7 posts tagged “management”

There are many of the difficulties encountered by institutional management. In this discussion our interest is on identifying pressures that often make discretionary managements conductthemselves in predictable, repetitive patterns. There are two basic source_sof pressure:

• Internal factors, primarily influenced by institutional structure.
• External factors, primarily influenced by the actions of clientele who have placed their funds under discretionary management.

Internal

Institutional management, whether the contributions are voluntary or involuntary, incorporates two basic elements: sales and performance. Of the two, sales is more important because if no reason is given for the contributor to entrust monies, the contributor is not going to do so. And with no money to manage, there is no institution. Elementary.

The primary institutional sales tool is image. Astute, presumably educated, well dressed personnel, plush surroundings, organizational names indicating solidarity, and other superficial characteristics are effectively utilized to project an image. Most investors buy the impression.

The average investor neither wants to take the time nor has the inclination to make objective comparison of the relative performance of the many institutions. Often the institution is chosen without any comparison because of a personal friendship with the institutional manager or salesperson, response to advertising, or media hype. For these poorly informed investors, the greatest influence on their choice of discretionary management is paid advertising, which makes the larger (more heavily advertised) institutions appear preferable. We do not intend here to demean sales. Salesmanship is an integral part of all societies; it is involved in politics and religion, as well as in the overall economy. Our point is to emphasize the sales aspect of institutional structure because it is often overlooked byinvestors, and it forms the basis of some predictable institutional market behavior.

While most investors are not keenly aware of the differences in performance among institutions, most institutional managers definitely are. With their firms having costumed and situated themselves in similar surroundings, the managers must do something more to enhance their sales. The obvious factor to emphasize is performance. However, this creates a dilemma since most institutions fare relatively poorly over time. Irrespective of what the institution has really accomplished for clientele, it isobligated (to assure its existence) to make past performance look as good as possible.

For those institutions that publish their holdings, the easiest way to project the image of superiority is for the holdings to have appreciated dramatically since the time they were purchased. The accomplishment of this task is within the grasp of any attentive third-grade student: sell holdings that are losing and retain those that have appreciated. Then—ah ha—when the institution's holdings are published, it will provide the image that the institution has a fantastic ability to achieve superior results. To add to the image, right before the holdings are to be published, the manager determines which stocks have gone up the most and are receiving the most positive media attention, and then buys some irrespective of the current high price. The end result is a published portfolio that is stuffed with winners and the "hottest" current stocks. The impression is that the institution has both a history of winning and continues to be "on top of the market" by having positions in those stocks currently in vogue.

This process of adjusting portfolio for the sake of appearance—window dressing—is most pronounced when the majority of institutions publish their quarterly portfolios, on or near the last day of March, June, September, and December. As might be expected, the window dressing effect is most dramatic during December when it is combined with selling by the public and others for tax reasons.

The problem with window dressing is, of course, that it not only involves the precise formula for loss (buying high and selling low), but also precludes optimal profit capture by retaining positions that are too high and destined to fall.

To those who conduct themselves professionally, being aware of the influence of window dressing adds to the benefits obtained by normal shifting in relative strength. In effect, window dressing aggravates pricing, making prices too high/low than they would be without the effect. Being aware of the window dressing pressures in combination with normal rotational shifts in relative strength can, in itself, more than double the return available from the market as a whole as measured by the popular averages.

The risks associated with portfolio modification for the sake of appearance are magnified in management techniques stressing "growth" stocks. Retaining a position simply because it has attained an exceptionally large gain could involve the stock's being in the attainment phase of the life cycle concept. In this phase quality stocks are most vulnerable to steep, often sudden price declines.

3. Familiarity with the Institution

Beyond knowing the specific investment techniques being employed and the specific analyst(s) involved; it is important to be properly treated by the institution itself. The better analysts who have achieved some notoriety will generally have many accounts and many millions of dollars to supervise. As such, it may be impractical (or physically impossible) for the analyst to be in continuous, personal contact with all clientele. Support personnel are necessary and investor's communication with the analyst's aides should be in a familiar, congenial atmosphere.

