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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP679: Quality Shareholders by Lawrence Cunningham w/ Clay Finck
01:12:16
Clay Finck discusses Lawrence Cunningham's book — Quality Shareholders: How the Best Managers Attract and Keep Them.
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Clay Fink
You're listening to tip. Hey everybody. Welcome to the Investors Podcast. I'm your host, Clay Fink. I'm absolutely thrilled to bring you today's episode as I'm going to be chatting about this wonderful book titled Quality Shareholders by Lawrence Cunningham. Lawrence has an impressive and diverse resume. He's the Director of the John Weinberg center for Corporate Governance at the University of Delaware. He's also the Vice Chairman of the Board at Constellation Software and a Director at Markell and Kelly Partners Group. When it comes to corporate governance, there is no one better to learn from than Lawrence. Cunningham's also written a number of other excellent books including Quality Investing, Berkshire Beyond Buffett, Margin of Trust and the Essays of Warren Buffett. When I first discovered the book Quality Shareholders, I thought it had somewhat of a cheesy title. I mean, why would a company or its managers really care who their shareholders are? Then once I started digging in, I discovered that the shareholder base is actually incredibly important and good managers should work to attract quality shareholders. As Cunningham puts it, anyone can buy a stock in a public company, but not all shareholders are equally committed to a company's long term success. Today's companies need quality shareholders, as Warren Buffett called those who load up and stick around or buy large stakes and hold for long periods. During this episode I'll cover what constitutes a quality shareholder versus other shareholder types. The edge that quality shareholders bring in terms of their investment approach, how quality shareholders impact the share prices of public companies, what managers can do to attract and retain such shareholders, how quality shareholders view executive compensation the number one job of the board in delivering value to shareholders, and so much more. This book was an extremely fascinating read and it really resonated with me on so many levels as a quality oriented shareholder my myself. So with that I bring you today's discussion on Quality Shareholders by Lawrence Cunningham. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors podcast network. Since 2014 we studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host Clay Fink. I wanted to kick off today's episode with a quote from John Ruskin. Quality is never an accident. It is always the result of intelligent effort. So what does it mean for a company to be high quality? And how can shareholders be high quality themselves? This term quality can be hard to define, but oftentimes we know it when we see it. And this concept of quality is what led me to want to do a thorough review of this book by Cunningham titled Quality Shareholders. For those in the audience who may own and operate their own private businesses, they may have full control of that business and have full control of who can buy and who can't buy an ownership stake in that business. But for public companies, they don't really have that luxury. Essentially, anyone can buy share in a public company. However, this doesn't prevent managers from trying to attract certain types of shareholders and repel other types of shareholders. Cunningham believes that overall, the quality shareholder population has been shrinking and the goal of the book is to grow the cohort of quality shareholders and to add to the elite group of companies and leaders who can attract them. While being a quality shareholder is not strenuous, it does require patience and diligence. One of my favorite sayings from the book that Cunningham shared was a quote from Buffett in his 1979 shareholder letter, eventually managers get the shareholders they deserve. And I think this ties into just so many things in life. Of course, there are some things in life we can't necessarily control, like the country or city we're born into, the family we're born into, et cetera. But there's something to be said about, you know, we get the friends we deserve, or we get the job we deserve, or we get the spouse we deserve. And I'm also a big believer that tip gets the podcast listeners that we deserve. It also ties into the saying that from Munger, in order to get what you want, you have to deserve what you want. Managers have a way of attracting certain types of shareholders, and this book gets into just how that process works. So we broke up this book into three different parts. Part one covers the importance of quality shareholders and the edge that quality shareholders have. Part two covers quality engagement and how managers can attract a quality shareholder base. And part three covers the features of corporate governance, which includes director selection, executive pay, and shareholder voting. So to get this episode kicked off, let's discuss why quality shareholders are just so important. For many managers of public companies, short term oriented shareholders remain a major concern. In the mid-1990s, shares of Berkshire Hathaway started to get quite expensive when looking at the dollars per share value. In 1995, it was valued at over $24,000 per share. And then when you look at the median household income in the US it was around $34,000. So one share was quite pricey for sure. A few shareholders decided that they were going to pool their Berkshire shares together into a trust and then issue fractional interest at vastly lower prices. So Buffett believed that this was going to attract short term traders and undercut everything that Buffett was trying to accomplish with Berkshire's cultivation of long term committed shareholders. So as a result, in 1996, Berkshire elected a dual class share structure of the A shares and the B shares that we all know of today. Originally 30B shares would be equal to 1A share, and then in 2010 they did a 50 to 1 split. So now it's 1500B shares are equivalent to 1A share. Another challenge for many managers is that the dominant shareholder cohort overall are index investors. These investors might passively buy and hold something like an S&P 500 to just participate in the overall market, but the vast majority of investors simply aren't going to know 500 companies well and be able to share an informed opinion should a shareholder vote take place. So in the book Common Stocks and Uncommon Profits, Phil Fisher likened to companies to restaurants. Just as each restaurant has a different menu that caters to different tastes, companies cater to different shareholder preferences. Cunningham explains that in 1979, Buffett took this another step further. Companies draw particular shareholders by communicating a specific corporate message backed by action. The message produces a self selected shareholder base to match along dimensions like time horizon, ownership levels and engagement. While all companies have some mix of index investors, short term oriented investors or traders, value investors or potentially even activists, Buffett has tried to attract only what he calls high quality shareholders. Cunningham describes these shareholders as those who buy large stakes and hold them for long time periods. High quality shareholders view themselves as part owners of a business. They try to understand the businesses they own and focus on the long term results, not the short term market prices. Shares of Berkshire Hathaway have declined by over 50% on three different occasions under the leadership of Warren Buffett. And had the