Shareholder activism: How we failed to create value in 800 hours
Burton Flynn and Ivan Nechunaev
“If you don’t like something, just sell your shares” – this is what the chairman and controlling shareholder of one of our portfolio companies tells investors. In fact, he offered to buy our shares after his CEO eagerly shared with him our thoughtful recommendations for unlocking value in the company, which we spent an entire month developing.
Another company offered us a board seat but never used the well-crafted investor presentation we built for them. A third company’s CEO politely said he “appreciated our efforts”. And when we revisited the fourth company six months after our month-long ESG advisory project, they still had no idea what ESG was.
These were the fruitful outcomes of the four month-long friendly shareholder activist engagements we conducted last summer with the help of four MBA research analysts from the Wharton School and Harvard Business School who each travelled to a different country and spent 200 hours 1) comprehensively analyzing one of our portfolio companies and presenting our thesis to the CEO for feedback, and 2) developing recommendations to the CEO for improving the company’s ESG standards in order to unlock value for shareholders and create positive impact for other stakeholders.
A month at a Vietnamese rubber manufacturer
While rubber production is the $300m agricultural company’s original business, they have extensive legacy land holdings from their rubber plantations and recently started monetizing these lands. The company’s monetization strategy involves selling some of their unused lands and partnering with developers to build industrial parks for Chinese companies establishing operations in Vietnam due to cost efficiencies and the US-China trade war pushing manufacturers out of China. We bought the company’s shares before the market realized the value of their land and future industrial park cash flows. In the subsequent six months the stock price had nearly doubled. We sought to discover whether there might be more unrealized value or if the upside had already been captured.
Evaluating the firm’s prospects, we hit the ground running. We met with the company’s chairman, CEO, COO, and other senior executives, asked them to complete our detailed proprietary ESG questionnaire, and took a tour of their rubber plantations and the industrial park. After these meetings, we sought to do differentiated primary research to determine the company’s business prospects by meeting with three other investors, sell-side analysts from all major Vietnamese brokerage houses, several lawyers, an investment banker, and a competitor. We also visited three other industrial parks, discussed the economy with a local Wharton alumnus who is a real estate investor, and gained more insights about the Vietnamese real estate sector from a Bloomberg reporter that covers the region.
Upon learning more about the company, its competitors, and the market dynamics, we built a sum-of-the-parts valuation, separating the firm’s rubber and real estate businesses. Based on this analysis, we concluded that the then-current stock price required the company to meet the next few years of its optimistic strategic plan without delays and without any room for error. Even more, the prices of industrial real estate in Vietnam would have to continue climbing for years, despite being at historically high levels. Although lately there has been a rush to develop industrial parks in the country, we were concerned about the risk of a real estate bubble given how fast prices had already risen. Additionally, the company would need to secure multiple approvals and permits in order to achieve its steady pace of land sales, and despite the Vietnamese government’s progress on initiatives to liberalize its economy there is still heavy government involvement in economic decisions such as land sales and zoning which creates bureaucratic bottlenecks.
We also found that the company had a complex and misaligned shareholding structure: the controlling stakeholder is a Vietnamese state-run agricultural company which is also a customer, competitor, and major shareholder in the subsidiaries of our company. The circularity and complexity of this shareholding structure allows the government to potentially play on both sides of the table in land deals that the company intends to sign, and we found that there were very few independent individuals who could represent the minority shareholders’ interest in key company decisions such as real estate transactions.
Our recommendations to management were to 1) improve transparency of financial reporting to shareholders by showing the real estate and agricultural segments of the business separately; 2) establish an independent valuation committee to approve land deals with the Vietnamese government; 3) post an investor presentation on the company website; 4) introduce an employee stock incentive program; and 5) be more transparent regarding their environmental and social risk management.
Given the high valuation and risks inherent in executing multiple years of land sales, we exited our entire position at an attractive return. Our deep-dive analysis paid off: six months after selling, the stock price had dropped 40% as the company was unable to realize a major land sale with the government and has not received government approvals to develop certain lands into industrial parks.
At the entrance gate to the industrial park of a $300m Vietnamese rubber company turned land developer
A month at a Malaysian semiconductor servicer
A $400m high-end microchip assembly, testing, and packaging solutions provider domiciled in Malaysia – which we have owned for over two years – serves some of the biggest technology and automotive names in the world and is one of the most experienced and profitable companies in its industry, consistently delivering strong performance. However, it remains deeply undervalued as it trades at just above 3x EV/EBITDA, far below its peer group. We wanted to better understand why. We also thought the CEO would be receptive as he had been very keen to receive feedback from us during our previous interactions.