Support personnel can provide warning signs. If there is rapid turnover, terse responses, or any other form of discontent, it could indicate that there are problems with upper management's abilities to conduct themselves properly with employee's or clientele's needs.

Other warning signs can be the behavior of the specific analyst(s). It is Virtually impossible to properly manage money while repeatedly crisscrossing the country for interviews, constantly appearing in "dog and pony" shows (speech/seminar circuits), or being available for any media event that provides a chance for the analyst (or the organization represented) to get a picture or quote in the news. Proper money management takes time—lots of time involving continuous access to changing data that affect clients' goals and needs. Inordinate amounts of time spent on publicity tours can only detract from personal account supervision. It also raises a question: If the analyst is so well-known and so good, why spend so much personal time advertising?

As mentioned, it may be physically impossible for the manager to personally convey the logic for each investment decision to each client. However, the client should be aware of the manger's current basic reasoning. After all, maybe the manager went to that proprietary brain surgeon.

Most analysts whose client base is too large to allow individual verbal 1 communication will provide regular written correspondence regarding the reasoning behind portfolio positioning. If a manager does not provide such regular written or verbal communication, it could be a sign of laziness or pomposity, neither of which are characteristic of prudent account management.

The rewards, or the lack of them, associated with the selection of discretionary management are not limited to those who have personal control of their own funds and therefore have personal control of their own financial fate. Billions of dollars are taken from the earnings of people (employees, estates, trusts, and others) and turned over to discretionary management, over which the individual contributors exert little or no control. The abuses that can result from involuntary "contributions" (fat fees, funding the personal projects of managers, ludicrous costs paid to families and friends, kickbacks, and the like) are well-known. These abuses would stop if those making the involuntary contributions stood up and demanded their right to the three "familiarity" points just discussed. Such action would make a lot of nasty people angry, but would certainly provide a lot of nice people the money they deserve.

Although the emphasis is to assist individuals in developing and implementing their own investment strategies, we do not mean to imply that all money managers should be avoided. There are many competent managers.

Yet the selection of a manager cannot be taken lightly. The fate of the monies entrusted is most likely sealed at the time the manager is selected. It is no time to blindly follow friendships, media hype, or personal emotion. Almost all of the difficulties associated with the selection process can be eliminated by following three simple guidelines.

1. Familiarity with the Investment Technique

Money is a tangible: Either you have it or you don't. Generating money from money is a very specific process: Specific investments, must be chosen and the investments managed under specific techniques. Irrespective of how money is applied (even hidden in a mattress), there is an element of risk. To place the element of risk in a context suitable to individual resources, needs, and goals, it is mandatory that investors understand the specific investment techniques determining how monies are invested.

Obviously, avoid managers who stipulate techniques that have not produced suitable results when back-tested over a long period or who stipulate that their methods are proprietary (secret to all but themselves). Despite the glaring dangers, people seem to be attracted to proprietary "systems," the bait probably associated with greed. The fact is that the markets have been around for a long time. There is little that is not known and has not been adequately tested. In other words, would you entrust your life to a brain surgeon whose operational procedure was his own little secret? Suffice it to say that, within the financial community, there is ongoing communication among the ethical elements to provide clientele with superior products.

In effect, the investment method being utilized by the manager should be the same method you would personally use had you not decided to entrust the day-to-day investment routine to the expertise of others.

2. Familiarity with the Individual Analyst

Little known to the investing public, there has been a prolonged and ongoing battle within the financial community over full disclosure to clientele as to the specific identity of individual analysts managing the clientele's money in larger institutions.

Institutional management generally favors anonymity, stating that specific investment decisions (unless very bad and some underling is selected for blame) are a "team effort," and no one individual should be singled out as being better or worse than the team.

