The debate between Sir Martin Sorrell and WPP investors is warming up nicely. Yesterday, Sir Martin defended himself stoutly in an article written for the FT, much of which I found pretty persuasive. He makes a good case for having created value across the patch – shareholders have seen above average returns over a long period, tens of thousands of employees have jobs and the result today, from a business formed in his front room, is the world’s largest advertising and public relations agency. An extraordinary achievement indeed, and one that he would argue is worth every penny (and more) of what he is paid.
His little local difficulty, however, is that the 60% proposed rise in his pay packet this year compares with WPP’s 10% under-performance against the FTSE during 2011. And that of course is what has got shareholders angry. If they didn’t get their return, why should he?
But this is exactly where the debate should be – working out how best to link management performance with shareholder returns. There has been a considerable shift towards tying the two together over the past 20-odd years, but there are many who would argue that the right measures have not yet been chosen. Too much emphasis on share price growth, for example, means that management may (or indeed, not take) actions which may threaten the price, for example making investments in the short term (such as marketing or R&D costs which will hurt profits) that will benefit the company in future years but only after they have departed and cashed in their options.
We think there are three core measures against which management performance should be judged and each falls neatly into the mantra we teach that says that growth plus returns creates value. The measures are (a) EPS growth, (b) Return on Capital Employed or Capital Invested (ROCE or ROIC), and (c) Total Shareholder Return (TSR, the combination of returns to shareholders by way of dividends and share price growth in any one year). There may be other KPIs that any individual company may choose to add (for example, in a company seeking to grow in emerging markets, the proportion of revenues derived from such markets), but any company that rewards its senior management team on a proportionate combination of these three metrics will find that rows with shareholders like that encountered by Sir Martin are few and far between.
It’s always interesting to take a close look at the press release announcing a deal. People who have been on courses at FinanceTalking know full well about how we go on about the creation of shareholder value, by which we mean that the management of a company generate cash flows at rates of return that exceed the company’s cost of capital. We add that growth matters too, because higher cash flows are obviously more valuable than lower ones. And that’s it really. That’s all that management has to do to create value.
We also teach that there’s too much emphasis on earnings per share. It’s an easy metric to play with because on the face of it the company with higher earnings is making higher profits and then it’s easy to apply a multiple to earnings to get a sense of value – the price/earnings ratio. But what EPS doesn’t tell you is how much capital needs to be invested to generate that growth and it can easily result in two companies with exactly the same revenue and profit profiles into the future being given the same value, even though one company’s cash flows are half of the other’s because of the greater need to re-invest.
So we always look for the bit in M&A releases that talk about the returns the acquisition will make on the capital being invested to purchase it and whether and when the acquisition will cover its cost of capital. No mention of it in the CGI release yesterday on the acquisition of Logica. Just the usual stuff about enhancing earnings per share (albeit by a very healthy amount, which suggests they’re buying it on the cheap). The drafters of the release should check out the bible on Valuation written by McKinsey: “Deals that strengthen EPS and deals that dilute EPS are equally like to create or destroy value.” Talk instead, McKinsey suggest, about the cash flow returns on capital and whether they are in excess of the cost of that capital. That’s creating value, and that’s what will bring investors to invest in the story.
It’s all getting near meltdown out there in the eurozone and the politicians had better come up with something PDQ. All the talk has been of open-ended ECB funding and/or eurozone bonds (effectively the Germans underwriting the periphery’s debts in perpetuity), which many are saying is the only solution. The price to be paid in those peripheral countries will be high – loss of fiscal sovereignty, endless austerity and all bowing to Berlin – and the Germans are probably none too enthusiastic about paying off Spanish and Greek debts for ever either. So nobody wants it and, just for good measure, it’s probably illegal under the EC constitution as well. Make up or break up, Dave? The making-up is a non-starter.
But here’s a thing. Talk to ANYBODY in the eurozone, from Greece to Spain to Finland to Germany, and they ALL want to retain the euro. Yes, even the Greeks. What they don’t like of course is the price they have to pay, but nobody has explained to them properly that the two things live together (look at what Syriza has been saying in the Greek election). The point is that the eurozone lacks democratic legitimacy because the people have never been asked if they support it. It’s just been rail-roaded through by the politicians and all the people can see is bureaucracy from Brussels and control from Berlin. The euro, if you like, had an illegitimate birth through the creation of the eurozone.
