Tuesday 26 June 2012

CEO Compensation: Jarislowsky Opines, Algoma Central Delivers

It's reassuring that it isn't just me complaining that CEO compensation is way too high these days. Billionaire investor Stephen Jarislowsky recently appeared in this BNN clip saying he doesn't believe it is either wise or necessary to pay CEOs amounts that have gotten totally out of line. Amusingly, or scarily, he admits that he, a highly experienced and sophisticated investor, has a great deal of trouble figuring out the extremely complex pay schemes found in most big publicly traded corporations. He blames the historical out-of-line rise in CEO pay as being due to two factors: the public disclosure of pay, which made CEOs ask for what others were getting and the arrival on the scene of the compensation consultants, who have created all the insanely complex pay structures that magically produce higher pay whatever the company results or stock performance (I think there is probably a rule of thumb that the more opaque a CEO pay plan is, the more likely the shareholder will get taken advantage of). 

Whether pay gets reduced, both in relative and absolute terms, by shareholder "say on pay" or Boards putting the hammer down, it needs to happen. Another BNN clip with Globe and Mail reporter Janet McFarland and Fair Canada (as in, fair to investors) executive director Ermanno Pascutto, talks about the small advances in Say on Pay votes in Canada, which as ever in the hands-off Canadian regulatory landscape is voluntary here in contrast to the mandatory regime in the USA.

One company that caught my eye through this Globe and Mail article as being more on the right track than many others is Algoma Central (TSX: ALC). The description of it as old style with no stock option plan for the CEO, which is what Jarislowsky recommends, made me look up the latest Management Information Circular on Sedar.com to see the pay structure. Indeed, the CEO pay scheme is actually understandable, only a base salary plus an annual cash bonus scheme, half of which gets deferred and paid out only after three years. There are no options, no benchmark peers that automatically drag up pay, no golden parachutes and the pension accrual formula is the same as for other employees (CEO Wight is grandfathered in a very generous DB plan of 2.25% per year while new executives (after the Jan 2010 closure of the DB plan to new employees) go into the DC plan that all employees apparently receive). There is a new twist to the bonus plan for next year - half the cash bonus, instead of merely being deferred for three years, is notionally invested in common shares that vest in three years and are paid out based on the value of the shares then. In other words, unlike options, which have no risk to the CEO, there is downside risk - if the shares go down, the CEO loses that amount of the bonus, just like a real shareholder would. Sounds good to me. The only part of the pay that looks dubious is that the CEO Greg Wight's base pay, on which bonuses are based, rose at more than double the inflation rate in both 2010 (+6.6% over 2009) and 2011 (+5.5%).

Of course, sensible pay doesn't guarantee good stock performance. ALC's stock return has languished in the last five years, doing worse than the overall TSX. As the Globe article says, it might be a buyout value play since it looks quite under-valued (a P/E of 6.3 and a P/B around 1, profitable every year for the last 5 - see TMX here). The controlling ownership structure and the consequent lack of liquidity and analyst coverage seem to be getting in the way of value recognition.

Wednesday 13 June 2012

Labour-Sponsored Rip-off

The union labour movement likes to think of and to portray itself as fighting for the common man, for fair dealing, for social justice, for honesty in business and so on. At times it does, witness its support of an expanded Canada Pension Plan.

Why on earth then would it continue to allow its name to be besmirched with one of the unmitigated disasters of investing for the common retail investor, the horribly exploitative abomination known as the Labour-Sponsored Investment Fund (LSIF), also called the Labour-Sponsored Venture Capital Corporation?

The history of LSIFs according to Wikipedia had a naively noble origin - fledgling companies need capital to thrive and grow, so the labour movement pushed the government to give generous tax breaks to average joe retail investors putting money into funds that would invest in these companies. It would stimulate the economy and create jobs. Professional managers in the funds would research and figure out which were the best small companies to choose. So the theory went.

The reality is that putting money into any old small company doesn't work. Many, indeed, most companies don't survive and grow, they unfortunately wither and die. And when the incentive structure is such that the fund managers make a lot more money a lot more easily from collecting high fees than on choosing future star companies, which is hard to do at the best of times, while the managers have none of their own money at stake, putting money into any old company with a cool story is the easy way out. The recipe was set for LSIFs to fund weak companies and provide little or no lasting job creation in the real economy while uniformly losing money for investors and allowing financial managers to systematically strip money through exorbitant fees (like 5, 6, 7, 8% annually).

The proof is in the pudding, and it has been for a long time. Go to Morningstar Canada and pull up a table of current LSIFs. There are seven with a positive 10-year return out of 82 funds, not bad you might say since they outnumber the six with a 10-year loss. It's not so good, however, when we remember that many long term losers disappear through being bought and merged into other funds. Two examples are the Capital Alliance Ventures Inc and Canadian Medical Discoveries Fund, both of which started back in the 1990s and have ended up folded into the GrowthWorks Canadian fund (I traced the history of these funds in this post last year). Here's a telling chart from Morningstar that shows the downward slump of CMDF and of the overall Retail Venture Capital Index compared to the BMO Small Cap index.

The CMDF is now in dire straits. Thanks to Ken Kivenko sending on the news published here and here in the Financial Post, we learn that CMDF is essentially insolvent. Fundholders are caught between the proverbial rock of not being allowed to withdraw funds and the hard place of being asked to approve CMDF taking on a loan merely to pay the managers' fees. It's inevitable that fund investors will lose big time, sooner or later. Yet the show is allowed by government (by the feds and some provinces continuing to offer a tax credit) and regulators to go on.

