Friday, September 28, 2012

Egregious management behavior

A company's management can make or break an investment.  Considering how important a company's management is to returns it's almost absurd to not consider the quality of management when making an investing decision.  At the same time adding a premium or giving a hair-cut to an investment for management quality is akin to double counting.  In theory the quality of a company's managers should be reflected in a company's results.  Companies with long sustainable track records of superior execution will most likely be run by above average managers.  A company that persistently bumps along in the bottom quartile most likely has poor management.  Unfortunately the idea that results always expose the quality of management is false.  Sometimes a great company is run by an idiot, and other times even the most skilled managers can't turn around a bad situation.  

One of the ideas I pound the table over on this blog is the concept of a margin of safety.  The idea is that every company has a fair value such as a private market value, a sum of the parts, or an industry accepted multiple of a given metric which can be considered an intrinsic value.  As outside investors we don't get to see how the sausage is made, so we have to make estimates when we valuing companies.  The idea is that if an investor purchases a stock at enough of a discount to the fair market value, or intrinsic value that if one or more estimates are incorrect the investor at worst won't realize a capital loss, and at best will still experience a gain.

One aspect rarely discussed with respect to the margin of safety concept is that a margin of safety also protects an investor against management stupidity.  In many, or most cases, managers interests are not aligned with outside shareholders.  This is one reason I prefer family-run companies with long operating histories.  As a minority shareholder my chances of being taken advantage of are reduced, not eliminated, but reduced.

Outside shareholders/minority shareholders are the black sheep of the business world.  In daily operations at most companies no one is thinking of how to conduct their behavior to maximize shareholder value.  In some circles maximizing shareholder value is just another synonym for cutting wages or staffing, neither high ideals.  Unless minority shareholders are concentrated catering to their interests and needs is very difficult for a company.  A company with 200 shareholders could have 200 different points of view and opinions on what a company should do next.  The board of directors is supposed to protect shareholder interests, but it's difficult.  Most boards don't know shareholders individually, and they aren't sitting across from them in a conference room like a CEO might be.  The result is often boards side with management when a conflict arises.

The above lays out the problem of shareholder-management relations.  I haven't said anything new, these are issues that people have been writing and speaking about since the corporation was created.  The purpose of this post isn't an expository essay on shareholder-management relations, but instead to inform readers that this is a matter of utmost importance, especially for value investors.  

To understand why this matters to investors I want to show three examples of management misbehavior.

Three examples

Solitron Devices

I've written about Solitron many times in the past, even going as far as writing a letter to the Board encouraging share buybacks and an annual meeting.  As of this post nothing has come from my letter except a boilerplate response.  In response to my letter a reader took it upon himself to research the company and get involved.

The reader is someone who I email back and forth with fairly frequently and is a very intelligent individual.  I say this because after reading his experience some people might just brush off his story with a simple explanation like maybe he didn't ask the right questions, or say them the right way.  Unfortunately his experience with the CEO of Solitron isn't unique, I've heard the same story repeated almost verbatim a few times.  He detailed his experiences in talking to the CEO of Solitron and trying to get in touch with the Board.  The story is chilling for any minority shareholder (myself included):


Some readers might not follow the link so I want to include a quick summary.  In short valueprax contacted the CEO of Solitron with a number of general questions regarding Solitron's business.  The CEO stated he couldn't talk on the phone and that valueprax should email him his questions.  He did and was given the run around.  Valueprax then decided to try to contact the two independent members of the Board.  The highlight of the story for me was that one Board member refused to talk, he just sat silently breathing into the phone and in the background his wife complained about how annoying the phone calls were getting.

The problem at Solitron is their CEO only owns 30% of the company, yet runs it as his own private company.  The company hasn't held an annual meeting or a directory election since 1994.  According to valueprax's story the company hasn't had an actual board meeting in years, possibly decades.  Corporate governance at Solitron is a complete sham.  There is no board who can or will represent shareholders.