Many analysts counter that the "team" argument is a joke. It allows the institution to maintain fat salaries for dead wood ("good old boys") while inhibiting the advancement of truly superior individual analysts—sort of a slave labor relationship. These analysts further contend that the institution's desire for anonymity is to keep monies under institutional management. If the better analyst, known to clientele, were to leave the institution, _the clientele would also leave to keep their funds with the superior analyst.

To us the bottom line is simple. You should know the specific analyst who is involved with your money and have some means of individual _communication. It is your money and you have a right to know both the investment methods being used and the individual making the investment decisions.

In the world of investment techniques, the originators of the methods often manage money using those techniques. In effect, the investor often has access to the source. If the source is not in the money management business, he or she will probably be willing to direct the investor to a manager who has demonstrated a familiarity with the originator's work. If the originator is dead or out of business someone else will likely emerge as the best known analyst following the technique who can personally provide (or personally recommend another for) appropriate discretionary management. If you want the best, nothing can be lost by seeking it.

The proponents of LBOs, usually the managements involved and those who are paid fat fees to construct the deals, point out that shareholders benefit by getting to sell their stock at a substantial premium relative to what the stock would be worth if there was not an LBO offer. They also point to somewhat hazy theoretical benefits including (but not limited to) concepts that the nonpublic corporation will be more competitive and thereby benefit the economy as a whole. In addition, they contend that those who provide the financing (usually through junk bonds) are pro. vided higher interest rates than they could otherwise obtain.

Critics of LBOs contend the only true value is to those who construct the deals and the management that takes over the corporation, in that they are provided very large profits with relatively low risk. They maintain that the added debt burden to the corporation detracts from its financial stability, using the high default rate of junk bonds as proof. Their criticism also includes a couple of accusations: For one, the junk bondholders are not properly appraised of the risk involved. Also, when banks are involved in the financing, the taxpayers (because the bank's deposits are insured by the federal government) are subsidizing a process that does nothing except make a select few enormously rich and destabilize the overall economy, as the U.S. savings and loan debacle clearly attests.

Irrespective of the arguments, one aspect is clear. The managements who are buying the stock from stockholders (the owners) are, in effect, competitors thinking they are buying the stock cheap (at least relative to their risk). Otherwise, why would they want the stock all to themselves? Our main point is to demonstrate that the objectives of management and shareholders (for whom management presumably works) can often bedivergent and directly competitive.

Corporate Raiders

Corporate acquisitions can take one of two forms: friendly or hostile. In riendly arrangements, the buyer and the corporation to be acquired agree

on the terms involved and all proceeds (usually) rather smoothly. In hostile situations, the management of the corporation resists the buyer's actions. The buyer in such instances is usually termed a raider.

For a variety of reasons, including the possibility of loss of employment, managements do not like raiders. They want the raider to go away. To entice the raider to leave, they may offer incentives, such as buying the raider's stock in the corporation at a price significantly above the free market price, providing the raider high paying preferred stock/bonds, or any other enticement that leaves the raider with a profit sufficient enough for him to promise not to return. These payments are called Greenmail. In a greenmail arrangement corporate management has paid off the threatening party without the permission of shareholders (or owners). The _shareholders have not even been given the choice as to whether they want to take the raider's presumed offer.

Thus, once again, corporate management and shareholder objectives can diverge and, in effect, place management and shareholders in direct _competition.

Some raiders have perfected their activities to an art, getting paid off _repeatedly without ever really making a serious attempt to takeover the "threatened" corporations. Other raiders have been known to buy stock in a corporation, then announce (or imply) that they might takeover the corporation at a price higher than the current market price. Speculators might rush in and push the stock higher. The raider then "changes his mind" and sells his stock into the buying demand (higher prices) created by the speculation. Such activities turn ethical stomachs. They are mentioned to reinforce the true nature of the market, which includes avoiding the assumption that corporations are automatically investors' friends.

