The description for a Brandes webinar in October 2021, “Quality Shareholders: Who They Are and How Do They Add Value?” began:
By one definition, a “quality shareholder” analyzes company fundamentals, holds substantial stakes in a few for the long-term, and engages with management on specific challenges.
As noted, that’s one definition — one which does not apply broadly to the general practices of the investment management industry. Therefore, it is by no means a universal definition of a quality investment approach, but examining it raises questions for asset managers and those who evaluate them.
Companies
Philip Ordway of Anabatic Investment Partners, one of the panelists on the webinar, described “three things all companies need: Effective capital allocation, ‘good’ shareholders, and meaningful communication with stakeholders.” That spare definition emphasizes both the central role of capital allocation for company managers and the need for clarity as to purpose for all parties involved.
Ordway offered a long list of characteristics he believes are common among those managers/firms who are “adept at capital allocation.” It starts with an investing mindset, with the board and leadership “embracing” their roles as capital allocators and focusing on cash flow and per-share metrics — plus taking a long-term view and being willing to allow for autonomous decision making. Then there are the desired cultural qualities, including frugality, humility, and the willingness “to learn, adapt, be different, and look temporarily dumb.”
Just as interesting is his exposition of what not to do. That reads like a list of standard operating procedures for many CEOs, including making decisions regarding dividends and share repurchases that aren’t optimal (violating “Rule #1: Do not destroy value”), worrying about and playing to the sell-side community (and offering it “guidance”), and neglecting the power of communication to align owners and others.
By hewing to one or the other of these lists, “over time companies get the shareholders they deserve.” (For those interested in being in the first group, Ordway recommended practices for the board, executive team, and those involved in investor relations — “IR does not exist to please Wall Street, court favor with sell-side analysts, or get the stock price as high as possible” — and cited the importance of having an “owner’s manual” which lays out the operating principles for all to see, so that everyone is on the same page.)
Shareholders
Lawrence Cunningham, a professor at George Washington University, was also on the Brandes webinar. He has been analyzing what he calls “quality shareholders” for a number of years; the most comprehensive review of the work is in a 2020 book. The topics are also addressed in a paper of his.
Cunningham divides shareholders into four quadrants derived from two dimensions — their time horizon (or “vision”) for decision making and their level of conviction in position sizing. He refers to those who take a shorter-term diversified approach as transients, longer-term diversifiers as indexers, those who take concentrated positions for short periods as activists, and quality shareholders as those who invest in a concentrated way for the long term.
Using that construct, the asset management industry is dominated by the first two categories — indexers and transients. No doubt the use of the term “transients” would rankle those who find it applied to them; by process of elimination, that bucket would include a sizable majority of asset managers.
As Ordway does, the referenced paper argues the case that there is a mutual attraction between quality companies and quality shareholders. It also includes lists of companies and shareholders that meet the criteria for the respective categories, based upon research by Cunningham and others.
Others in the chain
What appears above is a pretty simple model of the world; in most instances the investment chain is more complicated than that.
The owners of an asset management firm, be they public or private entities, have expectations for returns on their ownership stakes. If the owners aren’t those involved in managing the assets (and are more interested in financial results than the investment tenets of the firm), conflicts can arise during the inevitable fallow periods that accompany any long-term strategy.
A bigger problem is that asset owners or individuals who invest with a manager might profess to understand its beliefs and intended approach, but then evaluate the manager through a performance lens in a way that is at odds with those precepts. Most asset flows (in and out) are in response to performance, making a manager’s job more difficult than it is for those who have a relatively stable pool of capital.
That is the crux of the problem, the reason why so few firms fit into Cunningham’s quality shareholder category. Their business models are predicated upon gathering assets, with the same strategy often being sold to different kinds of buyers with dissimilar interests and characteristics. In most cases there isn’t a unity of philosophy akin to the mutual attraction (albeit rare) between companies and shareholders described above.
To alter Ordway’s phrase: Over time asset managers get the investors they deserve. It’s very hard to run a concentrated portfolio with a long horizon if your investors aren’t in sync with your approach in good times and bad — and patience often runs thin.
Questions for discussion
If you are part of an asset management firm, how do you answer the questions below? (Asset owners, investment advisors, and others in the investment chain have related questions to ask themselves. Such introspection is an important part of continuous improvement.)
Into which of Cunningham’s quadrants would you place your firm?
What modifications would you make to his construct?
Considering Cunningham’s dimensions of time horizon and concentration, has there been a change in either or both in terms of your implementation over the last five years?
Should there be a change regarding either of those dimensions for you to generate better investment performance for the future?
How do you describe your investment philosophy?
What are the hard choices you have to make to implement that philosophy?
Are there any you haven’t made but should?
What percentage of your asset base invests with you because of your investment philosophy rather than other considerations?
Is there any way to better qualify potential clients given your business model?
What determines the “quality” of the companies in which you invest? Of the investors that you have?
How would the members of each of those groups answer a similar question about you?
A conversation between Cunningham and Ordway is available on MOI Global.
Published: January 4, 2022
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