Usually management malfeasance is associated with large salaries and huge perks, that isn't the case with Solitron.  Without a properly functioning board the CEO is running the company unrestricted, and shareholders, the true owners are ignored.  Keep in mind if all of Solitron's shareholders united they could vote out Mr. Saraf along with the Board and replace it with individuals who represent shareholder interests.  

Pioneer Railcorp

Pioneer Railcorp is a holding company that owns a number of shortline railroads across the US.  The assets themselves are very high quality, and the company operationally has done quite well.  Shareholders have done alright, but they would have done much better if senior management hadn't looted the company.  Keep in mind Pioneer is a small company, they did $19m in sales last year, and have a market cap of $18m.

Pioneer fits the stereotype of management abuse, there are too many things wrong to even enumerate them individually.  How about we start with the salary being paid out to the former CEO, $457k a year for 20 years.  Operating income would increase 10% if this overhead didn't exist.  At this point many readers will brush off the salary as a non-issue, of course, what company doesn't pay their CEO an excessive amount?  And who cares about severance pay, everyone's doing it right?

The severance is only the beginning, the former CEO also gets paid $220k a year for being a director.  Taking home $770k for attending a few meetings is quite the cushy job!

The worst part is a complicated transaction the company entered into with a third company Heartland.  Heartland is a vehicle to hold the former CEO's Pioneer stock, Heartland pays the former CEO a payment of $12k a month for the option to purchase his stock.  Heartland might never own any of his stock, but they're paying for that option monthly.

There is another strange transaction with Heartland that I don't quite understand.  For me the value of the assets and the company were overshadowed by the behavior of the former CEO.  What further sealed the deal was when I googled the former CEO's name and found articles alleging that he was channeling money from Pioneer to fund a strip club empire he runs in Las Vegas.  The strip clubs had run afoul of the law numerous times both in Illinois (where he previously lived), and in Nevada.  If an executive is running into legal problems in a known seedy industry with a lot of leniency I can't imagine what that says about how things were run when he was at Pioneer.

TSR Technical

TSR Technical is a company that does IT staffing in the NYC area.  The company is a net-net and is severely undervalued.  I'd seen the company written up on Whopper Investments in the past.  A reader with a lot of experience in both unlisted stocks, and shareholder activism emailed me today.  He mentioned that he wrote a letter to TSR outlining how management behavior was out of line.  Over the past few years as the company's profits have declined management pay has only increased.  A summary on my part would't do Tony's letter justice so I've asked permission to share it below:




How to take action

I hope the takeaway for most readers is that management behavior and actions can't be overlooked when researching an investment.  I'm sure though that some of the egregious behavior called out in this post has some blood boiling, it makes mine boil.  The thought that someone who owns a less than 50% of a company can divert profits from shareholder to their own pockets is disturbing.  The fact that many managers engage in this sort of behavior is completely unacceptable.

So what can a minority shareholder do to fight back?  The first action is to vote proxy's for companies that issue a proxy.  The second is to do what Tony has done and write the Board a letter.  Sometimes writing a letter doesn't work and stronger action is required.  Jeff over at Ragnar is a Pirate is trying to get Solitron shareholders together to force a proxy and annual meeting, this is a huge step in the right direction.

My concluding thought can best be summed up in the following quote: "Don't just sit there, do something!"


Disclosure: Long SODI, I own 1 share of PRRR

10 comments:

  1. Nate,

    Interesting post as always. A thought going back to Buffett's early days that I always took with me is that if you are going to deal in this world, you need to have the capital to effect change (i.e., buy enough to really have a say). Sanborn Map was the perfect example of this in terms of the lengths you have to go in order to create the catalyst.

    Munger always hits on incentives and unless you (and me) can create an incentive for them to make changes (we have enough votes to fire in other words) nothing will happen.