Taking a Corporation Public

In taking a corporation public, instead of management buying stock from the public, it is selling its stock to the public. The sale may take the form of new stock issues, selling stock held previously taken private by means of LBOs, or simply large blocks of stock held by management in corporations already trading publically. Whatever the form, the implication is clear that management is selling because the price of the stock is too high. Again, the managements of corporations so involved have placed themselves in direct competition with other investors.

Avoiding competitive abuses from corporations entirely is not possible. Slimy types have been known to work their way to the top of some of the finest corporations. Once identified as the unethical types that these individuals almost always are, they can be avoided by staying away from the corporations with which they are involved. To reduce the possibility of being victimized by unscrupulous corporate managements, we confine investment interest to the issues that meet the selection criteria where shareholders concern plays an important role.

Stock Splits Versus Stock Dividends

Many texts and financial publications differentiate between stock splits and stock dividends. There is no real difference. Stock dividends are nothing more than small splits. For example, if a corporation has a

3-percent stock dividend, someone with 100 shares would be issued 3 (or 3 percent) new shares.

Almost all articles state the reason for stock splits and stock dividends is so that the stock will be at a lower price level, which makes the stock attractive to a wider range of investors. Because of wider appeal, the assumption is that the stock's price will be more easily supported and consequently will rise more easily. Although this theory might get nods of approval in ivory towers, in the actual market it is not always true. In fact, many stocks literally get smashed after stock splits. This is because of a combination of naive investors bidding up the price too high in anticipation of the split, and professionals shorting in the knowledge that the price is inflated because of irrational buying demand.

The most important realistic aspect of stock splits to corporations is thatthey increase the number of outstanding shares. The more outstanding shares there are, generally the more trading and eventually the moreshareholders. The more shareholders there are, the more difficult their communication with each other and thereby the lower the chance of a concentrated effort by shareholders to oust management. The end result is to make management more secure in its position. This can effectively place the management in a situation of perpetual control, without its ever owning any of the corporation's stock.

Insider Trading and LBOs

New issues and stock splits are the result of overall corporate policy. Competition from corporations can also be from individual officers and directors who have access to information concerning the corporation thathas not been made available to the public—an obvious advantage. Those having such positions within a corporation are called insiders.

The existence of illegal insider trading abuses is obvious, as demonstrated by publicized arrests and indictments. However, the large majority

of corporate insiders (probably) adhere to the law and report their buying _and selling to the Securities and Exchange Commission, which is required i_n an effort to ensure they are not basing their decisions on information not available to the public. These reported trades (often after a significant time lag) are available to the public and provide the basis for a wide range of analytical methods and financial advisory services.

The reasoning behind monitoring reported corporate insider trading is simply that the group's knowledge of corporate events will result in their trading being profitable. Studies indicate that this assumption is basically true. However, the results of these studies of reported insider trading fall well below those considered acceptable by the methods. Insider theories fail to provide acceptable results apparently because the insiders themselves do not understand the market as well as they should. (The topic of corporate insiders is expanded on in Chap. 6.)

The most notorious abuses of insider information (by both corporate managements and others) involves mergers and acquisitions, primarily leveraged buyouts (LBOs). The term leveraged buyout simply means that leverage (or borrowed capital) is used to buy the stock of so many stockholders that the corporation involved is no longer public. Control is transferred to a relatively few individuals who have arranged through borrowing, to purchase the stock. The process is often described as taking the corporation private.

Because of the large amounts of money involved, the fees paid to those who construct the LBOs (although usually a small percentage of the total) can be huge with relatively minor risk. The buyers often include members of corporate management, who also stand to profit dramatically with very little risk. The risk is taken by those who put up the borrowed money to effectuate the purchase of the stock.