Our first meeting was at the company’s main operations two hours north of Kuala Lumpur in the heart of Malaysia, where hundreds of machines the size of industrial refrigerators were lined up and whirring as people in white lab coats and jumpsuits closely examined microscopes. We met with the CEO, CFO, plant operations manager, and line employees. To determine the market’s perception of the company and what it would take to unlock additional value, we also met with six sell-side analysts who cover the stock as well as three major local investors. Additionally, we made site visits to two of the company’s competitors, met with their management teams, and attended their investor briefings.
As a result of these efforts, we gained several important insights. First, customers expect prices to decrease by 10% per year, which requires constant process innovation. To stay ahead of the curve, the company is investing heavily in automation and expects to have one of its sites fully automated within months. They have an intricate culture of constant training to improve business efficiency and effectiveness, and have undertaken several initiatives to reduce electricity consumption by 10% per year. Second, the company’s revenue has historically been driven by its consumer electronics segment (primarily cell phones) which has become a mature industry with thinning margins. To address this threat, the company has positioned itself to capitalize on the automotive segment which sees a growing demand for electric and autonomous vehicle sensors. Third, the company is expanding its product line within the industrial segment to capture growth driven by artificial intelligence, automation, and the internet of things. In addition to accelerated growth, these industries also provide higher margins than the consumer electronics segment.
After comprehensively benchmarking the company’s ESG practices against those of peer companies, we learned that although its operating, environmental, and social practices were best-in-class, investor transparency is lacking. The company didn’t have a dedicated investor relations professional, investors’ access to management was limited, and there were gaps in disclosures regarding growth drivers, key customer segments, capex expectations, and cash management strategy. For example, the company hasn’t communicated to investors what the cash – equivalent to 50% of annual revenues – would be used for. Additionally, the company’s absolute stock price was higher than that of 97% of companies on the Malaysian stock exchange, making it difficult for many retail investors to own shares, and as a result trading liquidity was very low. The company had also recently lost its compliance with Islamic investment standards, making it uninvestable for many Malaysian institutional asset managers.
Our recommendations to management were to 1) enhance transparency by providing detailed information on strategy execution, performance, and product lines, issuing regular press releases, improving company marketing materials, hiring an investor relations officer, and participating in investor roadshows and conferences; 2) improve cash management by increasing dividend payout ratio, declaring a special dividend, or performing an accretive acquisition; and 3) increase investor accessibility by performing a stock split or bonus issuance, and regaining Shariah compliance.
Although we attempted to increase our position following our deep dive, we struggled to find enough liquidity in the market. The stock price had increased by nearly 50% before the coronavirus crisis but even after retrenching still remains positive.
After presenting our analysis and recommendations to the CEO of a $400m Malaysian semiconductor servicing company
A month at a Philippine land holding company
Over the past three decades, a $50m Philippine holding company we added to our portfolio last year has accumulated a vast land bank in Batangas, one of the largest and fastest-growing provinces located just a couple of hours south of Manila. Land values in this industrial, agricultural, and manufacturing hub have skyrocketed in recent years as a result of several structural tailwinds: 1) improving connectivity between Manila and neighboring provinces due to the ambitious government infrastructure program which aims to boost infrastructure spending to 7% of GDP from 2% during the previous administration, 2) robust economic development driven by increased foreign investment and the migration of businesses out of congested Manila, and 3) a diverse tourism market that has seen more than 500% growth over the last six years. The company owns land in locations with prime development potential – near national roads, parks, schools, white sand beaches, premier dive sites, tourist attractions, malls, and a major port and industrial zone – and is the only listed property business with significant presence in the region. However, because the company had previously made little effort to monetize its land assets and return any of this value to shareholders, it has no sell-side coverage, is sparsely known by the domestic investment community, and trades at only 0.2x book value. We invested in the company after they began to demonstrate a commitment to pursuing more consistent land sales (many at 5-7x cost) and generate recurring revenue through joint ventures with developers and operators. As the company’s first foreign institutional investors, we saw an opportunity to help hone their monetization strategy, professionalize the business, and increase transparency, unlocking further shareholder value.
The day after arriving in Manila, we had our first of several meetings with the CEO, COO, chairman of the board, an independent director, and the executive overseeing the company’s communication with investors. To gain a deeper understanding of the value of the company’s land assets, we met with their local property management team in Batangas and spent a day touring all properties, including the newly constructed Monte Maria center, a five-hectare pilgrimage site home to the world’s tallest Virgin Mary statue – somewhat akin to Brazil’s Christ the Redeemer – which will open to the public in 2021. Because there are no other institutional investors or sell-side coverage, we liaised with 15 Philippine Wharton alumni to conduct background checks on the company and better apprehend the competitive dynamics and trends in the region’s property market. We also met with four local and global real estate investors, executives of three of the largest developers in the Philippines, and government officials including the governor of Batangas and the former undersecretary of the Philippine tourism department. During these conversations, we reviewed case studies on developments in the regions just north of Batangas that have seen strong commercial and residential real estate growth over the past five years, and discussed ESG and sustainability practices in the Philippines and how property companies were evolving to meet the country’s updated sustainability requirements mandating the issuers to publish sustainability reports.