quality shareholders continue to focus on the long term results that Berkshire provided. I'm sure that the vast majority of them were just unfazed by the declining share prices and potentially even bought more shares when the market offered the business far below its intrinsic value. Back in the 1980s, Buffett was able to almost exclusively attract high quality shareholders. He was able to do this in the way he managed Berkshire and the way he communicated to his shareholder base. He shared in one of his Letters, in the 1980s, if you looked at a one year period, 98% of shareholders at the end of the year were shareholders at the start of the year. So there was just so little turnover in the shares and who was going into and out of the stock. When you looked at a five year time period over 90% of shareholders remained shareholders at the start of year one through year five. And almost all Berkshire shareholders were held by concentrated investors, with Berkshire being the largest stake in their portfolio, more than twice the size of any other stock they had. Buffett's quality shareholders helped contribute to Berkshire's success. They gave Buffett a long term Runway. They promoted a rational stock price, and they deterred shareholder activists from wanting to break up the conglomerate as it continued to grow larger and larger. But today, other shareholder cohorts have come to take a larger stake in companies like Berkshire. And of course, we've seen the rise of index investing. As much as 40% of public companies are owned by index investors or closet index investors, which are investors who essentially own hundreds of stocks and aren't likely to vary too much from the index in terms of performance. And each shareholder segment brings something to the table. But they don't come without drawbacks. So activists, they can promote management accountability, but they may not necessarily think long term and they could even become overzealous. Index funds enable anybody to achieve market returns at a low cost, but they can't understand the specific details of every company they own. Traders offer liquidity to the market, which is simply pretty amazing to think because any of us can just go buy and sell any security with a few clicks thanks to this liquidity. But traders have a short term focus and might not even care about the underlying fundamentals of the business they're buying or selling at all. Cunningham writes that a substantial cohort of quality shareholders balances the shareholder mix and counteracts these liabilities. Quality shareholders can help managers repel activists who are taking things to the extreme and want to take the business in a direction that is undesirable for the managers and the quality shareholders. For example, in 2019, Ashland Global holdings received calls for a quote unquote strategic review from an activist. The company then reached out to its quality shareholders who formed a united defensive front and the activists proceeded to back off and withdraw. Unlike the index investors, quality shareholders know their companies well. And unlike the traders, quality shareholders think long term, which is a fairly rare trait in today's short term oriented world. In recent decades, there's also been three rising trends among institutions. First is the rise of index investing, of course. So in 1997, less than 8% of mutual funds were indexed and today more than 40% are. Second is the substantial shortening of the average holding period, indicative of increased trading for arbitrage, momentum structure strategies and other short term drivers. And then the third trend that we've seen in recent years is the rise of activism. So many managers face the constant threat to corporate control from rival firms, takeover artists, and colorful raiders. So it wasn't until the past two decades or so that specialty firms developed that were essentially dedicated to the practice of shareholder activism. So there are many repeat players like Bill Ackman, Dan Loeb, and Paul Singer. Another challenge for managers is that with the increased diversity of shareholders come different demands from each of them. So some shareholders might not even be focused on the potential for an economic gain in their investments. So when you look at some shareholders, they might push for something like a labor agenda, or others might push an ESG agenda that managers don't necessarily agree with. Cunningham highlights three traits that distinguish quality shareholders from other cohorts of shareholders so the first trait here is conviction. Quality shareholders view themselves as part owners of a business, and true ownership of a business requires conviction that is developed through thorough research and disciplined decisions. Investors who enjoy studying businesses or micro analysis will likely enjoy such an approach to investing. Others might view stock investing as buying a security that has the stock chart they can see that's updated minute by minute. Or perhaps they simply view it as a stream of future cash flows or a political instrument. The second key trait for quality shareholders is patience. Cunningham writes here. Quality shareholders are generally risk averse. Sustained patience reduces both reinvestment risk and expense risk. On reinvestment risk, selling shares results in capital needing to be reinvested, and finding new outstanding investments is time consuming and difficult. On expense risk, trading and taxes are immediate costs of selling, disguising the stated nominal returns that draw attention. Owning outstanding companies for very long time periods not only limits expense risk but reaps the benefits of compounding. Quality shareholders are not motivated to beat the market in any given year, but to generate returns over long periods of time. Steeled with patience and discipline, quality shareholders sleep well at night. Untethered from slavish attendance to the index and unburdened by urgent trading needs, they favor low volatility portfolios that can mostly tend themselves. End quote. I just loved that passage there from Cunningham. So many great points to ponder on. I just really resonated with it as well. And I really desire to be that type of shareholder myself in the businesses that I own. The third key trait is engagement. Quality shareholders help grow and develop the businesses they own through the supply of patient capital. They want to promote the best long term interests of the business and its shareholders and aren't interested in promoting matters that are outside the scope of the company's mission or managerial skillset. They're happy to engage with management, but usually prefer to do so in a private and not public manner, like the activists. That's not to say that activists can't be quality shareholders as well, and that their voices shouldn't be heard. However, managers typically prefer to have quality shareholders who aren't activists trying to shake things up. This also brings the question whether an individual investor is better off investing in index funds or investing in great businesses for the long run. On the one hand, there's the argument that most professional investors underperform the index, so what chance does this give, you know, an individual investor like myself? But on the other hand, you can clearly see that when you look at many of the managers who do outperform that we've interviewed here on the show. Having conviction and having patience when holding these great businesses can bring handsome rewards to shareholders. So you can refer back to the interviews I've done with managers who have outperformed the market. This includes DevContissaria, which is coming up here in December. Francois Vershon, Joseph Shaposhnik, Derek Palecki, Richard