To entice shareholders to sell their stock to the LBO group, the buyers will offer a price that is at a significant premium above the usual market price. Those involved in the LBO know that a higher price is going to be offered before there is public announcement. In the United States, trading stock with such insider knowledge is illegal. However, a large number of people are involved. Corporate managements, lawyers, bankers, underwriters and their staffs are aware that a higher price is going to be offered, and the temptation to cheat is obviously great. By buying the stock before the announcement of a higher price is made, huge profits can be obtained with minimal risk. As a long list of arrests and convictions, involving hundreds of millions of dollars in illegal profits (most taken from ethical shareholders), clearly demonstrates that such insider trading can be pervasive.

3. Dividend Protection and Growth.

Dividends play a role both in added income and in risk reduction. To maximize these benefits, a corporation's dividend policy must be established and stable. The decision as to what portion of earnings will be paid to shareholders in the form of cashdividends, relative to the amount retained to finance future corporate growth, must be reasonable.

A consistent dividend policy, providing adequate assurance that the dividend will continue to be paid (protection) as well as increase (growth), reduces the possibility of unpleasant "surprises." It also reduces the number of stocks we find suitable for investment consideration.

4. Liquidity.

One of the primary advantages of common stock as an investment type is maneuverability; theinvestor can buy or sell quickly with very low transaction costs. This ease of movement is termed liquidity.

Liquidity involves two elements, which vary as to the characteristics of individual stocks:

1. The number of shares a stock trades daily. This is the standard measurement of liquidity. It is only reasonable to confine interest to thoseissues that provide sufficient trading volume so that orders can be accommodated without disrupting price.
2. The "mix" of investors in the stock's market. To us, the liquidity factor also involves an aspect largely ignored in conventional analysis. Professional participation mandates the realization that success depends on the actions of other investors. It is only logical, therefore, that the more varied the market participants interested in a particular security, the more areas of potential profit.

We will detail that market participants can be isolated and categorized (public, institutional, market makers, etc.) as to their repetitive behavior, which can provide us opportunity. The more varied and abundant the prey, the easier the task of the predator. Consequently, our liquidity requirements provide a dual function in filtering for both the number of shares traded and the number of different participants. Accordingly, the list of qualifying stocks is decreased.

5. Shareholder Concern.

Unfortunately, a corporation's fundamental (earnings) success does not automatically translate into the success of shareholders. In a variety of ways, management can intervene to block owners (shareholders) from experiencing presumed benefits. Greenmail is the corporate acronym for blackmail. The usual form is a "hostile buyer" (supposedly independent of management) who purchases a relatively small amount of outstanding shares and then threatens to buy controlling interest. The connotation is that with such control it will oust current management and ravage the corporation's assets.

To avoid the greenmailer's threat (and retain their paychecks), a common reaction is for the management to deem it "wise" to buy the green- mailer's stock at a price above "market." That is, "pay off" the greenmailer at prices higher than those available to other owners (shareholders).

Although greenmail could conceivably be justified in some instances, in general we question the credibility of managers that engage in such practices, thereby disqualifying their corporations from investment consideration.

The capitalization structure of corporations (that is, the monies the corporation utilizes to fund its activities) involves two basic sources: equity (monies contributed by and/or earned for stockholders) or borrowings (debt). The capitalization "structure" is simply the ratio of debt versus equity.

To avoid "hostile takeovers," greenmail and other activities that could interfere with management's security, a popular maneuver is to restructure. The general pattern of restructuring is for the corporation to add debt to the point that the new debt load makes the corporation less attractive to potential buyers. The excessive debt has the net effect of reducing the corporation's fundamental quality, with the excessive interest charges detract from earnings and making it more difficult for the corporation to survive adverse economic conditions.

The Right to Earnings

This right is the most important single characteristic of common stock, for it (at least in most theories) is the dominant factor in determining stock price. The corporate earnings (theoretically) belong to the owners (stockholders), who therefore have the potential to realize tremendous profit if the corporation is successful.

One must not blindly assume, however, that if corporate profits rise the stock will also appreciate. The fact is that there is no automatic correlation between corporate profitability and common stock pricing. It often takes more than earnings gains to create an advance in the market price of a stock.

