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.
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 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 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