Lawrence, Pierre Langevin, and John Huber, all of which are proponents of buying and holding wonderful businesses at fair prices. With the increasing share of index fund investors, this may also provide opportunities for stock pickers. For example, it might lead to market distortions where some great businesses that aren't included in the index aren't getting these massive passive flows and are thus mispriced or underappreciated by the market. Or great businesses outside of the US are naturally overlooked because they aren't included in the S&P 500. Now, that's not to say it applies to, of course, all types of companies that aren't in these segments, but it's maybe a good place to go fishing. Pivoting the discussion here slightly, one way in which shareholders can make a difference is the shareholder vote. So while most shareholder votes are decided by a wide margin, there are at least a few hundred annually that are close calls in terms of which way they go. With companies like BlackRock and Vanguard owning sizable stakes in thousands of companies through these ETFs, there's no way that their stewardship staff, you know, of just a couple, dozens of people, will be able to make an informed decision on each vote. So many index funds are essentially outsourcing their decision making regarding shareholder votes to two large proxy advisory firms. So that's Institutional shareholder services, or ISS, and Glass Lewis, which combined control 97% of the market. And these advisory firms, they share voting recommendations based on best practices to optimize for a portfolio of companies rather than looking at each particular situation. And research shows that institutional investors are substantially more inclined to vote for proposals that advisors support rather than oppose. And Cunningham shares that while proxy advisor recommendations tailored to particular cases, they often add value to shareholders, but those based on general guidance without specific research do not. And this is really where quality shareholders can play a key role of countering ill advised proxy advisor recommendations. In one case in 2005, ISS recommended that shareholders withhold votes for Warren Buffett to become the director of Coca Cola. So Buffett had been a large shareholder of Coca Cola since 1988, and despite the clear alignment of interest with fellow shareholders, ISS believed that there was a conflict of interest with Berkshire Hathaway subsidiaries, including Dairy Queen, who was a customer of Coca Cola. And Cunningham referred to this as the all time loser for blind adherence to proxy advisor general guidelines. As I mentioned earlier, Quality shareholders can be a deterrent to activists seeking short term gains. If there are large stakes owned by Quality shareholders, then it may be more difficult for an activist to influence the management team. So in 2018, activists at Elliott Management, they signaled impatience with managers of Pernod Ricard, which is a spirits firm with 16% of the shares owned by the family. One of its quality shareholders, Tom Russo, had a $850 million stake in the company. And Tom Russo was actually interviewed by my colleague William Green on the Richer, Wiser, Happier podcast that was episode 13. Russo is well known for partnering with management teams that have the capacity to suffer and sacrifice short term gains for long term value creation. In the case of the activism taking place at Bernard Ricard, he stated, you have a classic case of a business that could show a lot more today if they choose to. I still think our best course of action is to invest meaningfully at the expense of operating margin today for more wealth tomorrow. End quote.
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Clay Fink
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Lock in a 6% or higher yield with a bond account only at public.com forward/wsb that's public.com forward slash WSB brought to you by Public Investing member FINRA plus SIPC. As of 926 2024, the average annualized yield to worst across the bond account is greater than 6%. Yield to worst is not guaranteed. Not an investment recommendation. All investing involves risk. Visit public.comdisclosures/bond account for more info. All right, back to the show when companies are behaving a bit unconventional, it certainly helps to have shareholders who understand and appreciate the unconventional conventional approach or have that capacity to suffer. Cunningham even takes it as far to say that having a large base of quality shareholders can help serve as a competitive advantage for the company because it helps managers keep in long term outlook. So another example is Markel, who's led by CEO Tom Gaynor. In Markel's 2016 letter to shareholders, it writes, we believe that Markel remains unique among most publicly traded companies in emphasizing the forever time horizon as much as we do. That is an immense competitive advantage that very few organizations enjoy. The only reason we remain free to do so is that you, our shareholders have placed an immense amount of trust in us. And Cunningham also adds that having a quality shareholder base that puts trust in management generally puts less pressure on the management team to produce short term results so that they can put more focus on the long term. I think with some businesses, if you have a lot of shareholders who want results now, whenever the company disappoints, the shares are just going to sell off a lot with shareholders bailing and you might have a lot of volatility in the stock both to the upside and the downside with all these momentum traders going in and out of the stock. For a quality management team that attracts a quality shareholder base, I think it's the opposite. There's lower volatility in the stock because it doesn't attract as many investors looking for a quick buck. And when the company disappoints, you don't have as many shareholders bailing because they believe in management's ability to execute over the long run. This generally keeps the share price trading in a range close to the intrinsic value most of the time, which also means that you won't get a ton of opportunities to buy at bargain prices. Gaynor also expanded more on this competitive advantage. He writes, having the right owners with a suitable long term time horizon provides us with an immense competitive advantage. In today's world, short term and artificial time pressures permeate too many decisions. Our dual time horizon of forever and right now allows us to make necessary right now decisions on a day to day basis, but we always get to make those decisions with the forever mindset guiding us while we do so. That is an incredibly rare advantage in today's world. End quote. Another benefit of quality shareholders is that they can actually help serve the company in some form as well. For example, in 2005 Berkshire Hathaway appointed Sandy Gottesman of First Manhattan to the board and he was the company's second largest shareholder behind Warren Buffett since 1966. Constellation Software has benefited from the board service of Steve Schochmer, a distinguished Canadian investor and a substantial shareholder, for decades. Cunningham doesn't disclose this in the book, but he himself is also a quality shareholder and he serves on the board of Markel, Constellation Software and Kelly Partners Group. Most are probably familiar with Markel and Constellation Software, but Kelly Partners Group is a small accounting firm that is quite an interesting business model they've compounded rapidly and I interviewed the founder and CEO Brett Kelly on our YouTube channel, which I'll be sure to get linked in the show notes as well. We also had Brett Kelly join our Tip Mastermind community for a Q and A