公司投资与派息政策讨论

Compliment s of: V O LU M E 2 6 | N U M B E R 4 | FAL L 2 0 1 4

Journal of APPLIED CORPORATE FINANCE

In This Issue: Are U.S. Companies Underinvesting?

The State of the Public Corporation: Not So Much an Eclipse as an Evolution 8 Conrad S. Ciccotello, Georgia State University

Capital Deployment Roundtable: 22 Panelists: John Briscoe, Bristow; Paul Clancy, Biogen Idec; A Discussion of Corporate Investment and Payout Policy Michael Mauboussin, Credit Suisse; Paul Hilal, Pershing Square Capital Management; Scott Ostfeld, JANA Partners; Don Chew and John McCormack, Journal of Applied Corporate Finance.

Moderated by Greg Milano, Fortuna Advisors.

Survey of European Experts Usha R. Mittoo, University of Manitoba

Are Certain Dividend Increases Predictable? The Effect of Repeated 118 David Michayluk, University of Technology, Sydney, Dividend Increases on Market Returns Karyn Neuhauser, Lamar University, and Scott Walker, University of Technology, Sydney

Capital Deployment Roundtable A Discussion of Corporate Investment and Payout Policy New York City | May 28, 2014 Photographs by Yvonne Gunner

22 Journal of Applied Corporate Finance • Volume 26 Number 4 Fall 2014

Greg Milano: Good afternoon, I’d like made by executives may well be the most to welcome you all to this roundtable on important determinant of how well their capital deployment. We’re very pleased share price performs over the long run. to have a panel that represents such a You can reshape a company through range of views and experience—one that acquisitions and divestitures, grow it includes corporate financial executives through capital investment, or shrink it and investment bankers as well as activ- by distributing cash to shareholders. In ist investors. Our plan is to spend the fact, you can completely change what next hour or so talking about the over- industry you’re operating in—because all strategy for deploying capital while your ability to sell assets and raise capital considering all the major alternatives for to buy others gives you the power and the reinvesting capital in the business or dis- means to change it.

tributing it to shareholders. But before we proceed any farther Many people have different ideas with the discussion, let me say a bit about about what it means to deploy capital. the people who have agreed to join us But let me start by telling you how I today.

think about it. Our basic subject here is John Briscoe was recently named all the things corporate managers can do Senior Vice President and CFO of with the cash their companies generate Bristow, the Houston-based leader in both internally through their operations providing helicopter services for oil and and what they raise from the outside gas transportation and search and rescue. from banks and financial markets. Man- Previously, John was Chief Financial agers can use that cash to make capital Officer of Weatherford International investments, fund research and devel- Limited for about two years. Before opment, increase working capital, or that, he had almost 30 years of experi-they can use the cash to grow by buy- ence in different parts of the energy ing other companies and forming joint industry, mostly in oil field services, but ventures. But if they have more capital several other areas, including a number than they need, they can distribute it to of energy MLPs.

shareholders through dividends, either Paul Clancy is the CFO of Biogen regular or special, one-time dividends, or Idec, a biopharmaceutical company that through buybacks of their stock. And, of Paul has worked with for about 14 years, course, companies also have the option the last seven as CFO. Prior to that he of increasing their financial flexibility by spent about 15 years at PepsiCo. paying down debt or building up cash. Michael Mauboussin is head of Global And so that’s our main topic for this Financial Strategies at Credit Suisse, afternoon: How do companies make where he advises corporations and inves-these decisions—and how should they tors on topics related to capital markets be doing it? theory, valuation, corporate strategy, Of course, there are lots of other and decisions. Before that, he was Chief things CEOs and CFOs need to do, but Investment Strategist at Legg Mason I’ve increasingly come to the conclu- Capital Management, where he worked sion that the capital deployment choices with Bill Miller on lots of issues, includ-

Journal of Applied Corporate Finance Volume 26 Number 4 ing investment process.

Paul Hilal is a partner at Pershing Square Capital Management, a well-known activist hedge fund that manages about $18 billion. Paul has served as a shareholder representative on the boards of three public companies over the years. Scott Ostfeld is a partner and co-portfolio manager at JANA Partners, a $10 billion value oriented hedge fund known for its shareholder activism.

Don Chew has been the editor of the Journal of Applied Corporate Finance and its predecessors for well over 30 years

now. He was a founding partner of Stern Stewart & Co.—a firm I later joined for 10 years and became a partner of. During Don’s tenure as editor, the JACF has been sponsored or owned by a number of financial institutions, including the Midland Bank of England, Continen-tal Illinois, Bank of America and, most recently, Morgan Stanley. A little over a year ago, Morgan Stanley sold the JACF to Don, his associate editor John McCormack, and Carl Ferenbach, the retired co-founder of the private equity firm Berkshire Partners who now serves as Chairman of the Environmental Defense Fund.

And last but not least is John McCormack , who, as I just mentioned, is associate editor and co-owner of the JACF. Before joining Don as associate editor, John was an analyst at Morgan Stanley who focused on questions of accounting and value—and before that, he worked as a consultant at Stern Stewart specializing in serving the energy industry.

And as I told you already, I’m Greg Milano , CEO and co-founder of Fortuna Advisors, a shareholder value-focused

Fall 2014 23

strategy consulting firm that advises me that’s where to find the special sauce companies on everything from busi- for creating long-run value. And since ness strategy, portfolio management and Paul was the one who suggested that I capital deployment to performance mea- read that excellent book, I will start by surement and incentives. We differentiate asking him for his views on the overall ourselves through the thoroughness of process of coming up with the right capi-the training and coaching we provide to tal deployment strategy.

help managers think more like private owners inside the public company. Paul Clancy: Greg, I agree that capital So, that’s our cast of characters. And deployment and capital allocation are before I give up the floor, let me also very important and can really determine mention that the idea for this roundtable a large amount of a company’s value cre-started with a book that Paul Clancy first ation over time. But I would add that suggested to me. The book is written by operating performance, innovation, a highly regarded value investor named understanding your business, and having William Thorndike, and it’s called great strategies all allow you to be better The Outsiders: Eight Unconventional at capital allocation—because they all CEOs and Their Radically Rational give you more choices, more opportuni-Blueprint for Success. The book provides ties to use capital in a way that creates accounts of how the CEOs of eight future cash flow and value.