    Not saying these investments should be made without the capital (we have to make it somewhere), but it should be kept in mind.

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    1. I think I agree but I'm not sure. There are plenty of cheap companies where management behavior is less than ideal, but the price paid more the compensates for it. I've mentioned it in passing, but never written specifically on it, but I like family controlled companies. I feel a family with a long operating history is less likely to screw shareholders, because they'd be hurt as well.

      I think prudence needs to be applied when pushing a company. Some companies (such as Pioneer) are so bad that I just avoid them entirely. Others are bad and need a prod or two. Some are bad, but are so cheap, and won't change I really don't care (Hanover).

      The great thing about the internet is that I don't have to have a ton of capital to effect change, just a loud voice and a large audience. It seems with Solitron the ideas I proposed hit a nerve with shareholders, I haven't heard from ANY who disagree with me yet (except for Saraf), so it's a matter of leveraging this loud voice.

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  2. Hey all:

    A lot of people are seeing what is going on in these small companies and they are not pleased.

    Don't underestimate the pressure a dozen motivated shareholders can exert.

    These old guys are set in their ways, running a sleepy company, going smoothly, getting paid.

    All of a sudden, they start getting letters. They are mentioned in unflattering articles. Their name is associated with "bad things" on the search engines. Shareholders are calling them, asking questions. Members of the board are getting jostled.

    Next step, the lawyers start getting involved. That will get their attention.

    Management will need to either:

    A). Reform their behavior & seriously consider shareholder demands
    B). Buy out the meddling shareholders
    C). Take the company private

    The internet is going to facilitate activists getting together. By themselves, an individual activist will have little power. Combine a dozen of them, and you very well might get some action.

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    1. Thanks for the comment, you summarized a lot of my feelings on this. The internet gives a lot of us smaller holders a voice because we can band together and have our voice heard.

      The reality is for most of these unlisted companies the end game is one of three things:
      1) continue business as usual
      2) merger
      3) go private

      The best we can do as shareholders is try to force 2 & 3, that's where value is realized. Unless management somehow suddenly gets religion 1 isn't going to be the best route.

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  3. Surprised you didnt mention FFI. The first merger attempt was obscene, and the revised merger is likely worse.

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    1. It's not just FFI, if I started going through some of the companies I've run across with these issues no one would finish the post.

      FFI is terrible, what they did originally to minority shareholders who were bigger than the oddlot was cruel. For someone to buy in after the price drop it had potential, but they really did screw existing shareholders. I expect this same deal to be the same. I sold my 500 shares for a nice gain, I have no desire to build a position or see where things head.

      I was planning a followup post on FFI once the proxy hit, nothing so far.

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  4. I bought a small position in PRRR in 2009 so I could truthfully email them as a shareholder (I knew they would not request proof, but I don't like to lie) and request the annual report. I promptly sold my shares after reading about the compensation for the retired CEO. I started investing in the fall of 2008, so this was shortly after I started reading Qs and Ks. Even as a newbie I could easily see how management was using the company like a piggy bank.

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    1. I understand the sentiment, I'm holding onto my share just to continue to receive annual reports. I can't see myself increasing my position unless something radical with the Heartland situation changed. This is truly a piggy bank for the ex-CEO.

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  5. I find I generally prefer the family owned businesses as well. When you've put so much blood, sweat and tears into building something out of nothing you treat it a little differently. Or for me, maybe it's more of a founder still running things (and owning a big %) that can get me really interested.

    As you mention though, one always has to be careful! Probably you're aware of the Adelphia scandal (Rigas family self dealing), but that's a good one to read summaries of to have some red flags in the back of your mind.

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    1. William,

      You're right, family owned companies are no guarantee against bad behavior, but they do set the hurdle higher. A family owned company is no excuse to close your eyes to what's going on. I think Pioneer Railcorp is a good example, a founder with a large stake who'd rather loot the company than let it grow.

      Thanks for the comment!

      Nate

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