earlier this year. And Lawrence Cunningham will also be joining the community for a Q and A on Zoom in late December 2024. So tying back to Cunningham's point on the company's stock price trading close to the intrinsic value I had a few questions with regards to this that I just wanted to share here with the audience. So the first question with regards to this is who's to really say what a high quality company is really worth? And second, how can this one segment of shareholders really dampen the volatility and keep it within a somewhat reasonable range? So you have these short term traders that prefer to get the highest share price possible so they can get the most out of their position for a quick buck. And quality shareholders are generally uninterested in the immediate sale and they're generally attuned to stock market volatility more broadly, so they prefer a share price that bears the most rational relationship possible to the company's intrinsic business value. So for managers, having a stock that is overpriced can actually be an issue for a few reasons. The first reason being that if you want to pay employees with stock, they may come to find out at a later date that they were given a bad deal. So they might have been given shares at $100 a share, but they would probably be upset if those shares are actually worth around $50, and the stock ends up reverting back to that $50 range at a later date. The second reason that an overvalued stock is not necessarily favorable is that if shares are used to make an acquisition, then the seller may come to find out that they were given a bad deal. And the final reason is that an overpriced stock can actually attract short sellers, which usually aren't a lot of fun to deal with, as Elon Musk can attest to. Cunningham claims that there's evidence that suggests that companies with ownership dominated by quality shareholders tend to enjoy stock prices that are less volatile and more rationally tied to business value. And then I love the way he puts it here. Ben Graham famously called the stock market in the short run a voting machine and the long run a weighing machine. To update that insight, voting today is principally done by indexers and transients or short term traders, while weighing is the contribution of the quality shareholders. End quote. And when you think about it, it really makes a lot of sense. You know, these index fund buyers are simply just buying regardless of the fundamentals. It's just passive flows. While quality shareholders, they may be buying more shares when the stock is undervalued and just hanging on, or not buying more shares when the stock's too high or it's less rationally priced. So part two of the book covers quality engagement, which outlines the strategies that managers can use to attract and retain quality shareholders. In the intro here, Cunningham explains that managers can do some basic things that are likely to be overlooked by indexers and transients. A lot of these things don't really cost much. They include corporate mission statements, annual shareholder letters, and annual shareholder meetings. He explains further that quality managers encapsulate the corporate personality in a mission statement. They share insights on challenges with a thoughtful annual letter, and they reflect on both the mission and challenges together at an engaging annual meeting. They can also do things like not give in to Wall street and make quarterly earnings guidance and opt for a longer term focus. Above all, they can make a cautious commitment to what quality shareholders value most, which is effective capital allocation. This refers to a simple but elusive idea that treats every corporate dollar as an investment put to its best use. Next year, Cunningham gets into the corporate message. He says that the corporate message a company sends should actually suit the company and is distinctive. It needs to be honest and true. So one thing that Berkshire Hathaway did was publish an owner's manual that explained in simple terms their business, the goals, philosophy and limitations Here are a few items that were included in that owner's manual. Although our form is corporate, our attitude is partnership in line with Berkshire's owner orientation. Most of our directors have a major portion of their net worth invested in the company. Our long term economic goal is to maximize Berkshire's average annual rate of gain and intrinsic business value on a per share basis. Accounting consequences do not influence our operating or capital allocation decisions and we will be candid in our reporting to you, emphasizing the pluses and minuses important to appraising business value. Prem Watsa from Fairfax Financial is another great example of someone who had these solid principles internally within the business and then eventually he started sharing them publicly as well. He emphasized their focus on growing long term book value per share and not quarterly earnings. They're always looking at opportunities, but they put a particular emphasis on downside protection and look for ways to minimize loss of capital. They encourage calculated risk taking and look to learn from their mistakes. Cunningham also shares a few examples of weak versus strong mission statements. So a weak mission statement uses clever rhetoric or empty slogans. So for example, one weak mission statement he shares here is to be the best in the eyes of customers, employees and shareholders. End quote. And then we can contrast this with a strong mission statement. He shares one from Walt Disney, Creating Happiness through Magical experiences. So you look at employees, you look at shareholders, they're both going to love this and generally they're going to believe it to be true. Now when I do read some of these mission statements, like one from Nike and Sony, it's hard for me to really differentiate between a strong versus a weak one. But maybe it's an area you can look to sort of sift out some of the phonies in these management teams and try and differentiate the strong versus the weak ones. So next we turn our attention here to the annual letter. Cunningham explains that an artfully drafted shareholder letter provides insights into the company's values, culture and outlook. He has one sample here from Tom Gaynor that explains that in order to be a successful company, Markel needs to be aggressive and be willing to make mistakes to win. An unhealthy fear of mistakes can lead to being too passive or too fearful. It is important to be willing to act positively and accept reasonable mistakes so that the organization can learn and grow and deal with a rapidly changing world. So since the annual letter is both optional and regulated, it allows the CEO to convey both the personal and corporate personality and is an excellent tool in attracting quality shareholders. Many CEOs simply don't bother with writing an annual letter, and those who do most of them don't necessarily write letters that are actually worth reading. If one were to search for the best written shareholder letters by CEOs, you would likely see the same ones coming up over and over again. Luckily for us, Cunningham also wrote the book Dear Shareholder, which shares the best executive letters from a number of great CEOs, including Buffett, Watsa, Mark Leonard, Jeff Bezos, Robert Gozetta of Coca Cola, Weston Hicks of Allegheny, Brett Roberts of Credit Acceptance, among others. Most great letters are easy to read and easy to understand and score high in clarity and candor. They're upfront about the challenges facing the company. In fact, it might even be a good sign that the challenges are highlighted much more than the triumphs, because it helps build trust and shows that the CEO doesn't have a big