People see the world from where they sit.
Central bankers approach the world from a money perspective. They argue that since money drives the economy, reducing the price of money will result in more borrowing and buying, prices will rise and the economy will grow.
As a fund manager, he saw the world in terms of productivity and investment and wanted businesses to thrive, Allan Gray’s chief investment officer, Andrew Lapping told a group of financial advisors at the Investment Forum 2018.
This was not about forecasting the future – which was impossible to do – but about trying to determine what assets were really worth, he added. In doing so, investors had to avoid being steered by the price of a security, market chatter and management. Instead, they had to focus on the long term, whether a business was sustainable and consider the cash-flow the business would generate through the cycle.
To determine what was really going on in a business, investors required facts, Lapping said.
“The strange thing is management often actually try and obscure the truth from you as an investor. They are not necessarily frank.”
The frightening aspect is that management is often misleading themselves in the process.
Lapping said this was far worse than deceiving an outsider, because it meant that management was not in a position to admit to mistakes and improve the company’s fortunes.
While UK property group Intu’s results sketched an exciting opportunity and its management argued that it was a wonderful investment, the company had been going backwards for quite some time, he said.
“What this means is they continue to perpetuate the same errors. Instead of taking a step back and saying ‘oh, this is not right’, they continue to do the same thing.”
A similar situation has played out in the local construction sector, where many companies were involved in arbitration cases that stretched over long time periods, only to realise that they priced jobs incorrectly for years.
Aveng was one example of a company that had a tough time, after it grossly overestimated an amount it believed it would win in an arbitration case against Australian firm, QCLNG.
Lapping said the sooner parties – including fund managers such as himself – accepted the truth and admitted their mistakes instead of hoping that things would improve, the sooner they could run good businesses.
In South Africa, where the regulatory environment was fairly weak, self-regulation among companies and industries was important, he said.
During the financial crisis, US consumers bought houses they couldn’t afford. Banks were happy to lend them the money, repackaged the loans and sold them under questionable circumstances. In turn, ratings agencies gave these instruments a triple A rating. In the end it all came crashing down.
Lapping said one could blame the investors who bought the debt, or the clients who accepted loans they couldn’t afford or the ratings agencies. However, if banks really took a long-term view of their businesses they ought to have realised that they should not have been lending money to people with no income.
But in an environment where everyone else grew their advances at 15% or 20% per year, it was very difficult for management teams to face the facts.
The same was true for non-executive directors in the South African environment.
“How many non-executive directors actually have the skills and the knowledge to stand up to an executive team – and usually people who become the CEO of a company are pretty powerful characters – to stand up and say: ‘Well, actually I don’t think this is right. We shouldn’t be doing this or what about this?’ I would hazard a guess – it is difficult,” Lapping said.
Moreover, if management was trying to obscure the truth, the chances that a non-executive director would be able to see what was going on were extremely slim, he added.
“What is the incentive for a non-exec to stand up for what is right for shareholders or what is right for businesses? There is no incentive… The incentive is to be silent because then they keep you on the board and you continue to make R1 million a year or R2 million a year.”
Non-executive directors who made life difficult for management are unlikely to be reelected.
“If the non-execs on the remuneration committee don’t have a very clear view [of] what is going on, how can they judge management? How can they judge their capital allocation ability? How can they judge their operational ability?”
Many management teams didn’t know that they have underperformed for ten years or that their return on equity was 10% less than the industry median. Because management was not looking at the facts themselves, non-executives couldn’t judge them. This was one of the reasons they favoured long-term (five- to seven-year) incentive structures. Investors would only really know if an investment was successful in the long term, he said.
“Giving annual bonuses and things like that is actually a bit of a waste of time. I mean one-year performance, six-month performance, it means very little in long-term cycles.”
Long-term incentives also helped management to think about downside, he added.
In order to invest wisely in sustainable businesses that could generate great returns over long periods, investors have to be in a position to see the truth.
“We must push for the truth, push for the facts and push for the correct incentives… Unfortunately if you give people the wrong incentives, nine times out of ten they will do the wrong thing and I don’t think people do it purposely. It is often subconscious.”