A merica n compa nies ma naged to It’s also important to keep in mind create extraordinary shareholder value that corporate managers are by nature over time. And one of the book’s main competitive. They are always compar-themes is how successful CEOs vary ing themselves to competitors and their strategies in response to major peers— and that kind of competi-changes over time in both the capital tion has been a major contributor to and product markets. They adjusted the success of corporate America. But their strategies in response to changes there is a caution here—one that stems in industry competition and the capital from the reality that the typical corpo-markets. At one point in its history, a rate scorecard usually has a short-term company might have succeeded with orientation. The metrics most com-well-planned and executed acquisitions. monly used for performance evaluation But a few years later, in a very different tend to be earnings in a given month, env ironment, t he sa me compa ny quarter or year. But a company’s value stopped acquiring other businesses and depends on its long-term cash f low used its excess cash mainly to buy back and its return on capital deployed as its own stock. opposed to its current earnings. Think The main lesson of the book, then, about companies like Amazon—and is that the value-maximizing capital it’s also true of Biogen, where I work. deployment decisions depend on not In such cases, it’s easy to see the impor-only the internal operations of the com- tance of allocating capital in ways pany, but also the external environment that are designed to increase the long-in the capital and product markets. To run stream of expected cash f low, or

24 Journal of Applied Corporate Finance Volume 26 Number 4 what I like to call “intrinsic value per share.” And when I say intrinsic value per share, I’m thinking about a measure of value that includes not only the next quarter’s earnings and cash flow, but also the expected long-run effects of today’s decisions to allocate capital. Intrinsic value per share should be the lens that is used to evaluate all forms of capital deployment, including dividends and share repurchase as well as acquisitions.

Viewed in this way, the capital allocation process necessarily involves a rich conversation that draws on practical experience as well as research findings, and it’s taking place in a world with forecasts that involve lots of unknowns and unknowables.

Milano: John, as our other corporate representative, do you want to weigh in on this?

John Briscoe: I think companies need to be sure that they’re really getting back to the substance of the capital budgeting or allocation process. Is the budgeting process just something that you go through mechanically each year? Do you look mainly at what was invested last year, and use that as your baseline? Or do you really try to start with a clean slate and ask what will generate the best returns for the cash available? And what does your company do when its cash position is not equal to its attractive capex opportunities? Do you simply limit capital investments to your immediately available cash resources? Or do you consider raising new funds?

Although limiting corporate investment to internal funds may not be a

Intrinsic value per share should be the lens that is used to evaluate all forms of capital deployment, including dividends and share repurchase as well as acquisitions.

Viewed in this way, the capital allocation process necessarily involves a rich conversation that draws on practical experience as well as research findings, and it’s taking place in a world with forecasts that involve lots of unknowns and unknowables.

prospects. an effective strategy is whether it cre-Paul Hilal: That’s right, I graduated with ates value—and I too like Paul’s term Milano: Michael, you’ve spent a lot a JD/MBA in 1992. “intrinsic value per share”—and you of time during your career thinking can’t do a thoughtful valuation without and writing about capital deployment Scott Ostfeld: And I was in the JD/MBA understanding a company’s strategic strategy. How would respond to the Class of 2002. position comments you’ve just heard? So, you can’t make intelligent capital Mauboussin: Business schools tend to allocation and valuation decisions with-Michael Mauboussin: I agree with pretty teach strategy in one department and out understanding the strategic position much everything that you, Paul, and finance in another. So in strategy, you of your company and the profitability of

Journal of Applied Corporate Finance • Volume 26 Number 4 Fall 2014 25

your industry. That’s an important mes- you mind giving us a brief preview of the sage of the Thorndike book, of which I main findings?

too am a big fan. As an investor, you have to be living at the intersection of these Mauboussin: We’re working on a project two areas. now where we have tried to estimate, for Another important message of the every year starting with 1980 through Thorndike book, as Greg mentioned, is the end of 2013, the total amount of that the right investment and financing corporate capital allocated to each of strategy varies with time and circum- the following activities or transactions: stances. And for that reason, I think the (1) M&A; (2) CapEx; (3) R&D; (4) best answer to most of the questions we stock buybacks; and (5) dividends. We will be discussing today is: “It depends.” also looked at divestitures. And we Is buying back stock good or bad? The then tried to make sense of the data by right answer is, it depends on a lot of tying it to the findings of academics to variables—on your investment oppor- understand the merits of each of these tunities, on your current stock price, different investments and distributions and maybe even on the tax preferences of capital over time.

of your investors. Is an acquisition likely One of our most interesting find-to be good or bad? And the answer again ings is that the average corporate return is, it depends on the company’s strengths on invested capital in 2013 for the top and capabilities as well as the opportu- non-financial 1,500 companies—calcu-nities in the markets. When evaluating lated using a measure called Cash Flow companies, the most thoughtful and Return on Investment, or CFROI— sophisticated investors try to understand reached an all-time high for the last how corporate managers think about 60 years. In other words, what might these questions, and how likely they are be described as corporate efficiency in to be thoughtful and judicious as they using capital is today at record levels. allocate the capital. But, at the same time, the growth in The last thing I’ll say here is that corporate assets has been below average there are sometimes major conf licts for the past ten years. As a result, there between incentive compensation plans has been an unusually large accumula-that are based on short-term perfor- tion of cash. In fact, the cash held by the mance metrics and the overall goal of S&P 500 in aggregate was $1.7 trillion long-term wealth creation. As real-world at year-end 2013. While about $1 tril-practitioners, we need to address that lion of that cash is offshore, it is still a issue. very large number.

Now, as any valuation model will Some Historical Perspective on tell you, value is a function of growth the Corporate Investment Decision as well as return on capita l. A nd Milano: Michael, you’re now working although the high rates of return have on a big research project at Credit Suisse been applauded by many investors, our that looks at corporate investment deci- findings raise the possibility that com-sions over a long period of time. Would panies could be sacrificing value-adding

26 Journal of Applied Corporate Finance Volume 26 Number 4 growth by limiting investment while pushing for ever higher returns. The goal of financial management, after all, is to maximize not returns on capital, but net present values. And as many of us were taught in business school, maximizing NPV means taking not just the highest-return projects, but all projects that are expected to earn at least the cost of capital.

So what does our research say about the relationship between value and growth? Over the years, we have exam-ined the relationship between total shareholder returns, or TSRs, and growth in EBIT. Until quite recently, this relationship had a negative slope, which means that higher-growth companies actually produced lower rates of return for their investors than slower-growing companies. But when revisiting the study last year, we found that the relationship had turned positive. And at the moment, the companies that are growing fastest are also getting the highest TSRs.