Why for example, has the Canadian Federation of Labour, the labour sponsor of the GrowthWorks Canadian Fund, not intervened through its majority (it nominates 8 of 12 directors) control of the Fund's Board, to say enough is enough, it's time to liquidate and wind up the fund before all the investors' money is sucked out of it? I'd like to see how differently labour Directors like Joseph Maloney and Edward Power, both of the International Brotherhood of Boilermakers, Iron Ship Builders, Blacksmiths, Forgers and Helpers and both on the Board since 2006, would react if they had more than their share ownership of exactly zero. (None of the labour directors have a big stake in Fund shares.) Of course, if the fund were wound up, messers Maloney and Cole would not collect the $16,000 or so in director fees they got last year.

Though the Canadian Federation of Labour doesn't take a fee from the GrowthWorks fund, in some cases the union itself does collect an on-going trailer fee. For example, the Canadian Police Association and the Association of Canadian Financial Officers are co-sponsors of the Covington Fund II. They collect an annual fee of 0.16% of the fund's net asset value, which turns out to be a tidy $480,000 based on the Fund's $300 million NAV (as of February 2012, per the Semi-Annual Report filed on www.sedar.com). All that for lending their name. Of all labour groups, one would think that police and financial officers would recognize and not want to take part in a rip-off scheme.

Disclosure: I am not neutral on this topic since I owned shares of both CAVI and CMDF and lost most of my investment before I managed to sell out a few years ago.

Saturday 2 June 2012

Book Review: Purple Chips by John Schwinghamer

Purple chips is author Schwinghamer's invented term to describe the best of the blue chip stocks. In his definition found on the book's website, purple chips are large companies with a market cap minimum of $1 billion which have an unblemished track record of seven years growing earnings per share (EPS).

The book lays out Schwinghamer's method for long term trading in the purple chips, i.e. his method for picking when to buy and when to sell. The method is designed, in his analogy, to hit singles and doubles, not to try for the home run. The method appeals to common sense since it is based on two factors - first, the idea that in the long term the stock price is determined by EPS (what Warren Buffett said thusly: "If a business does well, the stock eventually follows"); second, the fact that markets go through periods of optimism when investors are willing to pay more for earnings (reflected by rising P/E multiples across the board), or the opposite pessimism. For a particular stock there may also be company-specific good or bad news that causes the market's willingness to pay more or less for earnings, which he calls valuation resets. He thus establishes a reasonable trading range for any purple stock. The signal to buy is when the price goes above the upper bound and to sell below the lower bound. All this is summarized graphically on a chart which overlays EPS and stock price, such as the image below taken from the book.

That is the gist of his method, though there are more rules, which he explains, to fine tune the buying and selling decisions as well as for building a portfolio of such stocks (such as not exceeding 15% invested in any sector, or 3% in a non-dividend paying stock). Schwinghamer's system is unique but he takes the trouble to show how its conclusions about stock value are the same as a traditional fundamental financial and ratio analysis would come up with.

Schwinghamer's book is graced with clear direct informal writing including helpful analogies, with progressive and well-organized exposition from a very low assumed knowledge base to the somewhat intricate level of his unique system and with numerous charts and real stock examples (a whole chapter is devoted to several case studies that walk through valuation resets and buy/sell decisions, as well as profits thereby attained).

Though the method is clear, I believe there are a few big challenges for an individual investor wanting to try applying it:
  • extreme discipline and patience, which he admits himself might be the toughest task, since it may be necessary to wait for years before the price of a stock becomes favorable (e.g. in his Abbott Labs case study); part of the challenge is to constantly track quarterly results for all the candidate stocks and market moves
  • data availability and manipulation - he uses his Bloomberg professional terminal to quickly pull up and chart the trailing 12-month EPS for seven years against stock price; try to do that with Yahoo Finance, Google Finance, ADVFN, GlobeInvestor, your discount broker's version of stock research tools, or any other free online website.
The actual mechanics of the method are a bit complicated and subject to some judgement, especially the business of valuation resets and setting the exact location of the high-low price points. The author's explanation in an email response to my query was "The placement of the projected EPS line does influence the buy/sell targets. Keep in mind that this methodology has two objectives: 1) to lead you to invest in companies that have great earnings profiles and 2) to give you a high probability of buying low and selling high." i.e. it is approximate, not exact. Schwinghamer also warns that his method does not pretend to guarantee profitable trading every time on every stock. It is meant to work on average over multiple stocks and trades. Probably it would become easier after some time working with the method.

Those who might be interested in the method but are looking for an easy way to follow it can check the book's website where the Top Picks tab shows both the top 25 US and top 10 Canadian picks with current High or Low price assessment. With free membership registration, all 233 US and 41 Canadian Purple Chips are available.

The method is intriguing and makes a lot of sense and the book does a fine job explaining the method. Any investor considering buying individual company stocks, and especially those who believe in fundamental analysis, can benefit from reading the book and checking out the stocks named in the website. As I discovered on my other blog looking at the stocks in the Purple Chip list, there is considerable overlap with holdings in low volatility ETFs and a fair degree of overlap with stocks arising from various methods that seek out worthwhile companies.

My rating: Excellent book, 4 out of 5 stars.

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