[TOP STORY] Digging behind companies’ abbreviated results announcements

When ‘untrustworthy management teams…miss goals, they just shift the goalposts and then hope that nobody reads prior sets of results’: Keith McLachlan – Integral Asset Management.

SIMON BROWN: I’m chatting now with Keith McLachlan. You’ll find him at Integral Asset Management. Keith, I appreciate the early morning time. We are back in sort of earning season for the companies’ reporting periods to February. When they send out their Sens announcements, they’ve always got a couple of highlights from the results, and we need to be clear – [those are] the highlights the company wants you to look at. The lowlights they’ve buried somewhere else.

My question to you is – you mentioned that you glance at that, and then you go to something which is kind of top of your list –what is it that you go to first when checking a set of results?

KEITH McLACHLAN: Morning Simon, and you’re absolutely right. Management picking the highlights is [chuckling] a little bit misleading. Ultimately the shareholders and the market should [realise that]. The first thing that gets released – and we’re going to talk more specifically about the JSE, but this does happen around the world as well – is an abbreviated set of results. The first thing I’d do is ignore that, and click through to the full results.

In the full results I’m going to read the numbers before I read the narrative. What I mean by that is management get to write and get to wax lyrically on their view of things.

Now, their view of things is typically incentivised or they are incentivised to make it as positive and as rosy as possible, and in some cases it’s just downright misleading, their narrative.

So the first thing is I look at the numbers.

I want to know if the top line is growing and I want to know if that growth is driven by volume or price, depending on the company. Then we could dig down a little deeper, and we want to see if the profitability is improving or decreasing; not profits but profitability. So we are looking at margins, for example, and the like.

All of that trickles down into a cash flow statement. I want to make sure those profits are converting into cash, and then ultimately I want to have a look at the structure of the balance sheet. Is it deteriorating or improving, meaning is the debt piling up or have we got a very, very comfortable balance sheet?

All of that is being read through the lens of understanding management’s incentives, how they are portraying these things, before I circle around and read the narrative, because the narrative, often looking at the facts, will either add to them or detract from them. But you’re at least now armed with facts before you’re reading what is effectively a subjective view of the business.

SIMON BROWN: I take your point on that. You started, as you say, with facts – these are the hard numbers. This is the real McCoy in a sense. And then, with that in mind, when you go and read what the management get to say, you also get a sense of management, because you’ve now got the same facts they had and how they’ve interpreted [them]. Are they putting a rosy spin on them, or are they being bluntly honest and saying, ‘this was tough’ or ‘this was good’? It gives you a much better understanding of the management team in many ways.

KEITH McLACHLAN: Definitely. So sometimes you get anomalies in the results. We’ve just been through a period in South Africa with riots, floods and a pandemic. So there can be a large number of once-offs.

By the way, something that’s quite useful to do if you’ve got the time, is to go back into prior periods and read management’s prospects or forecast or outlook section, depending on what they call it, so that you get what they think the future is.

Now, management can’t predict riots and floods and things like this, so one shouldn’t hold that against them. So zoom a little bit more into what we are looking for. Are they doing what they say they’re doing? Are they executing upon the promises within the variables that they can control?

What’s very, very interesting is [that] honest, trustworthy management teams judge themselves harshly … you [also] get dishonest and untrustworthy management teams: when they miss goals, they just shift the goalposts and then hope that nobody reads prior sets of results.

So we’re not just getting a sense [of] the business, we’re getting a sense [of] the custodians of capital that are running this business. What are their incentives and why are they shifting the gold posts, and the like? That often comes down to bonuses. [Chuckling]

SIMON BROWN: I used to do that. There was one company on the JSE – I won’t name them, they’ve delisted it now anyway – and every year management would say, ‘Things were tough, it’ll be better next year’. I went back and read five years of reports; they had said that for five years, which meant that things were tough and not going to get better at all.

You mentioned ‘incentivised’ and that’s an important point as well. That probably comes more from the annual report. But of course, if management are there for the pay cheque and how they are going to get bonuses and be scored by the remuneration committee, [that is] is an important issue as well, because that’s frankly what they are going to look at most importantly.

KEITH McLACHLAN: Definitely. So we’ve got to distinguish between owner managers – these are guys that own over 50% in their own companies, and you’ll find them scattered across the small caps. There aren’t many of them in the large-cap area, but you’ll find them scattered across the small caps. These guys are aligned with shareholders. Depending on how they view the world, they can actually be brutally honest about their own companies because no one’s going to fire them – because they own the majority.

But then the vast majority of the listed market is run by professional managers who are put together and incentivised with various short-term [and] long-term bonuses. Understand what those are. These guys are often defending their jobs.

If you want to understand how a person’s going to act, go and have a look at the incentive set.

That’s really the foundation of this, because these are the guys that are building these results and then reporting them to us. It’s almost like a journalist writing a news article, but [with] an incentive to spin it in a certain way. You’ve got to understand that: what’s the incentive?

SIMON BROWN: And if the incentive is increasing Heps (headline earnings per share), then that’s what they’re going to focus on. If it’s return on equities, that’s where their focus is going to be. But I also like that distinction: if they’ve got 50%-plus, actually they’re just a shareholder, they can’t be fired. They’re going to want that share price more than anything to be moving.

We’ll leave there. Keith McLachlan of Integral Asset Management, I appreciate the early morning time, sir.

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