John McCormack: When was the inflec-tion point, Michael?

Mauboussin: Probably in the last 4 or 5 years, basically since the financial crisis. A nother interesting obser vation from our work is an apparent change in the market’s response to M&A in recent years. Past academic studies of corporate M&A have suggested that as much as 70% of deals not only fail to create value for the acquirer, but actually end up reducing its market value. But according to our survey of more recent work, that ratio has now fallen below 50%. In other words, a majority of deals now appear to create value for

I’ve spent much of my career criticiz-ing companies for an excessive focus on growth and too little attention to returns. But with our latest report, I now find myself in this weird situation where I might begin arguing the opposite. The case of Amazon.com is especially interesting to me because it’s growing rapidly off a large base. What that suggests to me is that the market may be saying that it’s no longer high returns on capital, but rather growth, that is the scarce commodity investors are willing to pay up for.

growth and too little attention to returns. you keep accumulating cash you don’t

off a large base. And what that suggests to And I for one have been arguing for a

M&A Strategy have consistently shown that acquisi-Milano: But let’s turn now to one kind tions financed with cash tend to receive of corporate investment, M&A. What a much more favorable reaction from the kind of industry factors make for a bet- market than those that offer stock. And ter acquisition process? Does it seem those that offer to pay higher premiums to matter whether an industry is grow- over market, as one might expect, tend ing or not growing, whether it has high to get less favorable reactions.

returns or low returns? Is there a particu- So, there are a number of characteris-lar type of company or type of industry tics of M&A deals that can help predict where acquisitions are likely to be better? success or failure from the vantage point Michael, can you summarize what the of the acquiring company’s shareholders. studies tell us about these questions?

Clancy: I think the studies also show Mauboussin: Well, let me start by that a series of smaller deals tends to cre-mentioning a book that came out ate more value than one large deal.

last year called “Masterminding Deal Breakthroughs and M&A Strategy and Briscoe: That’s true. But I’m sure there Analysis.” The authors looked at several are some large acquisitions that have categories of deals and assessed M&A turned out well. It’s just that there tends results. Interestingly, they found that to be so much management distraction when two declining companies in the with really big mergers that investors same industry get together, that actually tend to be skeptical, and rightly so. And tends to be a good merger and creates the distraction’s not just at the executive value. That’s what people refer to as an suite level, but it cascades down through “industry consolidation.” The authors’ to the line managers. People are unsure second category of profitable deals are whether they are going to lose their jobs “bolt-ons” and “line extensions.” But, because of the cost savings effort. when you start getting into new markets you’ve never been in before—what some Clancy: Divestments create a lot of value, people like to call “strategic” deals— too. You’re getting rid of this nuisance. acquirers tend to have a very low batting average. Briscoe: Yes. I just think people under-Now, in response to your question estimate the impact of the management about particular industries, although I distraction. That doesn’t mean that you don’t have specific answers, I do think can’t do things to try to mitigate that there are some findings that can be risk. You have to recognize it up front applied to the kinds of deals that take and then try to put in place things that place in certain industries. As I just will limit that because you’ve done it a mentioned, the overall returns to acquir- lot. I’ve been part of two organizations ers, although historically negative, have where we did a lot of acquisitions, as improved in recent years. And we have many as 40 of them—and we got pretty pretty persuasive evidence that the type good at taking these companies and of deal matters. For example, studies folding them into the larger company.

28 Journal of Applied Corporate Finance Volume 26 Number 4 And in all but a handful of cases, things have worked out well.

Mauboussin: John— and you too, Paul—from your corporate vantage point, do you think the M&A investment opportunity set today looks better or worse than it did say five, ten, or 15 years ago?

Clancy: On the whole, it looks better.

But, as you say, Michael, it depends; you can’t generalize too much. Take the conventional academic wisdom you just cited that two thirds of acquisitions historically failed to create shareholder value for the acquirer. We devoted a lot of time to research that question last year, which included taking a careful look at the McKinsey study that was done over 20 years ago. When you actually parse the data, a couple of really key things came to light. One is that there is a huge difference between acquiring businesses you’re already in and those that are not related to your core; acquiring unrelated businesses is almost always viewed with skepticism by the markets, while business add-ons and extensions are often well received. And we also find significant differences between the profitability of larger acquisitions and smaller deals, which are usually easier to integrate.

Milano: Companies usually justif y acquisitions on the basis of cost-cutting synergies rather than growth synergies.

Our research on acquisitions over the last 15 years shows that companies that experience higher growth rates in the years after an acquisition than in the years leading up to it have better share

price performance around the time of after the deals close, better at executing the acquisition. But having worked for and realizing the expected benefits. One an investment bank, I can tell you that of our Fortuna studies has shown that all the pitch books were focused on cost the more frequent acquirers deliver bet-synergies with almost no emphasis on ter share price performance. And I think extra growth. that a lot of it is just practice: you get good at something that you do over and Mauboussin: Well, M&A has been stud- over again.

ied at least 10 different ways over the last 40 years. McKinsey did a survey in Investors’ Take on Capital which they asked executives about cost Deployment synergies vs. revenue synergies. They Milano: But let’s turn now to investors’ found that, in a decent percentage of the perspective. Paul and Scott, when you look cases, the companies nailed their cost at a company, what do you think of the synergy numbers, but very few got their quality of the capital deployment choices? projected revenue synergies. So, inves- What are the attributes of companies that tors are still a bit skeptical about growth make good decisions? What causes other synergies. firms to make poor choices? What do you think companies should be doing differ-Milano: I’m not sure that “growth syner- ently than what they’re doing now? gies” is the right way to characterize my point. The real story is that there is a big Hilal: Each of the alternatives for excess difference between buying a company capital—capital expenditures, acqui-that’s stagnating just to take out costs, sitions, return to shareholders, and and buying a company that has growth repayment of debt—can be either an opportunities that can be funded and excellent or a poor use of cash. Investors their potential realized. A big acquirer tend to worry least about capital expen-can take a small acquisition and grow ditures. But the expected return from it to three to five times its previous size an acquisition is not only uncertain, in a few years—something the smaller but reduced by the competitive price firm could not have done alone. These the acquirer must pay for the target. By are often the best acquisition strategies contrast, companies can capture excess as long as the purchase prices can be returns from internal capital projects kept within reason. without having to invest at market-competitive prices—because the opportunity Clancy: Conceptually, then, that means is captive. They can invest in these proj-that some companies are better owners ects at cost, and earn return well above of assets than others. market returns.

