Problems at the Top Table: Governance is the key
Paul Richardson, Chief Investment Officer – 17 April 2018
Corporate events over the last two months have been dominated by a demonstration of why Governance is key to company analysis. At Mint, our bottom up stock-picking approach includes a large weighting to an assessment of Board and Management. Whilst this tends to be qualitative and thus arguably more subjective than numeric financial analysis, we would argue that getting this right is in fact often where investment funds can generate best risk adjusted returns for their clients.
Over 2017 Fletcher Building admitted a widely suspected failure to tightly manage their construction projects in their B&I (Building and Interiors) division, having to take significant write-downs and provisions. The sight of the largest and longest running construction company admitting to an inability to make money at the peak of the biggest building cycle in decades, despite its near monopoly position in most building materials sectors was disappointing, to put it mildly. This has put its balance sheet under strain and unsurprisingly the US investors in its private placement (USPP) have been negotiating a possible restructure or possible repayment. What is even more serious is what appears to be a failure by the Board of Directors to oversee their appointed CEO and ask the right questions of the management over a long period. The result has been a change in CEO, a restructuring of management, a focus on restoring the balance sheet and a fee cut by the Board. Comments by the Chair, implying that they were misled by the information they’d received in previous management reports (presumably over the last 2 years) are hard to fathom, given investors have voted in these Directors to be their eyes and ears.
Fletcher Building’s (FBU) share price has nearly halved in the last 18 months and is down 25% over the last 5 years. The NZX50 index in comparison appreciated by 87%. On 17th April, the company announced a large deeply discounted capital raising to shore up the balance sheet, and some additional asset sales. Formica is one of these assets that is now up for divestment. It was acquired by FBU in 2009 for $1 bn with a stated expectation that it would make over $120m p.a. in operating earnings. However, in the decade following, operating earnings have never been higher than $80m and averaged $50-60. That is an estimated accumulated earnings underperformance of over $600m alone over this period. This highlights that it is not just the B&I division where there have been problems, with loses and provisions effectively wiping out 2 years of profits. Hard questions should have been directed right across the entity.
On 22nd January, Fonterra also admitted to major issues with its Beingmate Chinese investment. This information was confirmed later on 21st March at its interim result. Beingmate is an 18.8% minority position that cost c$700m and was expected to return in excess of $250m p.a. in operating earnings. Here again, there appears to be an admission of long term underperformance without really owning the problem, which resulted in a $650m write-down (however as Fletchers this figure increases to $1bn as there were no operating earnings). Again, in this case, the CEO is out. The questions remain though, of the Board of the parent, as to the steps they had taken to understand this risk exposure. The sight of Fonterra finally signing a deal to work with the massively successful upstart A2 Milk Co is also revealing. Over the last 5 years, the listed Fonterra (FSF) units have fallen by 19% compared to the NZX50 rise of 87% and ATMs price rise of 2,040%.
Then there is CBL Corp. This listed NZ based global re-insurer whose CEO won the EY Entrepreneur of the Year award in 2017 and was about to head off to the global round of awards when it announced to the market on 26th February that its main business CBL Insurance (85% of revenues) was going into voluntary administration and was under investigation by RBNZ. Documents released since then show that the RBNZ had demanded that CBL make no offshore payments but the company went ahead with them, and then had to liquidate. It now appears that the FMA and RBNZ had been investigating the business since last August 2017. The agencies had appointed an actuary to determine what its asset base really was, and has been quoted as having concerns about the entity’s ongoing viability. The NZX announcements reported all this in similar terms and its listing was suspended on 8th February. We do not have the detailed information yet, and this is all sub judicae, but it appears that the Board of CBL, that any analysts would consider a highly complicated and potentially risky business, may also have not been totally on top of the issues. Investors might also be entitled to ask if CBL was continuously meeting its disclosure obligations. It is hard to judge what will happen with CBL but not many firms get out of statutory management unscathed.
CBL joins a long list of IPOs of the 2015 vintage that have performed poorly – many which arrived with an attitude that professional fund managers were too cautious and unsupportive of their merits. Since then Intueri and Wynyard (and now possibly CBL) have failed. Evolve, Orion Health and Veritas to name a few have all tracked well below issue price. Initial disappointers EROAD, Gentrack, IkeGPS and Serko have bounced back due to positive execution - we are happy to report. However really only Scales, NZ King Salmon, Arvida and Vista, which were part of that IPO season, have performed well. In our view, one of the differences between the strongly performing and weakly performing stocks has been the quality of their Governance. Certainly, ranges of other factors are at play such as the industry dynamics and regulations, but we remain of the view that governance should continue to be one of the most important aspects of a firm. Assuredly, an aspect we need to be comfortable with before making an investment decision.
Serving as a Director of a listed firm is a tough gig. Only the really experienced and capable should apply, as the information asymmetry between the Directors, Management and Investors will always be there. Recently, the NZ Institute of Directors held its annual conference, which included an interesting and fulfilling series of panels and presentations. In our opinion, this would have been the right place and time for the Directors as a profession to recognise and focus in on further governance improvements – as it had been needed in some large listed company Boards over the last few months.
As we have said in earlier website Notes, our inclination in 2018 has been to own shares where we are still confident in the business quality and growth. We continually keep an eye out for under-appreciated stocks and sectors. We will continue to re-order our portfolios to reduce exposure to industries exposed to disruptive technologies, new government initiatives (such as tax policies and minimum wage increases) and we will stay overweight to export led stocks and to Australian growth stories. But as we said in the introduction, the assessment of the quality of firm Governance remains a major part of our approach to stock ownership.
Disclosure: Mint share funds currently own A2 milk, Scales, Arvida, Vista and Fletcher Building shares, and do not own Fonterra Share Units nor CBL Corp. shares. NB: Mint has a role of Chair of the NZ Corporate Governance Forum (www.nzcgf.org.nz).