Based on our conversations with business leaders in the real estate industry, we learned that Batangas is still in the very early innings of its development and is at least several years away from having meaningful infrastructure able to accommodate an influx of residents from Manila. That said, the province’s industrial and economic growth is strong, and completion of major highways and railways (still 3-5 years out) should be a key driver for the property market, providing attractive development opportunities for landowners over the long run. By extracting price data from the major real estate marketplace websites on comparable land assets and researching the transaction prices of recent land sales in the region, we found that our estimated market value of the company’s land on a per-square-meter basis well exceeded book value (which reflects conservative third-party appraisals that occur on a rolling three-year basis), suggesting that the company owned significantly undervalued assets that could rerate as it begins selling some of the land at the current market prices.
While we gained greater conviction in the thesis that land prices in Batangas were poised to benefit over the long term, the company lacked a well-defined strategy for monetizing their assets, and failed to communicate the value of their land to investors. They had no investor relations professional or marketing materials, and their website had not been updated consistently to adequately disclose recent land transactions or JV partnerships. Furthermore, the company owns stakes in a number of small and unprofitable subsidiaries – such as gold and coal mining rights, a gaming company, and a development bank – that add an additional layer of complexity to the business and its ESG practices.
Our recommendations to management were to 1) commit to more consistent land sales and reward long-term shareholders with a regular dividend; 2) streamline the business by divesting from non-core subsidiaries and sharing a written strategy with investors; 3) improve transparency to potential investors by publishing an investor presentation disclosing up-to-date information on all land assets, joint ventures, and affiliates (which we even created for them as part of our engagement), updating their website, and hiring a dedicated investor relations professional; 4) grow the team to remove the human-resource bottleneck, and create a succession plan; and 5) introduce separate board committees chaired by independent directors.
Given the deep value inherent in the company, we maintained our position. While the stock price has performed in line with the broader market, we enjoyed a 20% dividend yield from the company’s strengthened commitment to monetize land assets and return cash to shareholders.
On top of the world’s tallest Virgin Mary structure, one of the real estate assets of a $50m holding company in the Philippines
A month at a South African furniture retailer
A $100m South African credit furniture retailer trading at 9x P/E was added to our portfolio two years ago as they recorded revenue growth for the first time after nearly two years of declining sales caused by the stricter regulatory requirements for lending to low-income consumers, the company’s main target audience. They had also just moved to diversify their business with an acquisition of a high-end furniture brand which didn’t rely on credit sales. As we hadn’t yet seen this translate into an improvement in earnings, we wanted to gain a deeper understanding of the business and provide our perspective to management.
After meeting with the CEO and CFO on our first day in South Africa, we proceeded to visit over 25 furniture stores of the company and its competitors in Cape Town, Johannesburg, and Pretoria, and interview 10 store managers and eight customers. In addition, we triangulated our in-store research with an analysis of online employee and customer reviews. We also met to discuss the company with four local investors (including two activist investors), three sell-side research analysts, a credit risk expert, a compensation expert, and a beneficiary of the company’s scholarship program.
From our store visits, we learned that the company had tightened its in-store credit approval process in an attempt to improve the quality of its debtors book and thus reduce bad debt expense, the company’s second largest cost after wages. However, not only is this likely to dampen sales as 60% of purchases are financed through credit, with the South African consumer under pressure the bad debt problem will likely intensify despite their best efforts. As Warren Buffett said, “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Through our due diligence, we found opportunities for operational improvement in the company’s omnichannel strategy: although the online store has the ability to drive long-term growth for the company, when we tried to place an order via customer service, it took three attempts to get through to a representative. Additionally, the store managers did not have the capabilities to order merchandise online on behalf of their customers, some of whom are far from being tech-savvy. In terms of governance standards, we discovered that the company has all six provisions of the Entrenchment Index: golden parachutes, poison pill, a staggered board limiting shareholders’ ability to replace board members, and supermajority requirements for mergers and amendments of the charter and bylaws. These provisions provide incumbents with protection from removal, leading to adverse effects on management incentives and behavior. This degree of entrenchment only exists in about 1% of the companies in our universe, and is empirically associated with both reductions in firm valuation and large negative abnormal returns. Additionally, we found that three out of the five “independent” board directors have board tenures of over 10 years (which breaches the definition of independence in many countries), and the firm has maintained the same audit firm for 29 years (fewer than 5% of companies in our universe had same auditors for so long or longer). Finally, management has done a poor job of communicating with investors: they only attend one conference a year and spoke to just one analyst in the past year.