But having said that, I think there Milano: Right—and some companies are are some problems with the corpo-just better acquirers than others. Some rate capital allocation process. During companies are better at finding, negoti- the budgeting process, CFOs receive ating, pricing, and closing deals—and a menu of capital project propos-

Journal of Applied Corporate Finance Volume 26 Number 4

als. If the people developing these opportunities—whether they are new business development executives in a capital-intensive industry, or internal efficiency-focused six sigma teams— know that the hurdle is 12%, they will find opportunities that clear that hurdle, develop them, and present them for funding. If the CFO raises the return hurdle to 14%, those same people won’t waste time developing 12% projects.

Instead, they will keep looking until they find projects that return 14%—and they will ultimately find them, or at least innovative ways to squeeze 14% returns from a 12% project.

In this sense, then, CFOs get from their teams the capital projects they set-tle for. If more CFOs raised the bar, they might be surprised by the better opportunities they get.

At the same time, though, I also often see managers struggle—and this is a different problem—to balance rates of return and growth. At a Bern-stein conference I attended recently, the CEO of one of the presenting companies explained that their capital projects have required rates of return that range from 12% for ultra-safe capital projects to 20% for more risky ones. One of the people in the audience asked, “Given how strong your rates of returns are, and the wide margin by which they clear your cost of capital, have you considered lowering your bar a little bit to acceler-ate growth?” The executive said, “No, we’re happy with our hurdle rate where it is.” He later conceded that this was based on a subjective feel for running the business, and was not the output of an intellectual framework.

And in fact, very few CEOs and

Fall 2014 29

If I were given the chance to offer one prescription to all companies, it would be that managements should take a strategic view of the company’s businesses that is dynamic—that is, subject to the possibility of continuous change. Companies need to monitor their businesses, and revisit the logic for continuing to hold them, on a regular basis.

John Briscoe

We often find managers choosing what call “addition by subtraction.” By exiting Milano: Scott, what’s your response to they believe is the “shareholder-friendly” a failing business, you not only liberate what you’ve heard so far? thing to do, but what is in fact not the capital, but you avoid the drag of a fail-value-maximizing alternative. Many ing business on management’s time and Ostfeld: First of all, I thought Michael’s managers view themselves as operators, focus. And that’s why an event like a sale comments on strateg y and capital not capital allocators or value traders; of a business can cause us to upgrade our deployment were extremely well put. and when they see a business with sub- rating of an entire company.

And to just build on that, strategy is par margins or returns on capital, their

company created twenty times as much problem with this is that such people value as was destroyed by the median often don’t get much formal training in bottom quartile company. Now, imag- finance or investing; and as a result, they ine if those two companies represented tend to think more in terms of account-two different divisions of the same com- ing profits instead of focusing on creating pany. In that case, the corporate leaders shareholder value. And this problem per-would be better off selling the losers for sists and is reinforced because too often 50 cents on the dollar and focusing their these CFOs are evaluated—by their attention on creating every drop of value compensation committees and their in the winners. CEOs—based on EPS accretion rather than value creation.

Briscoe: To put that same thought The other big problem in my experi-another way, management teams tend to ence is the so-called “agency” problem, focus on execution. That is, they focus the loss of potential corporate value that on doing things right rather than doing arises from the reality that, for most the right thing. They try to keep doing senior executives, their annual compen-what they have been doing for the last sation package is more material to them five years very well. What they generally than the appreciation of the equity they fail to do, however, is to have a strategic already hold. If the incentive package is brainstorming session about what they not appropriately designed, the execu-should be doing, and indeed about what tives’ focus on maximizing incentives businesses they should be in. rather than the value of their sharehold-If I were given the chance to offer one ings can lead to perverse outcomes. prescription to all companies, it would I recall talking with one CFO who be that managements should take a stra- believed that his company’s stock was tegic view of the company’s businesses significantly undervalued, and that he that is dynamic—that is, subject to the had no material high-return uses for possibility of continuous change. Com- his surplus cash. He believed this with panies need to monitor their businesses, conviction—and while I know that’s a and revisit the logic for continuing to pretty common belief, this guy had fairly hold them, on a regular basis, especially specific and plausible reasons supporting in very cyclical businesses like energy, his belief. And my advice to him was to where things can change so quickly and use his considerable spare debt capac-dramatically. ity to promptly repurchase a substantial percentage of his company. I explained Hilal: There are a number of common that a self-tender could be the best way themes one finds at companies that to carry out his strategy.

struggle with capital allocation. But he didn’t see it that way. His reac-One is the background of CFOs. tion was, “Well, I could do that, but if Some CFOs come to the position instead of levering to do a self-tender, because they started out as CPAs—and I repurchase shares gradually over the they may have been the company’s audi- years, I can enjoy a long-term earnings tor before becoming a controller. The per share growth tailwind, and I have

Journal of Applied Corporate Finance Volume 26 Number 4 the flexibility to repurchase more shares in those quarters where I am concerned about hitting my EPS target.”

But that was not, of course, the way a value-maximizing manager—or investors like us—would view the situation.

I asked him to pretend that he owned the whole business—that it was all he owned, and that it is what his whole family depended upon. Under those assumptions, he would be evaluated not on whether he showed smooth earnings growth, but on the value of his equity in 20 or 30 years. His response was that, although he personally understood the benefits of such a strategy, he didn’t feel that comfortable pursuing such a plan because his shareholders might not approve.

Chew: What you might have told him, Paul, is that he wouldn’t have to worry about his shareholder base because it would have changed as a result of the transaction. That’s what happened when Sealed Air borrowed 90% of its current market value back in the late 1980s and paid it out as a special dividend. In that case, the shareholder base almost completely turned over. In place of the widows and orphans—and the pension funds that invest much of their money—who were relying on dividends, hedge funds like Tiger Management lined up to buy their shares.

And after turning the capital struc-ture upside down, the company made remarkable improvements in operating performance—in part because they had to service debt, but, more importantly, I think, because management, together with the hedge funds, now had large equity stakes in the business.