ego. The way one executive put it in relation to his subordinates is that he was much more interested in hearing the bad news than the good news, because it's the good news that tends to take care of itself. Another common theme is the CEO growing into the letters, producing great work that gets better and better over time. Amazon shareholders were one of the lucky few where Bezos he wrote an exceptional shareholder letter the first year they went public, which attracted many quality shareholders. It was so good that he even appended it to the ensuing shareholder letters. In the future, as a host here at tip, I've reviewed countless letters written by fund managers and vetting guests who come on the show, and for the vast majority of them, they almost all read the same we look for a competitively advantaged business with high returns on capital, and we look to pay what we deem to be a fair price. For such a company. You want to look for someone who has some authenticity and they're a bit original. It doesn't just straight up copy what Buffett and these other super investors have said. I just revisited Francois Rochon's fund letter from 2023 and I had Francois on the show earlier this year. On episode 626 he shared the story of meeting Charlie Munger. He displayed a picture of them from 2002 and then he also shared a story from McDonald's from the 1960s where there was this dispute between Ray Kroc and Harry Sonneborn. Sonneborn believed that the economy was about to enter a recession, while Kroc believed that they should just ignore any recession and just focus expanding the business. And then over the next five years, of course, sales for McDonald's grew from $51 million to $385 million. It just makes trying to time the market or time the economy just look straight up silly. With the benefit of hindsight, of course, but I think that still carries through to today, which is why Franchua shared that example. And then there's what Cunningham refers to as the golden rule. Buffett says he writes to provide shareholders information he would want to have if their positions were revers. So if some CEOs try and explain things and it's just really complicated, that's going to turn away a lot of quality shareholders that might not be super familiar with all these technical terminology. And it just is really difficult for a lot of people to understand. Next, here we turn to the Annual meeting. The annual meeting is another opportunity for a company to share their culture and their vision for the business. Prior to the 1930s, annual meetings were something that nobody really wanted to attend. They achieved very little and probably weren't that interesting. As individual share ownership increased, the popularity of annual meetings started to increase as well. So by the early 1960s, there were 10 meetings that would attract 1,000 shareholders or more. In 1975, Buffett hosted his first ever annual meeting for Berkshire Hathaway. It attracted around a dozen attendees in the Omaha office cafeteria. By 1985, he would attract hundreds of people. 1995, thousands. 2005, tens of thousands. And then nowadays we of course have 40,000 plus heading to Omaha for the Berkshire meeting. As for the 2025 meeting that's coming up. That'll be the first weekend of May. TIP will be hosting a number of live events for our TIP Mastermind community, which is our vetted community of private investors, portfolio managers and high net worth individuals. We'll be having two dinners and socials and then a bus tour to see much of what Omaha has to offer and then really just give members the opportunity to network in person. I'll have the link to join the waitlist to apply for the community in the Show Notes for those interested and then also TIP is going to be hosting a couple of free events for our audience members. Those are going to be on Friday and Saturday evening and Sean O'Malley, my colleague, will be organizing these. You can reach out to sean@sean theinvestorspodcast.com that's S H A W N and also have a link in the show notes for more information on how you can attend the meeting and more information regarding the trip to Omaha. If you do plan on going to Omaha, I would highly recommend getting your flights and hotels booked as soon as possible as they tend to get quite expensive as we get closer and closer to the event. And it's of course one of the biggest events of the year for Omaha, so attracts a lot of people from out of town. The Berkshire meeting features the six hour Q& A session with Warren Buffett and a whole weekend of events. So while I do enjoy attending the Berkshire meeting at the Chi center, my favorite part really is just connecting in person with like minded people that I typically only get to see around once a year and some of which are members of our Mastermind community and others might be guests we have on the show here or people I work with at tip. So that reminds me of one of my friends, Alex Morris, who writes the popular blog the Science of Hitting. He also has a book coming out in January 2025. It's titled Buffett and Munger Unscripted and it covers three decades of investment and business insights from the Berkshire shareholder meetings. And I know that there's also a podcast out there that has most of the meetings recorded and published online for free, which is really a great way to take in all of Buffett and Munger's wisdom in an audio format that they've released over the years. One of my favorite things that Munger said when the tribute was played in the 2024 meeting last year, he referred to the Berkshire annual meeting as a celebration. He said that celebration is part of making a group of people work well together. It's a celebration and you can just see it and feel it at the meeting where all these shareholders there, they feel like they're part of this community out of any company in the world. It's very likely that Berkshire has the most quality shareholders. And I think that community feel that a business can generate can almost be like a positive reinforcing cycle that helps keep quality shareholders in and that attracts new quality shareholders each year. So this strong quality shareholder base can help attract and retain new quality shareholders. And Cunningham argues that while many companies have transitioned to a digital format for the annual meeting, executives who practice the live in person meetings can have a competitive advantage in attracting quality shareholders. This brings us to the discussion on quarterly contact with shareholders. So there's some debate on forecasting and whether they're a good thing or not. There's no legal requirement for companies to publicly forecast their upcoming performance. And this is a practice that has started to spread in the 1980s and 1990s. And I think it's safe to say that analysts just love forecasts since it helps them put together their own forecasts. Cunningham, however, believes that the drawbacks of quarterly forecasts far outweigh the benefits. The first reason is that forecasts are not information, they're predictions and guesses. Given the vicissitudes of business, no one can be highly confident in them, no matter how carefully they're developed. The second reason Cunningham doesn't like forecasts is that they take enormous time and effort to develop, which could be used for more important tasks. And then the third reason is that forecasts can turn into goals or really a test for the business. And this can also create these perverse incentives and potentially lead managers to optimize for the short term to the detriment of the long term. For example, management might decide to cut their R and D expenses to boost eps, which might look good for that quarter. But if R and D has a high return over time, then