A recent conversation with a former ASX director provided the inspiration for this blog post – after we were given a rare, front-row view of an ASX board seat during a time of crisis, such as the COVID-19 pandemic. The insights provided were things we’d suspected but have never heard firsthand and only confirmed some of our beliefs about professional directors.
As the COVID-19 pandemic gripped markets in March of 2020, sending the index down 38% in just three weeks and credit markets into a freeze, CEOs and boards scrambled to comprehend what this meant for the liquidity of their businesses. Do we have enough cash to see this out? Can we get access to debt or do we need to raise equity? As these conversations played out … lurking in the background of corporate headquarters were the investment bankers and consultants - armed with pitch decks painting the most dire of outcomes for balance sheets and thus director liabilities should liquidity become a serious problem.
Our director went on to explain that after the board had rejected investment bank after investment bank, trying to entice the company into a dilutive equity raise … one banker correctly assessed that although this board was strong as a whole, they were weak as individuals and proceeded to call and email individual directors discussing how they could be potentially liable if they are proven negligent. The banker stressed that with a number of litigation financiers actively looking for cases, shareholders could easily finance a trip to the courts should they be willing … This threat … coupled with the uncertainty of COVID-19 pandemic saw the bankers earn their payday as these professional directors couldn’t hit the capital raising button fast enough.
Directors hold the keys to arguably the two biggest controllable of a business – those being - incentives and capital allocation. Unfortunately, only a small minority really appreciate this. One founder within this minority is Mark Leonard, Chairman of TSX listed Constellation Software – a serial acquirer of vertical market software businesses. Leonard is more than believable on all topics around vertical market software and corporate governance. Constellation’s track record is remarkable and one that we believe all investors should study. Since listing at around $18 per share in 2006, CSU is up 116x or 37%pa !! (the average 100 bagger takes around 20yrs or 25%pa!).
We’d argue that most, if not all companies, particularly founder-led companies, have the same corporate governance choices, yet only a very few have the discipline, patience, and foresight to ensure that shareholders are appropriately represented …. And we believe these choices are indicative of the types of decisions that are being made across the rest of the business.
Leonard’s 2018 letter (attached) is a master class in how boards should be selected and structured. Many boards could save many hours and many millions in consulting fees if they took just 10 minutes to read Leonard’s wisdom. Leonard opens the topic of corporate governance highlighting that the performance of most boards has been ‘awful’ ….
Qualified and competent directors are rare, and not surprisingly, the track record of most boards is awful. According to the 2017 Hendrik Bessembinder study of approximately 26,000 stocks in the CRSP database, only 4% of stocks generated all of the stock market’s return in excess of the one-month T-bill rate over that period. This means that 4% of boards oversaw all of the long-term wealth creation by markets during that period. Even more disturbing, the boards for over 50% of public companies saw their businesses generate negative returns during their entire existence as public companies.
Leonard then goes on to state that the typical tools for dealing with corporate governance, being - Director Independence, Diversity and Term – are a reasonable starting point for most companies however these tools fall well short for those seeking long term outperformance. Leonard emphasises governance is only one part of a director’s role and limiting the tenure of a capable director will do more harm than good.
Governance is necessary, but it is not sufficient …. Helping extend the extraordinary track record of building intrinsic value should be the board’s primary function. You are unlikely to achieve that by replacing their proven and obviously very rare Directors and Officers with new ones who are statistically unlikely to have ever experienced anything like consistent high performance.’
Leonard stresses that for a business is to achieve sustainable long-term performance, the directors must assume the role of ‘mentor’ … not ‘governor’.
Unfortunately, that means that the default role for most directors is as a governor ,not a mentor. Some investors find that acceptable. I’d argue that governing is table stakes. Coaching and talent nurturing are the places where directors can make a significant contribution and help a company become part of Bessembinder’s 4%.
Leonard believes that there are only two reasons why someone should consider joining a company’s board:
A way to invest a significant portion of their net worth and be able to watch it closely
Learn and apply those learnings to their own career and investments
Finally, Leonard outlines to readers the 'search criteria' for a potential CSU director (table below). Many agree that CSUs search criteria an extremely, high-quality way in which to select a director and they also appreciate the poor track record of most boards. However, we’ve seen few investors incorporate the quality of a board into their assessment of a management team and its ability to allocate capital … despite it clearly having such a massive impact on the long-term performance of a business.
One measure we use to assist in our assessment of a company’s board is the ‘business savvy to compliance ratio’. This ratio shows the number of board members we consider to be ‘business savvy’ to those we consider ‘compliance professionals’ … where a business-savvy board member is someone who has either a very successful capital allocation and/or operational track record. A few notables within our portfolio that sit high on this ratio include – Objective Corporation and Lovisa with ‘business savvy’ to ‘compliance’ ratios of 100% and 80% respectively.
If you know of any businesses that practice this type of ‘shareholder friendliness’ – please let us know – we love investing in them!
Thanks for reading,
Lachlan Morgan, CFA