Fall 2014 31

Hilal: That’s a perfect illustration of the some want share repurchases. point. The CFO in my story said that he But underlying all these differences, liked his shareholders and didn’t want the most fundamental demand by inves-to alienate them, and that they liked a tors as a group—what we refer to as “the predictable story. If you’re beholden to market”—is for the creation of share-shareholders who for some reason want a holder value. And as Michael reminded smooth EPS trajectory, you’ll get one set us, the best way to create shareholder of shareholders. But if you demonstrate value is to follow the NPV rule: take only that you will predictably act to increase those projects that are expected to earn shareholder value, you will get a different more than the cost of capital. And make kind of shareholder—and, in my view, a sure that your existing operations earn at more sophisticated investor that will be least the cost of capital—and for those capable of assigning higher values to your that can’t meet that standard, then be shares. But I didn’t persuade him. prepared to shut them down or sell them to another owner that thinks it can.

Chew: In my experience, most manag- By following these principles, compa-ers think that their shareholder base is a nies have the best chance of maximizing given; it’s something they’re stuck with their “intrinsic value.” In the end, that and have no way to influence or change. approach is likely to drive the most They inherit their shareholders with the value. Of course, in some cases even job, and they have to support that con- well-thought-out strategies don’t work stituency through thick and thin. out—and well-run companies can fail.

But, in my view, the most reliable way Hilal: Precisely. Not many CFOs are for companies to achieve long-run suc-interested in the turbulence that comes cess is to use the value creation principles with a turning shareholder base. at the core of finance theory to drive both current performance and continu-Clancy: When talking about this ques- ous innovation in the business.

tion of investor clienteles, I think it’s important to distinguish between the Briscoe: I agree completely, Paul. Com-habits and preferences of individual panies ought to focus on how to create shareholders and the process of share- the most value and not on keeping their holder value creation. People tend to current shareholders happy. If you focus confuse the two. Individual sharehold- on how to create the most value—and ers are, of course, human beings with you do a reasonably good job of explain-all the strengths and limitations we ing your approach to the investment expect of them. Many shareholders, for community—you will find shareholders example, have really short time horizons, who appreciate what you’re doing and much shorter than the planning staffs want to buy your shares.

of most corporations. But many other Michael mentioned the importance shareholders buy and hold. Some share- of aligning management’s interest with holders want dividends, while others shareholders.’ Companies should ensure favor growth through acquisitions. And they have a compensation plan in which

32 Journal of Applied Corporate Finance Volume 26 Number 4 managers cannot win unless the shareholders do. To me, a system that rewards corporate managers for meeting or beat-ing EPS targets is almost certain to lead to some kind of accounting manipula-tion. There are just too many ways to create earnings that don’t end up increasing cash flows or long-run value. You have to find performance measures that show where capital is either generating cash and high rates of return—in some cases, measured after depreciation, when depreciation is a real cost of the business; in other cases, before depreciation and R&D, when such expenses really represent an investment in the company’s future. The stock price of Amazon.com, by the way, represents the best illustration of the market’s ability to make that discrimination that I can think of.

Milano: I think that much of corporate America’s capital budgeting mistakes can be attributed to the law of unintended consequences. Most corporate managements set out to do the right thing by their shareholders—but then they often get side-tracked by relying on proxies for value that end up misleading them into bad decisions.

We did some work for a very large company that was earning very high rates of return on capital. We evaluated corporate-wide and divisional performance, and we were shocked by the low rate of reinvestment in their highest-returning business. When we asked management about it, we were told that there were no more promising investment opportunities in this business.

But we found that the compensation plan was driven by how much you could increase the return on capital. This meant

If you have a great capital allocator sitting at the top of a company, then you don’t need the constraint of dividend payments to help make them avoid negative-NPV investments.

In that case, I agree that an opportunistic capital allocation approach is the right way to do it. Let the Warren Buffetts of the world continue to hold on to their capital and use it at their discretion.

But there are a lot of companies out there where this model won’t work, a lot of companies that benefit from the discipline of either high leverage, or paying out capital on a regular basis in the form of dividends. If what I was saying was wrong, the business model of hedge funds like Pershing and Jana would not have produced the high returns and attracted as much capital as it has.

more than 40% to bring up the average. 35% return opportunities in one area But in the other businesses that were while investing in 15% projects in Chew: What they needed, Greg, was our earning only, say, 10%, they could invest another. At the same time, the company old EVA financial management system or

Journal of Applied Corporate Finance • Volume 26 Number 4 Fall 2014 33

something like it. That way, all the divi- projects. One way that the new CEO sions would have had incentives to take of Canadian Pacific has helped improve all projects that earn more than the cost performance is by educating the team of capital. Even though it’s been many all the way down the line on what years since we both worked at Stern return on capital means. He starts with Stewart, I still think EVA is as good a broad company addresses to groups that single period measure as you can find. include the employees from all levels at the company. To illustrate the concepts, Briscoe: I’m a fan of EVA, but I don’t he talks about a hypothetical lawn-think that you can depend on just one mowing company that people can easily metric applied in exactly the same imagine. Using that company as an way at every company. You have to example helps each employee develop an create different f lavors for particular intuitive feel for the cost of capital and companies. You need to be able to shareholder returns. He likes to talk, for measure performance internally so that example, about “sweating the assets.” line managers can understand how their This education has a very powerful performance affects the whole. And you effect on behavior.

want the line managers fully aligned with So, I’m a big supporter of John’s both senior managers and shareholders. point about the importance of driving education and incentives down through Mauboussin: Do the investors in this all levels of the organization. group agree with that? And have you seen companies with really well-designed Businesses with Different Time compensation systems? Horizons Milano: Paul Clancy, you’re in a business Hilal: I agree completely with what that, at least on the outside, appears to John just said about educating the team behave an awful lot like the situations further down the line. The CFO can we’re talking about; it produces a large fund only the value-creating projects that and fairly stable stream of cash f low. are presented to him or her. Employees But you also have another part of the who don’t understand shareholder business where you’re trying to develop value creation can’t be expected to do future value from your research. It may as good a job spotting value-creating be hard to manage business activities opportunities. As a result, the quality of with payoffs far in the future using the the capital projects presented to a CFO kinds of tools and incentives discussed will suffer if the team below isn’t properly here. How do you cultivate a value trained. mindset in such businesses?