that would be a decision that actually destroys shareholder value. Because of these reasons, Cunningham states that quality shareholders oppose quarterly guidance since they're more interested in maximizing long term shareholder value. Quarterly conference calls pose a similar challenge to quarterly guidance. The quarterly calls also aren't required, but they might be useful in a sense of updating shareholders on recent trends and answer questions that they might have. While there may be some good information provided on the quarterly call, much of it might prove to not be very useful. Maybe some of the questions from analysts aren't really that helpful. They might be interested in selling securities instead of asking more strategic questions that you'd hear from quality shareholders. And I've heard some quality shareholders speak in the past about how a lot of businesses just don't require a quarterly update like an annual is just fine for a lot of businesses that don't see a lot of change quarter to quarter. So turning to the useful metrics for shareholders While much of assessing a great business is qualitative, professor Peter Drecker said, if you can't measure it, you can't improve it. This brings us to the question, which metrics should managers and investors use to measure business performance? Quality shareholders want to know which metrics management uses in assessing the business's performance, and they want managers to be consistent in the metrics they're using and not switching and using just what happens to be best during that specific time period. And they want to know why that metric is chosen, what's the rationale and the reasoning behind it. Economic profit is one example. This is a metric that's been used by Credit acceptance. In their 2017 annual letter, CEO Brett Roberts stated, we use a financial metric called economic profit to evaluate our financial results and determine incentive compensation. Economic profit differs from GAAP net income by subtracting a cost for equity capital. Economic profit is a function of three variables the adjusted average amount of capital invested, the adjusted return on capital, and the adjusted weighted average cost of capital.
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Clay Fink
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So in the case of credit acceptance, they're sharing this measure to assess their performance and then help give quality shareholders a sense of how the business is actually performing over year to year or long time periods. Investors need to be careful though, because sometimes these non GAAP measures can be an opportunity for management to try and paint a rosy picture when reality really isn't so bright. Munger he used to call adjusted EBITDA BS earnings. I think that especially for more novice investors or maybe newer investors should probably be careful about trusting these other measures provided by management that might overlook key expense items like amortization, depreciation or even stock based compensation. So the GAAP or the IFRS numbers, they offer a lot of value to investors because it allows them to easily compare businesses using a common system. But every company is unique and it requires a tailored metric to show how it's performing. Investors should probably utilize both the accounting numbers and the metrics that are provided by the managers to assess the business's performance. I think this also ties in well with one of the realities of investing, which is that great companies usually don't grow in a smooth, straight line. Buffett would often say that he doesn't smooth quarterly or smooth annual results. He would actually prefer a lumpy 20% return over a smooth 10% return. So I think if you're holding a great business, we should expect some earnings misses that don't meet the transients or the short term investors expectations and understand that if you're expecting a 15% return on average, some years are probably going to be below that and some years are probably going to be above that. And transients hate the uncertainty of such results, which I think can give even quality shareholders an advantage if they're patient in letting the management team perform over time rather than expecting great results every single quarter. Tom Gaynor wrote in his 2013 letter, at many organizations, volatility causes people to go nuts. Experience has shown they're tempted to tamp down and pretend that the world is a smooth place. We do not share this delusion. We think that unnaturally attempting to minimize reported volatility would diminish long term profitability of the company and work against the interests of long term owners of the firm. End quote. I think oftentimes it can be those plateaus in the business that can actually sow the seeds for the company's next leg of growth. So I'll use an example here of a company I own. It's a company called dinopolska, which is a convenience store or grocer out of Poland. In 2024, they've been facing a number of headwinds that has led to slower growth for their business. So Poland, they just issued a 30% increase in the minimum wage and that directly increases Dino's expenses. With Poland's economy slowing down significantly, it's actually teetered on deflation. So Dino's competitors have started to drastically cut prices and run these marketing campaigns. And this is likely to be pretty short term pressure on Deno as it really isn't a sustainable practice by them. And then the Polish consumer is just financially strained. A couple of years ago they had nearly 20% inflation and that's now come down and normalized. And then Dino is also working on building out these new distribution centers which are going to be used for the future stores that are going to be built and that depresses 2024 earnings. So I think some of these headwinds will soon dissipate or potentially even turn into tailwinds. For example, with the minimum wage increase in theory, I would expect consumers to now have more purchasing power. And over time this is going to boost Dino's top line and bottom line. And once their distribution centers are built, they're going to be able to use those to help fuel future growth. And this really ties back into Tom Russo's point of management, focusing on the long term and having that capacity to suffer. And despite these headwinds Deno is still in an excellent financial position relative to their competitors, and they continue to reinvest all of their cash flows into future growth at a high rate of return. And they've also seen their store growth slow down in 2024. So management expects 270 new stores in 24, and then they're looking at around 350 stores in 25. I think if they're able to continue to have a high return on invested capital on these new builds and the recent stores start to hit maturity, you'll see revenue and earnings growth start to normal and pick back up. But we shall see. Cunningham has a chapter on capital allocation, which of course we discuss extensively on the podcast here. I like how he thinks about capital allocation and sort of the order of operations of how capital should be allocated. So first he explains that excess cash should be reinvested back into the business when the return on invested capital exceeds the business's cost of capital. And then you take what's left over and you either allocate that to buybacks or acquisitions, and this should be utilized if they are value accretive to shareholders. So for buybacks you want to purchase when the shares are trading below the intrinsic value, and if neither of those are a great option, then excess cash should be returned to shareholders in the form of dividends. And it's really that simple. If you look at Berkshire Hathaway, they've never paid a dividend