ownership and shareholder rights, implements effective remuneration structures in line with long-term performance, delivers high-quality and meaningful reporting to its shareholders and other stakeholders, and manages the environmental and social aspects of its business.”
Let’s look at a specific example that shows how the Fundamental Equity Team handled concerns about an acquisitive technology holding’s governance. The team responded with an in-depth investigation and active engagement with the company’s leadership team – all of which was designed to help improve results for investors.
Asking the right questions
When the share price of the holding experienced material underperformance compared to its peers, the team began a formal review process to understand why. What exactly was keeping the share price at a level that represented a significant discount relative to similar businesses?
The review, which included ESG analysis, found that the company’s return on investment capital (ROIC)1 was declining, and that this was putting downward pressure on the share price. Historically, the ROIC for this company had been relatively stable, hovering around 20 per cent (see graph). But about five years previously it had begun to decline, quite sharply in some years. Now it was sitting in the low teens. As a point of comparison, the company’s peers had ROIC levels at least two per cent higher.
A review of management’s compensation structure raised the possibility that the company’s incentive programs were potentially failing to incentivize the necessary discipline surrounding acquisitions. The team conducted a thorough due diligence of the company’s compensation plan, including meeting with management to discuss increased transparency and better understand the company’s approach to acquisitions.
Identifying the source of the problem
The team looked closely at the company’s short-term and long-term incentive compensation and found that neither reinforced a disciplined approach to acquisition pricing.
Specifically, the company had tied short-term incentive compensation to revenue targets and adjusted operating income targets. The team didn’t believe these absolute-dollar metrics supported shareholder value creation, and they could motivate management to look for acquisition opportunities without fully weighing the impact of price and valuation.
Meanwhile, the company had tied long-term incentive compensation to absolute and relative stock performance over a three-year period. This had the potential to align management with shareholder value creation, but it could also prompt the leadership team to take on too much risk – as it had when it started borrowing more to fund acquisitions.
The investment team believed that the company should improve the synergy between management incentive compensation and clear drivers of shareholder value creation. In the investment team’s experience, companies sometimes put too much emphasis on absolute dollar and growth targets and not enough emphasis on free cash flow generation and returns. Given the material impact of acquisitions on company returns, the investment team determined that it would be beneficial to have some portion of incentive compensation linked to ROIC.
Engaging with management
Manulife Investment Management’s ESG policy describes how engaging with company management can give investment teams “insights into management quality, business drivers, and the strategies of the companies in which they invest” and help them “assess companies’ risk exposure to ESG factors and the companies’ management of that exposure to protect shareholder value.”
Conversations with management can be especially useful in situations where the team has concerns about governance. They provide an opportunity to hear management’s side of the story – after all, there may be good reasons why the company made certain decisions – and also to provide constructive suggestions for improvement.
In this case, the team approached the company in 2018 to share its findings and concerns, explaining that connecting incentive compensation to ROIC would communicate to shareholders management’s long-term focus and demonstrate its commitment to align capital allocation decisions to shareholders’ interests.
The company was open to the dialogue and receptive to the concerns raised. As a first step, the company provided more transparency on its growth strategy in its 2019 annual report, including details on its inclusion of ROIC as a key financial metric. Looking ahead, the Manulife team plans to keep up an open dialogue with the company, as with all of the companies in its portfolio, and will continue to monitor issues such as executive compensation.
For more information about the Canadian Core Equity strategies managed by Patrick Blais and his team, visit the Manulife Fundamental Equity Team page.
1 ROIC = net operating profit after tax [NOPAT] / total invested capital [TIC]; NOPAT = net income + interest expense net of statutory tax [so interest expense × (1- statutory tax rate)] + amortization of intangible assets – any one-time deferred tax gains); TIC = equity (as recorded on the balance sheet) + net debt + cumulative amortization of intangibles (to capture what was originally spent for an investment) – the tax shield associated with the intangible assets (to capture the tax benefit of the intangible assets) – any one-time deferred tax gains. Note: “Any one-time deferred tax gains” are removed to prevent distortion of the recurring financial metrics of the company.
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