A good exa mple is t he ra il industry. One of our big investments Clancy: You have to tailor your perfor-is in Canadian Pacific, which is an mance evaluation and compensation enormously capital-intensive business— systems for businesses with longer pay-railroads typically spend as much as offs and time horizons. But you also have 18% of revenue each year on capital to impose some discipline on capital

34 Journal of Applied Corporate Finance Volume 26 Number 4 spending, even in R&D. Over the last 20 to 30 years, the pharmaceutical business has shown that within the same industry some firms can produce very high rates of return in R&D, while other firms can end up wasting large amounts of capital.

Why does this happen? As companies get bigger, there is a well-k nown tendency for bureaucracies to develop that, once they get established, can be very hard to manage. Bureaucracies have proven to really impair the scientific discovery process.

For us, R&D decisions are bigger decisions than many acquisitions or share repurchases. Over the course of five or ten years, the deployment of capital to R&D is often larger than the return of capital to shareholders or acquisitions.

So, it is the crucial determinant of value creation. And when assessing R&D expenditures, you have to have a multi-year time horizon—and you must take a portfolio approach since a lot of the projects are not going to come to fruition.

One of our strategies is to identify as quickly as possible the projects that aren’t going to work and then shut them down. If done right, that process alone can create meaningful shareholder value. The choices you make are so early in the process that you really need to make those decisions based on science—because at that point the financial projections are so uncertain. At this stage, you can’t really put together a model of probabilities and say this is the NPV. We do some financial calculations, but the approaches are very probabilistic;

they’re based on thinking about a number of different scenarios, and trying to assign probabilities and cash flow outcomes to each of them.

Milano: So R&D is so early in the pro- they spent about a quarter of that buy-duction process that you have to make ing back stock in 2009 when the market decisions based on science rather than dropped in half. It should be the exact projected cash flows, right? opposite. How many managers of public companies are thinking like owners and Clancy: We still maintain some guard- about NPV and intrinsic value per share rails that are tied strongly to an economic when making these decisions? model. I think most companies have seen Michael, you’ve done a lot of work in that when you do scientific work in areas the behavioral economics area. Is there that you actually know about, you have any role for management “irrationality” a higher chance of success. It’s when in explaining corporate buybacks and you stray in the pursuit of diversifica- M&A?

tion—and this is true not only of R&D projects, but also acquisitions—that Mauboussin: Well, let me start with the companies generally don’t make wise or simple point that companies tend to buy informed decisions. back shares when they have lots of cash, and that tends to be when earnings and Briscoe: But it seems that ultimately the stock prices are at relatively high levels. present value of future cash flows still But when their stock prices are low, their applies, even if a little bit differently in earnings and levels of cash also tend to different industries. In some cases, the be low—and so they’re less likely to buy cash that you’re investing may not pay back stock when you might think they back for years, while in others you may should.

generate cash returns almost immedi- And the same thinking applies to ately. But that said, I think you’re always M&A. Managers are likely to fail to seize going to end up in a better place with opportunities during deep bear markets tweaks and adjustments to performance because they, like investors, are scared; measures that are designed for the par- and when you’re scared, the natural ticular industry. response is to conserve capital.

But having said that, I also think that Stock Repurchase: Buying High executives effectively make a distinction and Selling Low between dividends and buybacks that Milano: Ok, we’ve spent a good deal of I’m not sure they are aware of making. time talking about corporate investment CEOs try very hard to avoid cutting divi-decisions. Let’s now discuss how compa- dends, even in downturns. And they are nies decide to distribute capital, either also pretty reluctant to cut capital expen-through dividends or stock buybacks. ditures. So, with dividends and capex First, can someone tell me why com- both pretty much fixed, that makes share panies spend four or five times as much repurchases a “residual.” If we’ve made on stock repurchases when their stock is our investments and paid our dividend, expensive than when it’s cheap? The S&P and we still have some money left over, 500 companies spent over half a trillion then we’ll consider doing a share repur-dollars buying back stock in 2007 and chase.

Journal of Applied Corporate Finance Volume 26 Number 4 In 2009, corporate managers were scared like everybody else. With cash levels then relatively low, very few managers were prepared to do buybacks. And the opposite is true during good times when residual cash is higher but, unfor-tunately, so are share prices.

Milano: I like to call that the “pecking order theory” of capital deployment.

Companies do buybacks only when they have nothing better to do with money, which tends to be when you’re producing more cash, which also tends to be when your share price is high.

Ostfeld: That’s true of cost cuts, too. You generally get massive cost cuts only when revenue drops. Why? Because management psychology and confidence can matter a lot. We like to say that corporations are momentum buyers. It’s the confluence of higher cash levels, confidence in your own business, and good feeling about your external environment that drives companies to buy and invest—and the price becomes almost irrelevant. The record for stock buybacks was set in the fourth quarter of 2007.

But after the financial crisis set in, the buybacks stopped—and dividends became the main if not the only way to pay off excess cash.

Clancy: Michael, what do you think is the best way for companies to think about the question of dividends versus stock buybacks?

Mauboussin: Dividends can be a positive signal to the market, but if your stock is undervalued, I prefer to see buybacks.

There’s the possibility of a better rate of

Fall 2014 35

return, and the shareholder can time his enon; they came about in the early 1980s or her tax consequence. as a result of a change in the legal and regulatory environment. Until the cre-Briscoe: But what if you’re expecting ation in 1982 of a legal “safe-harbor” for your dividends to rise over time? Does companies buying back their shares, buy-that change the analysis? backs couldn’t really happen in a major

way. And this means that we still have Mauboussin: I don’t know if that really only a little over 30 years of history of matters. If dividends are not paid, or are significant buybacks.

paid but not increased, then sharehold- Now the studies of the first 15 of those ers still own part of a company that is 30 years showed that buybacks actually holding on to that cash. And it’s the total added a lot of value for the existing share-return—that is, capital appreciation plus holders. But the results have been different dividends—that matters to investors. for the most recent 15 years. The work I’ve seen suggests that buybacks are still good Ostfeld: But if you think about the divi- for shareholders. But that tends not to be dend as an investor, you may prefer to get true for companies that do buybacks for that cash directly because that return of the wrong reasons—for example, to offset capital prevents managers from wasting anticipated dilution from executive stock the money. And for that reason alone, a option grants.

growing dividend strategy could result in significant capital appreciation. Ostfeld: When we talk about “good for shareholders,” are we talking about Mauboussin: Absolutely. That’s Mike significant abnormal returns on the Jensen’s “free cash flow” theory: paying announcement of the buybacks, or are out money to shareholders in any form we talking about the long-term effects of prevents management from doing some- the buybacks?

thing dumb with the cash.