because they're always either reinvesting, going and making acquisitions, putting this even excess cash on the balance sheet, or doing repurchases when the price makes sense to the management team. Cunningham made a couple of interesting points with regards to share issuance and share buybacks. Disciplined managers rarely or don't ever use shares to fund an acquisition. He writes that using stock can inflate the price of the purchase and it almost feels like play money or it feels like poker chips. Then it feels like actual cash, which can be a bit dangerous for many managers. I think one of Buffett's biggest mistakes was issuing stock to purchase Dexter's shoe, and that ended up being a flop. He used shares in the early 90s and that compounded his mistake. And then with regards to buybacks, buybacks are essentially purchasing shares from the more short term oriented shareholders, which actually increases the company's proportion of quality shareholders, which I thought was a super interesting point. There's and then since quality shareholders are attuned to good capital allocation practices, they tend to shy away from managers who overpay during buyback periods. And ideally, the company's more opportunistic with buybacks. It goes to Buffett's line of being greedy when others are fearful and fearful when others are greedy. Next, we have part three of the book here, and this is a section titled Pivot Points. And this highlights three salient features of corporate governance, which includes director selection, executive pay, and shareholder voting. So starting here with director selection, Cunningham discusses one board that scored the highest marks for outstanding corporate governance. They had 15 distinguished members independent of management, and numerous committees which all composed of independent directors who were diverse in gender, race and skill set. And they were all displayed on the company's website. So the role of the chairperson and the CEO was also held by different individuals. So a noted scorer of governance, quote unquote best practices. They voted this company one of the best five boards in corporate America. And under this board's oversight, the company it led collapsed in a multibillion dollar flame out. The company he was describing here was actually Enron. Ever since the collapse of Enron over two decades ago, corporate players have debated the board's role and boards continue to struggle with their oversight. So in the 1970s, corporate directors were typically chosen by the CEO. And then from the 1980s to the early 2000s, institutional shareholders started to play a bigger role in selecting directors and emphasized that the director should have greater independence so that there's less conflict of interest. Quality shareholders seek directors with a shareholder orientation. They're business savvy and they have a true interest in the particular company and its stewardship rather than simply following perceived best practices. Cunningham writes here, the number one question quality shareholders have about any director candidates is whether they are shareholder oriented. That is, all directors should act as if they're a single absentee owner and do everything reasonably possible to advance that owner's long term interest. So as a result, it would make sense that the director held a sizable personal stake in the companies that they serve. So they themselves are owners. And the board's most important job is to select an outstanding CEO. And all CEOs must be measured according to a set of performance standards. If the CEO doesn't live up to the board standard in terms of performance of the business over, we can call it a reasonable time period, whatever reasonable means, then it's the board's job to just replace them if they aren't upholding those standards. And above all, quality shareholders care most about substance when it comes to corporate governance. They want really sound reasoning behind particular policies, and they aren't interested in checklists that prescribe good Governance indexers, on the other hand, are concerned about their performance of their overall portfolio rather than the performance of a particular company. So they might prescribe policies that might benefit the whole, but might not even really apply to one specific business because the indexer isn't particularly interested in the individual company. You start to see why an engaged quality shareholder can be so powerful. So think of someone like Tom Russo, who might have great connections, great insights or questions about a business that can be helpful to the board or helpful to the management team. And when you have a long list of engaged quality shareholders, it can really help create that competitive advantage for the business that we've discussed next. Here I want to discuss management compensation and performance. It seems that excessive compensation for your typical CEO is just what you expect with many of these large Fortune 500 companies. And the audience is likely familiar with the statistics that show that executive compensation has risen much faster than the compensation of your typical employee at a firm. And when you look at the shareholder base, these short term investors are transients and activists. They rarely consider executive compensation index. Investors, of course, are extremely passive in this arena, leaving it to the quality shareholders to help hold the board accountable on how much executives are paid and what incentives are in place with regards to compensation. There's also a history of corruption with regards to executive compensation. So in 2005, a number of companies were discovered to be manipulating stock option grants. They were backdating some of them to make them profitable and issuing others. On the eve of the news, which was calculated to drive the stock price up, Professor Eric Lee from the University of Iowa, he uncovered some statistical anomalies which led to investigations on more than 100 companies. And many had to restate their financials. And many executives were fired as a result of the investigation. And it's no secret to most boards that in order to get the outcome they desire, they need to incentivize the outcome they desire. One problem with some compensation packages is that they aren't necessarily symmetrical. So it might represent a great pay on the upside if the company performs. But the managers might not feel the pain if their efforts don't pan out favorably. So this is much of what's at play during the 2008 Great Financial Crisis. Many people on Wall street were taking extraordinary risks to the detriment of others, and they didn't feel much of the pain, if any of the pain. Cunningham writes. Credit markets failed in part because managers took huge gambles, as there was huge possibility for upside and limited downside to their pay, end quote. So stock options are quite prevalent, of course, in pay packages, which can also lead to poor incentives, because they could get a huge payoff if the stock goes up. But it's just like something like a slap on the wrist if it doesn't pay out. And Cunningham believes that to recruit quality shareholders, the best companies actually avoid stock options or they actually report their costs faithfully to shareholders. So this led to more regulations on the case of executive compensation. So there's three points here. So first, stock exchange rules require independent board compensation committees to set pay and decide disclose related policy. The second point here, companies must disclose the ratio of top executive pay to that of the median employee. And then the third regulation is that every three years, companies must hold formal shareholder votes on pay and ask shareholders every