Fund Manager Rosemary Banyard uses an insight from the late Charlie Munger to emphasise the importance of well-aligned incentives in driving shareholder value. She highlights the benefits of directors having significant shareholdings and well-structured remuneration packages focused on long-term goals, and warns of the pitfalls of conventional remuneration targets. An analysis of the VT Downing Unique Opportunities Fund shows that companies with well-aligned incentives tend to perform better, highlighting the need for rigorous economic criteria and cautious acquisitive strategies.

The late Charlie Munger, with his customary penetrating insight, once observed: “Show me the incentive and I will show you the outcome”. In the UK-listed company arena, one size does not fit all, but there are certain incentives which seem to us more likely to generate better shareholder value than others. Two which we favour are skin in the game, and remuneration packages which include any or all of: a long-term focus, the risk of personal loss, or the incentivisation of superior capital allocation.

Skin in the game

We define ‘skin in the game’ as directors (and occasionally founders who have left the board) who own more than 3% of a company. The larger a company is, the harder this hurdle is to achieve, and we recognise that a smaller stake in a big company could still be monetarily significant to the individual concerned. Furthermore, new management may simply not have had enough time to build up a significant holding. Nevertheless, we believe that significant director shareholdings represent greater alignment with our interests than any other remuneration package. We refer to it as ‘the owner’s eye’, and believe it brings the right blend of prudence and decisiveness, coupled with a long-term mindset.

It is noteworthy that in our fund, the VT Downing Unique Opportunities Fund (DUO), there are both high levels of skin in the game and management longevity within the underlying investee companies:

Overall, the weighted average holding of directors in DUO companies is 9.8%, and the average tenure is eight years as CEO.

We recognise that some of our investee companies are run by executives who may not meet the 3% ownership hurdle for whatever reason, but still have an owner’s eye and a longevity which signals superior commitment. These include Nigel Newton at Bloomsbury Publishing or Kevin Lyons-Tarr at 4Imprint who have clocked up 37 and 33 years respectively inside their companies.

Remuneration packages are a complex topic, and circumstances vary enormously. However, one element we regard very favourably, in bonuses or longer-term plans, is a target or underpin requiring a minimum level of return on invested capital or return on capital employed. This is particularly important where the company in question is acquisitive, as it incentivises capital allocation which delivers an economic profit, while penalising expensive or ill-conceived acquisitions, or poor integrations. The following companies held in DUO include such a target:

We also favour incentives that encourage long-term thinking and share ownership since this aligns with our own attitude to investment. Occasionally too, especially in instances where a turnaround is needed, there can be a case for an element of remuneration linked to an absolute (high) share price, which at least has the merit that it focusses the mind.

We set out three companies in DUO which exemplify some of these approaches below:

More conventional approaches to remuneration tend to involve targets for adjusted earnings per share, which leave shareholders open to all manner of “adjustments”, potentially including write-offs for previous errors made by the same management team! Worse still are targets linked to adjusted EBITDA, a measure for which Charlie Munger reserved a well-known and well-deserved but unprintable description. The difficulty with earnings per share is that it does not tell the investor a great deal about the capital that generates it, which we consider a crucial element to assessing the quality of a business.

We have performed an analysis of all the companies owned by DUO since launch in March 2020 to see whether there is a correlation between incentives and returns. We placed the companies into three buckets: A where management or founders own >3%; B where there are incentives that align with our objectives, such as ROCE targets, long-term holding periods or absolute returns; and C: the rest. We assumed for the purpose of this analysis that all companies were owned throughout the period at our average weighting.

The contribution of the three buckets to total return is shown below

The results made us sit up! In bucket A (skin in the game) average total returns were 63.6%. There were 19 companies, of which only three produced a negative return, and only two of these were into double-digit declines. In bucket B (well-crafted and aligned incentives), average total returns were 78.1%. There were only six companies, two of which were stand out contributors, namely Games Workshop and Diploma. In bucket C, total returns were only 12.5%. Here, there were the largest number of holdings at 23, of which five were insignificant (e.g. nil paid shares, in specie distributions). Of the 18 others, eight of them exhibited negative returns, seven in double-digits.

Key learning points from the data

How should we react to this data? Firstly, it’s important to say that correlation doesn’t always indicate causation! High barriers to entry and attractive financial characteristics may well be the strongest contributing factors to good performance. Moreover, the starting point for this data (and our fund) is 24 March 2020 in the depths of the Covid downturn in stock markets, so there will have been uneven experiences in and levels of recovery from the pandemic effects. Secondly, there is a concentrated number of stellar performers, although we believe it is quite common for many funds to have a few outsized winners over time. Thirdly, you might reasonably ask why we have held the most investments in bucket C! Of the 23 investments, as already stated, five were insignificant. Four of these and nine larger holdings have been sold, two in connection with takeover bids.  Some companies in bucket C clearly possess very good business models, have significant economic moats and excellent returns on capital, notably Auto Trader and Rightmove. However, many of those which performed the worst, and were at some point sold, had in common that they had made poor acquisitions and had taken on significant debt. The suspicion raised is that these management teams, possessing neither significant skin in the game nor properly aligned incentives, took undue risks with shareholders’ money with unfortunate results.

Key learning points for us from this exercise are that we must remain rigorous in our demands for superior economic characteristics, and even more wary of acquisitive strategies, particularly if we are investing in companies where management does not have significant skin in the game or incentives to deliver economic returns on our capital. We also think it important that any investment philosophy and process is dynamic, not static, involving self-reflection in the quest for constant improvement. So, at the time of writing, we have 15 companies in bucket A, 6 in bucket B, and 10 in bucket C.

This article is written by:

Rosemary Banyard

Manager of the VT Downing Unique Opportunities Fund

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Risk Warning

Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Important notice: this document has been prepared for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Any subscription to the fund should be made on the basis of the relevant product literature available from Downing or from the ACD, Valu-Trac; and your attention is drawn to the charges and risk factors contained therein. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 10 Lower Thames Street, London EC3R 6AF.