Milano: Both, but to me the longer-term Milano: There is a difference, though, effects are more important. And there’s because you can distribute free cash flow more recent data showing that compa-either through dividends or buybacks. nies that deploy a greater percentage of And to me the most important differ- their cash flow toward buybacks deliver ence is provided by all the evidence we lower total shareholder returns over time. now have that companies do a bad job But I want to go back to this question of timing their buybacks, buying when of bad market timing. At my company, their stock prices turn out to be high. we’ve come up with a measure we call “Buyback ROI” that quantifies the annu-Mauboussin: I’m not sure I agree with alized return of buybacks based on where that statement about the evidence on the share price goes after the buyback. buybacks. If you buy back stock at 20 and it rises It’s important to recognize that stock to 25 over the next year, that’s a 25% buybacks are a relatively recent phenom- Buyback ROI. By taking this approach

36 Journal of Applied Corporate Finance Volume 26 Number 4 over time, with buybacks happening quarterly over a two-, five-, or ten-year period, we see the returns are often quite poor, simply because companies keep buying their stock when it turns out to have been most expensive. The remain-ing shareholders that don’t sell into these buybacks are often worse off.

Clancy: In the last 15 years we had two bull runs each followed by bear markets.

Will we see a repeat of that over the next fifteen years or are we going to see something totally different? We don’t have as much historical data as we need to draw strong conclusions.

Ostfeld: In my view, all you have to know is that stocks tend to rise over time. If you believe that, then it’s axiomatic that buybacks create value in the aggregate, notwithstanding the evidence that they are poorly timed.

Does The Wealth Transfer Matter?

Mauboussin: Okay, but I think we’re missing something important here that I want to try and explain. There’s a value conservation principle that’s very important to keep in mind when thinking about the effects of buybacks.

Here’s my point: the value of a company following a payout to its shareholders is the same whether it’s a dividend or a buyback. What’s different is how shareholders are treated. If you buy back overvalued stock, the sellers benefit at the expense of the ongoing shareholders. If you buy undervalued stock, the ongoing shareholders benefit at the expense of the sellers. Only in the case of a dividend, or a purchase of stock at fair value, do all shareholders get treated equally. Also,

Our average hold at Pershing for our activist investments is about four years, which is much longer than a normal passive institution will hold a stock. When we make an investment, we consider ourselves long-term partners with the company.

In many cases, we have had very open and constructive dialogues with the companies.

In fact, they tend to view us as free consultants. They’re getting a study from somebody who’s got an enormous amount of skin in the game, who is aligned with their shareholders, who will give them advice based on the best interests of the shareholders and who will be around long enough to reap the benefits, or suffer the consequences of the advice. An outside consultant will want a fee and a banker will want a transaction fee. We’re not getting a fee from anybody. We just want the shareholders to win.

And there are CFOs and CEOs that recognize that and actually welcome the conversation.

Paul Hilal

Journal of Applied Corporate Finance • Volume 26 Number 4 Fall 2014 37

if you are the shareholder of a company own studies show that in recent years, that is buying stock, doing nothing is and on average, the companies that have doing something—increasing your per- reinvested a larger fraction of their cash centage ownership in the company. flow have had better share price perfor-So, Greg, I think I’m right when I say mance than the companies that reinvest that the focus of all of your comments and less. And those doing the biggest buy-analysis is on the ongoing shareholders. backs tend to reinvest less and their share price suffers. It’s as if the buybacks crowd Milano: That’s right, my focus is on the out the investment; it’s an easier path to shareholders that stay with the company, quick EPS growth.

the ones that don’t sell. I do care more about the investors that decide to hold Chew: But could much of the better my stock than the ones that have sold share price performance reflect the fact

it. To make an analogy, when I evaluate that those companies have much better acquisitions I don’t commend manage- growth opportunities than the compa-ment because the shareholders of the nies that choose the higher payouts? company they just bought walked away with a huge gain—even though that Milano: Possibly—but it could also might be good for society. I care about reflect the growing tendency of compa-what’s in it for the buyer’s shareholders. nies to pay people for improving their And in buybacks I care most about the returns on capital. Remember Michael’s shareholders that remain. point that companies are now delivering higher cash flow returns on capital than Chew: But if you take Michael’s position they have in any of the last 60 years. New that selling shareholders are as important investments tend to drag down short-as the existing shareholders, then there’s term returns, so less investment tends really only one question that matters in to boost returns. With the exceptions terms of whether buybacks are “good of a few industries, such as commodity for the economy.” What you want to chemicals, we found that the higher the understand is whether companies per- reinvestment rate, the higher the TSR. form differently, better or worse, as a So, when you say that buying back result of paying out all the cash. Was stock keeps companies from making bad it really excess cash—and did the pay- investments, that will be true of course outs thus help prevent companies from for the companies that are in fact mak-making bad investments? Or did the ing bad investments. But, on average, we company actually have good investment find that those companies that are invest-opportunities that the payouts caused ing more are delivering better share price management to pass up? performance for their shareholders.

Milano: I agree with you that compa- Hilal: That’s an interesting conclusion, nies pay out cash because they view it but, as I think Don was suggesting, you as excess cash; management doesn’t see have to be careful about causality. Does profitable ways of reinvesting it. But our the higher TSR result simply from higher

38 Journal of Applied Corporate Finance Volume 26 Number 4 investment budgets or greater opportunities, or, maybe from a third factor, the quality of management?

McCormack: Well, take the case of Exxon, which distributes a lot of capital through dividends and buybacks. When the company announced a reduction in its capex last fall, the market reacted negatively. But since investors like Warren Buffett have taken a big stake in the company, the price has regained its ground and more. And I think, as Paul suggests, that investors look at both corporate investment and payout decisions as important indicators of management quality. As Michael suggested earlier, it just depends on the situation.

A Brief Look at Private Equity Ostfeld: Well, to provide another vantage point to look at this, let’s consider the case of private equity. There the idea is that high leverage can add value by forc-ing management to pay out excess capital while also improving the operating efficiency of the business. And it’s easier to make riskier investments for growth when the board and shareholder are one and the same—though the high leverage could discourage you from doing investments with a weak business case.