six years whether to make those votes more or less frequent. Many companies that are popular among quality shareholders make it a point to have the executives receive a moderate salary relative to their peers. So here are a few extreme examples that help set an example of how shareholder friendly just some managers can be. So, Warren Buffett, of course, he has a salary of $100,000, and it's remained at that for 25 years, and he receives no bonus. So $100,000 to Buffett is practically nothing. So the only way he really benefits financially from the success of Berkshire is through the increase in the value of the shares he owns in Berkshire. And then Mark Leonard from Constellation Software, he's actually waived his entitlement to a salary and a bonus. And then he's also made it a point to keep the number of shares outstanding in Constellation Software at 21 million shares. And it's remained at that since the IPO in 2006. So no executives are just being handed out shares. And if you'd like to learn more about Constellation, I've reviewed Mark Leonard's letters back on episode 531, and Chris Mayer and I chatted about this company in depth on episode 608. And full disclosure, I do own shares in Constellation and dinopolska, which I'll be tying in here as well. So for Dino Polska, another one of my holdings, the founder and chairman, Tomas Biernowski, he owns 51% of the shares, and he also receives zero compensation. And then as of the time of writing, Cunningham found 250 top executives who received a very small salary. It was typically around $1 for at least one year over the past decade. And then if you extend that out over at least five years, when looking at the past decade, you'd find around 35 executives. So it's pretty rare to have CEOs or executives that get very little compensation. He mentions companies like Expedia, National Instruments and Post Holdings. Now these are obviously extreme examples. I think exceptional CEOs should be paid a reasonable salary at least. A CEO might earn 5 million, 10 million or even north of 100 million at a large Fortune 500 company and also add significant value to the business. But I think it's something to keep an eye on, because if a CEO is way overcompensated and they aren't really performing well, then one has to consider just how shareholder friendly they really are. It's also worth mentioning that taking no salary isn't always a great sign. There's a few examples of CEOs who have taken this approach to try and send a signal of a selfless commitment to a company's recovery. So Cunningham points out Chrysler in 1978 or Citigroup in 2007. We should also keep an eye on options packages and see if there's a big payout that's really coming for some of these types of executives. And then the last chapter in the book here is on shareholder voting, which I'll briefly touch on here before we wrap up the episode. Now, the traditional share structure was simply one class of shares where each share represented a proportional equal voting right. And over the past 10 to 20 years, dual class share structure has actually become more common. So one class of shares has more voting rights. And this allows someone like a founder to raise equity capital without giving up total control of the business. So Mark Zuckerberg, for example, he owns 14% of the shares in Meta, but he actually has over 50% voting rights. This can of course be beneficial, assuming that the majority owner for the voting rights has a long term mindset with the business. And it's worked out well for Meta, of course. And you don't want someone like Zuckerberg simply doing this to try and enrich themselves in the short term to the detriment of the broader shareholder base. And I can certainly resonate with the dual class structure because oftentimes with these good businesses, they can raise equity capital. The founder gets deluded and the new shareholders just want to take the company in a direction that doesn't align with the founder or with the founder's original vision. And the founder just loses control of their life's work. Phil Knight from Nike, he stated that he wouldn't have taken Nike public without the dual class structure. To help improve the outcomes of the voting process, Cunningham walked through a few different types of alternatives and proposals that have been considered over time. He mentioned time weighted voting. This considers how long the individual has been a shareholder. So the longer you've been a shareholder, the more weight your vote would have. And then other ideas he shared is removing index funds from the voting process altogether. And then Cunningham wraps up the book by stating no shareholder group can deny the essential functions quality shareholders play. They're a sounding board, constructive criticism, champion of the long term and ultimate arbiter of capital allocation and business value. The bottom line is that the quality shareholder cohort brings enormous value to companies and shareholders alike, as well as the markets generally. Corporate managers are likely to continue to get shareholders. They deserve, and most deserve a high density of quality shareholders. End quote. And then there are some interesting points in the appendix here that I wanted to share. So he includes a list of the top 20 quality shareholders. This includes firms like Berkshire Hathaway, Baupost Group with Seth Klarman, Fiduciary Management, Skopje Capital, Kensico Capital, Viking Group, and Matrix Capital. And then he looked at the portfolios of these quality shareholders and which stocks were most commonly held. So from top to bottom, here I'll share a few. So Alphabet was owned by nine of the 20 Facebook or Meta, and Microsoft, it was owned by six. And then we have names like Amazon, Visa, Alibaba, Thermo, Fisher, United Health, among others. Now one reason I've really enjoyed going through this book is because I truly believe that TIP has such a high quality listener base. When we host these live events, I just get to meet some wonderful people. And ever since we launched our TIP Mastermind community, I continue to just be so impressed by the caliber of the people we're able to attract. Members operate their own businesses or they recently sold their business to dedicate much of their life to investing. And some members even work for large multibillion dollar asset management firms. So if you're considering going to Omaha, I would really encourage you to make the trip. I think a lot of people, they envision almost going to Omaha. They envision it just being a lonely experience. They're sitting alone at the meeting. They're not the type to go and introduce themselves to people. But one of the things I really love about TIP is that we're able to connect these quality listeners and quality people together at events like the Berkshire meeting. So that's why we're hosting events for our Tip Mastermind community. And then Sean O'Malley will be hosting free events for our listeners as well. So if you're on the edge about going. I would definitely encourage you to go while Buffett's still around. I've been to, I believe, five meetings and I've been going the past three years and then I went to a couple before COVID shut down the annual meeting. So if you have any questions, feel free to reach out to Sean or I. Sean's email is sh a wn@theinvestorspodcast.com and then mine is clay theinvestorspodcast.com with that. Thank you so much for tuning in to today's episode and I hope to see you again next week. Thank you for listening to tip. Make sure to follow we study billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses go to theinvestorspodcast.com this show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. 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