Our recommendations to management were to 1) reduce insiders’ degree of entrenchment by eliminating the six provisions found in the E-Index and defining term limits for the board of directors; 2) reduce the chance of accounting manipulation by adopting a policy of rotating the audit firm every 10 years, and by appointing a majority-independent audit committee; 3) ensure that existing call centers are functioning efficiently; 4) improve integration of the online store with the physical stores by facilitating a mechanism whereby store managers can place online orders, and utilizing physical stores as a delivery hub for online sales; and 5) enhance investor communication by attending more conferences and organizing investor roadshows.
The dismal state of the South African consumer, the significant potential harm to shareholders through such a severe degree of entrenchment, and subpar independence and audit practices led us to sell our shares in this holding, saving us from the subsequent 60% decline.
After presenting our analysis and recommendations to the CEO and CFO of a $100m South African furniture retailer
During our deep dives, we received strong engagement from the companies. Management responded to questions quickly, openly, and politely. However, we knew that the true test of the companies’ commitment to improve their ESG practices was whether they would take recommended actions after our meetings. We were disappointed to see none of our recommendations implemented despite our vigorous research and engagement. However, given that this was our first experiment with friendly shareholder activism, we saw this as a learning process and took away several lessons that will guide our future engagements.
First, we should focus on companies that have ownership structures more conducive to implementing our recommendations. The more receptive companies were those controlled by a family for which the company represents a large portion of their wealth, whereas a company which was the smallest of multiple listed subsidiaries was hard to get the billionaire owner’s attention as it just didn’t move the needle for him. And trying to convince the CEO of a state-owned enterprise whose compensation was not tied to the company’s performance was even harder.
Second, we must identify the key decision makers and ensure that they are truly willing to implement improvements and this is surprisingly often not the CEO but rather the chairman or a member of the controlling shareholder family. As minority shareholders, we can never force a company to make changes. This is especially true when dealing with companies controlled by a single shareholder or family, as is the case with most companies in emerging markets.
Third, an effective engagement must go beyond simply making recommendations; it requires building relationships, inspiring, convincing, exciting, and consistently following up. Demonstrating deep due diligence and presenting our understanding of their business for feedback is a good start. But we need to be more explicit about the astonishing degree to which the market is misvaluing their business due to a few fixable gaps. We also need to help them appreciate our unique perspective as foreign investors who see hundreds of companies a year across dozens of markets and know what other foreign investors care about.
Fourth, we should start by recommending small easy fixes that cost nothing and have a big impact on shareholder value realization, such as reporting in English, publishing a detailed investor presentation, and going on a first roadshow. While some of our recommendations were such low-hanging fruit, the CEOs may have been overwhelmed by some of the bigger recommendations we made. Ideally, after they see the benefits from the quick wins they will come back and ask us for more. Then we can move on to ideas like changing governance provisions, paying a dividend, buying back shares, and divesting non-core assets.
Fifth, we need to provide more compelling evidence for how each recommendation can increase the value of the business. To accomplish this, we are continuing to review academic literature, working on rigorously analyzing the ESG data we have collected from hundreds of companies, and analyzing the outcomes of companies which have made such changes.
Sixth, we might want to avoid using the term ESG. Even though most of our recommendations are environmental, social, or governance-related, we found that the acronym may be a non-starter for many managers as they confuse it with CSR and see it as an additional cost rather than a means to grow the value of the business. Rather, we must consider alternative ways to frame the same recommendations.
Finally, although nearly all of our recommendations were governance-related issues, in the future we would like to identify more opportunities for environmental and social impact. The easiest way to do this is by compelling managers to include in their investor presentation a few slides disclosing key metrics. By shining a flashlight on these previously undisclosed issues, they should naturally improve over time. The next step is publishing sustainability reports. But we think the ultimate goal should be to help companies identify the Sustainable Development Goals to which they would be most well-positioned to contribute through their business operations. We envision accomplishing this through collaborating with a special SDG task force at the company, and by vying for inclusion of ESG-related KPIs into executive compensation.
We appreciate the excellent work of the MBA interns who helped with the project:
Apoorv Kumar (Wharton MBA ‘20 / Penn Law ‘20): Vietnamese rubber manufacturer
Alexander Dempsey, CFA (Wharton MBA ‘20): Malaysian semiconductor servicer
Nathan Baird (Wharton MBA ‘20): Philippine land holding company
Karen Nyawera (Harvard Business School MBA ‘20): South African furniture retailer