So here’s my solution to the euro problem. Ask the people if they want it. My guess is that the answer will be a very strong yes. And, whilst they’re being asked, the politicians should explain the price to them – obey the rules, get the budget deficits down, concede fiscal power to the centre, which of course they won’t like. But at least the people can say they’ve been asked and they’ve chosen a path.
Why has this never been done, you might well ask? It’s because the politicians were afraid the people would say no, of course. And they would have said (and would today say) no the wrong question, for example, do they want to join the EC (with all the stultifying bureaucracy that accompanies that thought coming out of Brussels)? But ask if them if they want to keep the euro and at the same time respect their intelligence by explaining what it means and my belief is that you’ll get a resounding affirmative. I would think it’s a matter of short weeks or months before a bank run in Spain or Greece finishes the whole thing off and then goodness knows what lies ahead. Get the polling done now and give the euro its legitimacy at last. It might even mean a few less riots this summer.
It must be an age thing. An old City observer, like myself, writes in the FT today about the importance of dividends and how we’ve lost sight of equity performance by over-focusing on share price growth. http://www.ft.com/cms/s/0/56783e2e-a992-11e1-9972-00144feabdc0.html#axzz1wLg1mOqa
He talks about the view in the mid-80s that dividends were a key, if not the key, part of a shareholder’s return. I have strong recollections of being taught the same as I entered the City in the early 1980s, with one grey-haired merchant banker telling me that the metric he always watched was dividend cover (the mulitiple by which earnings cover the payment of dividends), and he stressed the importance of this in falling markets. We’ve lost our way on this over the years as we’ve all turned our focus on share price growth, which the FT writer today interestingly ascribes to indexation and the trend towards share buy-backs.
I’m with him. In this market, look for the steady dividend payers with good earnings cover (at least two times). Then look for good defensive market positions and/or growth prospects in emerging markets. That takes you to the likes of Diageo, GSK, BAT, Reckitt Benckiser, Vodafone and Pearson as being core holdings in any porfolio, with the likes of RSA thrown in for its 8.5% yield and trading at around book value.
It’s that time again. The pattern goes something like this, and it shows why investors are loathe to put their money on what seem like banker bets (such as the collapse of the euro, which has seen many a hedge fund lose its shirt over the past two years). The markets (particularly the bond market vigilantes) drive the value of a financial instrument such as a 10 year Spanish or Italian sovereign bond to breaking point. When all seems lost and the breaking point seems finally to be reached, in comes the ECB, EC or whatever other life-saving body to announce some ground-breaking measure (it was the long-term refinancing option or LTRO last time) which dramatically changes the lie of the land. For a short few weeks, everybody thinks the problem might be solved – in other words, it’s RISK ON again and the markets charge north.
With Spanish 10 year bonds yielding 6.7% today, deep into the danger zone, and Italian bonds also now above 6%, the moment for the politicians/central bankers to intervene is upon us again. So expect an announcement of a radical sort any time now as another rabbit is pulled from the hat, but my guess is that the market won’t be quite so quick to believe the central bankers’ claim that they’ve solved it this time. They’ve come to realise that the sticking plaster solutions to the eurozone don’t work for longer than a couple of weeks and that major surgery is required which may even threaten the life of the patient. The fundamentals are out the window and nobody has a clue what anything is worth any more. Not easy being an investor in these markets.
So at last the politicians are getting round to making plans for the euro’s demise. They’ve been in denial, of course, because they have to be; the moment they concede that they’re making plans for the failure of the euro project is the moment that they concede that the game is up, and that’s when the panic really sets in. But planning is required, because the maelstrom of euro failure and contagion fall-out is upon us and the inevitability of it all becomes more apparent by the day. And incredible though it may seem, there really are no plans in place for the financial tsunami that’s about to hit us. Is it back to drachmas and escudos, nord-euros and sud-euros, or ECB money printing and eurobonds? Nobody has a clue. Which means that when the tsunami does strike, the damage will be much worse than any of us can imagine. But what is interesting is how little of this is priced into the markets. All the warning signs are blinking on red, red, red alert, but the FTSE still starts with a 5 and the dollar still trades at 1.25 to the euro. Not for long on either count, I think.
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