Reference Shareholders Needed

Public equity investors have poisoned the well we drink from — The antidote is the reference shareholder — Opportunity exists to create a new paradigm in public equity investing.

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REFERENCE SHAREHOLDERS NEEDED

In Europe there exists the concept of a "reference shareholder." A reference shareholder holds a large stake in a business, usually >5%, and serves as the de facto speaker for the entire shareholder base. Reference shareholders are typically families or foundations, investors that take a long-term view, build relationships with the management teams and boards, and, importantly, do not sell their shares based simply on price fluctuations. Reference shareholders are truly partners to the business.

This mindset contrasts sharply with the short-term nature of most public equity investors. Typical mutual fund turnover rates are 50-100%; said differently, mutual fund shareholders tend to own stocks for 1-2 years. With this turnover, management teams know that mutual fund investors are looking to capitalize on share price fluctuations as opposed to the long-term, intrinsic value growth of their business.

Passive investors are no better. While passive ETFs tend to trade less than mutual funds, they are, by default, absentee shareholders. Fraud, bankruptcy, excessive management compensation: no issue is important enough to rouse passive investors from their indifference to the struggles of a specific business.

Poisoning The Well

The public equity investment industry is poisoning its own well by demanding short-term investment results.

First, shareholders demand CEO compensation aligned with short-term returns. CEOs are now rewarded based on Total Shareholder Return, a metric that rewards CEOs for share price growth, not necessarily business value growth.

Next, CEOs seek to maximize their compensation. The biggest driver of share price, in the short-term, is the trading multiple. Short-term shareholders will sell, and decrease a company's trading multiple, if they do not see a path to returns in 12-18 months. Management teams, to earn their incentive compensation, must concoct stories about why their share prices will reward their short-term investors.

Finally, CEOs come to find that their share prices, and correspondingly, incentive comp, revolve around delivering on quarterly earnings or "exciting" news (buybacks, divestitures) to satisfy their short-term shareholders. Any management team participating in this game will neglect to reinvest in the business itself. This is why businesses fail to innovate, operate with overleveraged balance sheets, and repurchase shares at unattractive prices.

Passive shareholders simply amplify this effect. By holding large blocks of shares with no opinion on company strategy, passive shareholders implicitly support the strategy of short-term investors.

The result is poor long-term returns for all equity investors, despite excellent short-term returns for the CEOs earning stock based compensation and mutual fund managers charging large fees.

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Reference Shareholders Needed

The solution to short-termism is the reference shareholder. A shareholder that focuses five or ten years into the future, knowing that share prices will, at some point, follow the value created by the business.

A shareholder that takes a risk-first approach and demands lower leverage, to ensure the future survival of the business, as opposed to buybacks today. 

A shareholder that rewards management teams for long-term value growth, true value creation, as opposed to short-term share price pops.

A shareholder that, with its voting power, is a deterrent to the distracting and destructive practices of greenmailers and activist shareholders.

While many public equity investors may agree with the views above, they are hollow coming from investors that have demonstrated a history of selling shares in the short-term. Management teams may take calls from these shareholders, but it is simply a courtesy, a job requirement to manage a multiple. Active public equity managers can lament CEOs not taking their advice, but their reputations for short-termism precede them.

The Opportunity

Reference Equity seeks to be the reference shareholder for a handful of outstanding businesses operated with a truly long-term mindset. We believe that by bringing this disciplined, long-term focus, we can support value creation at the companies we own. We can push for the correct incentives, ignore quarterly results, encourage conservative balance sheets, and support reinvestment at high rates of return.

By creating a new paradigm for public equity investing, we ourselves can be the antidote to the current public market malaise. More reference shareholders are needed to drive this change.