Corporate management has the choice of doing any one (or a combination) of three things with earnings:

1. Retain them within the corporation to finance future growth.
2. Distribute them to stockholders.
3. Steal them.

Most texts on the market ignore theft, considering such nastiness a rare event that it is not important. The general perception of corporate theft is that of a slimy little over-the-counter stock sold to the public at a ridiculous price by management or a seedy embezzler packing misappropriated cash in a suitcase and running to Brazil. Theft at the expense of shareholders can take many forms and can occur in dramatic amounts in the largest corporations. There are two basic types of theft:

1. That in direct violation of law. All you need to do is look at the paper to see the Mr. Boesky types being taken away for stealing millions, or the billions in fraud that contributed in making the insurance protection for the entire savings and loan industry of the United States insolvent. Such behavior cannot be shrugged off or considered a laughing matter because of the light penalties; remember whose pockets—stockholders' and taxpayers'—were fleeced.
2. That not in direct violation of law. This includes management's paying itself exorbitant salaries, perks, options, and other compensation without merit. It also includes such practices as putting friends and relatives on the payroll at inflated costs or making corporate contracts at a price above real market value because of personal interest. In the most abrasive form, management sells corporate assets (or the entire corporation) to itself or "others," where management has an interest at a significant discount. In effect, any managerial "decision" that unethically takes from the rightful owners (stockholders) is stealing. Such activities are common and easily identified, but, since they fall into the classification of "business judgment," they are beyond statutory prosecution.

The point: There are very nice people and very nasty people involved in both the structure of securities trading and in the corporations represented by that trading.

As we will discuss in Chap. 2, there are methods to significantly reduce the chance of becoming victimized by scoundrels, but the reality of the market must include clear, ongoing recognition that the environment involves some unsavory characters. To repeat, it is not a team sport.

Setting thievery aside for the moment, can concentrate on whether corporate earnings should be retained to fund future growth or distributed to stockholders via dividends.

The generally "taught" academic approach is that the corporation (extrapolated to read "stockholders") is most benefited by applying earnings to future growth; consequently, a low dividend policy expands futurepotential.

From the perspective of professional investing, however, an exceptionally low (or inconsistent) dividend policy is a weak point. There is a real correlation between the degree of potential price decline and the dividend when the stock price descends to the point where the dividend payment is offering an exceptionally high yield in relation to the market price of the stock. In other words, people will buy the stock simply because of the dividend. This buying can help support the market price of the stock and minimize risk. It should be noted that, although the dividend yield may help soften the decline of a stock, there is no significant evidence that a high dividend in itself will help the price of a stock to advance.

We have found the three basic stockholder rights to be shallow at best, with only the right to earnings providing a general benefit. Even this right, stolen or not, provides no guarantee that the market price will appreciate.

As an investor, your primary concern is optimal utilization of common stock in your own capital growth. In this context, stockholder rights in themselves do not warrant any emotional attachment. The advantage of the stock market is liquidity. That is, you can easily move in and out of the stock market as well as within the market. By being long (buying) in anticipation of rising prices, or by going short (selling) in anticipation of lower prices you can benefit either way, as long as you correctly anticipate the direction, with very low transaction costs. It is a function of easy maneuverability to whatever area is providing the most opportunity at any given time.

To identify yourself with an individual stock issue is effectively to identify with the "rights." The rights are often illusion and in any form do not guarantee success. Emotional attachment to the rights only encourages relatively poor performance because it does not allow either objective reasoning or full utilization of the liquidity factor.

Face it. As a holder of common stock from a professional trading perspective, you are involved for the price ride. And, like it or not, to maximize profit, the ride has to be for a limited duration. No matter what the stock, the time will come to get out of the market entirely or obtain a position in another stock for another ride. To function as a professional, you must accept in fact that stock is a piece of paper to be utilized as a medium of exchange in acquiring the monies of others.