Chew: But, Scott, the equity in such transactions is also really expensive, don’t you think—more expensive than in the case of public companies, with their diversified shareholder base and low leverage ratios?

Ostfeld: I agree that the cost of equity is very high in private equity deals.

Chew: And, in addition to the very high the possible downside of missed growth leverage ratios, I think one important opportunities is typically too high for reason the cost of equity is so high is most of them.

that, if you don’t have many profitable growth opportunities and you have too How Do Dividends Add Value?

much equity on your balance sheet, Chew: But I’d like to come back briefly investors know that there’s a good chance to this question of how corporate pay-that you’re going to waste that capital on outs can add value—that is, how they bad investments. And that’s why, for the actually increase the expected operating kinds of low-growth, stable cash flow values of organizations.

producing companies that PE tends I think there are two very differ-to invest in, debt is generally a much ent reasons why dividends produce cheaper source of capital than equity. higher returns for shareholders. First Another reason debt is cheaper for PE is what academics call the “signaling” transactions is that PE firms are really effect. Unexpectedly large increases in good at managing leveraged capital dividends are a pretty reliable sign that structures; in fact I would say that man- companies are producing a lot of cash, aging high leverage is one of the key core and that management expects the com-competencies of private equity. If one of pany to continue generating cash. The their portfolio companies gets into finan- second main way that dividends add cial trouble and needs more equity, the value is more subtle but also, I would PE firms will often put more into their argue, more important. Dividends reflect own deals. managers’ commitment to pay out excess cash to shareholders, which in return Milano: I too am a big fan of the private allows them to earn higher returns on equity model, and I agree that it has been the capital left in the business. a tremendous success. There have been If you look at the performance of some spectacular disasters, but on aver- the world’s developed economies for the age it’s been wildly successful. past 130 years for which we have the But I don’t think the high leverage data, the highest average stock returns model works well for public companies. have been produced by the economies If you look at public companies and whose companies pay out the most in separate them by industry, in all but dividends. And it’s because of both of a handful of industries the companies those two factors. Yes, they’re generat-with above average leverage ratios have ing more cash that can be paid out, but lower TSRs. And so, leverage works well there are also forces in those markets that in a private company situation probably are pressuring managers to pay out the because of the huge ownership incentives cash. In countries like Japan and Italy, that the managers get. High leverage in companies have historically paid out public companies does not work so well. very low percentages of earnings—and in Japan, stock buybacks were illegal Chew: I agree. Most public companies until 1996. Shortly before the legaliza-cannot manage leverage effectively. And tion of buybacks, I remember a group

Journal of Applied Corporate Finance Volume 26 Number 4 of Japanese policy makers coming to our Stern Stewart office in New York to discuss buybacks. And those discussions really impressed on me how “unnatural”

it is for a corporate manager to want to return capital to investors, whether in the form of dividends or buybacks. After all, you’re taking an asset that is now under the control of management and you’re volunteering to pay it out to complete strangers.

But that’s consistent with the essential principle of Western market capitalism— that capital belongs to the investor. And in that view, any dollar that gets paid out is really in some sense a sign of management’s commitment to efficiency.

Managers know they work for the shareholders, so they pay it out if they don’t have a great investment opportunity.

McC ormack: Perhaps the clearest example of this principle at work today is the case of energy master limited partnerships, which are pass-through organizations that pay no corporate income taxes. To maintain their tax-free status, MLPs have to pay out at least 90% of their earnings. So where do they get the capital for growth? The answer is that most MLPs have been low-growth, steady-state enterprises that don’t require much capital. But there is a small but steadily increasing group of “growth MLPs” that pay out 90% of their earnings and then, in the same year, turn around and issue equity for roughly the same amount of the distribution—and to many of the same investors.

This is a lot like how U.S. public util-ities operate, paying out large fractions of earnings and then coming out with large secondary equity offerings every

Fall 2014 39

couple years. And I can very clearly U.S. companies, there’s a couple trillion remember Don’s and my old boss, Joel of market cap out there, and I find it Stern, saying that this practice makes hard to believe that a well-run company “no sense at all.” In Joel’s view, compa- won’t find people who will want to buy nies should never pay dividends because its stock if it doesn’t pay a dividend. you’re just putting it out with one hand and taking it back in with the other, and Briscoe: Well, that would mean turning the only parties benefiting from the pro- away a certain set of our shareholders, cess are the bankers that underwrite the and I’m not sure that we can get com-equity issues. fortable with the idea of doing that.

Well, to me the answer to Joel Stern’s conundrum is the success of today’s Clancy: We are one of the eight compa-growth MLPs. The MLP practice of nies in the S&P 100 that are not paying annual distributions and roughly com- dividends. We haven’t paid a dividend parable equity issues is essentially a because we haven’t reached the level of governance mechanism—it’s one that product diversification that we’d like. says that if you make a dollar and agree I agree that paying a dividend can add to pay it out in dividends, then you value by getting excess cash off the bal-will get it back the following year. And ance sheet. Permanent excess cash on this mechanism has proven to be very a company’s balance sheet is generally productive—investors have shown them- invested at low yields, thereby eroding selves willing to assign very high values value. But I think management should to these MLPs because they know they have the discipline not to waste cash have complete control of those dollars. flow. Dividend-paying companies can make bad investment decisions, too.

Briscoe: The MLP form works because it’s an expression of commitment. It also Hilal: Paul, I want to expand on your gets management laser-focused on maxi- point. Years ago, investors would look mizing cash flow. to regular dividends as a disciplinary And I agree with both you and mechanism for management teams that Michael that dividends impose taxes and might run off the rails. But, in the recent transaction costs on companies. But one decades, engaged shareholders like JANA important practical reality is, if you’re a and Pershing have helped management company that could pay dividends and stay focused on shareholder returns. As has chosen not to do so, there is a sub- these engaged shareholders exert greater set of shareholders that will not invest in influence, there is less need to rely on the

you. So, paying a dividend does open up regular dividend to maintain discipline. a pool of investors that otherwise would not consider you. Chew: Have you ever suggested to a company that they cut their dividend Mauboussin: Well, the market capitaliza- and reinvest more of their capital in the tion of the S&P 500 is around $17 or 18 business?

trillion. And if you add in all the other

40 Journal of Applied Corporate Finance Volume 26 Number 4 Hilal: Yes. And I think that if you have a good management team—or one that is at least responsive to shareholders’

concerns—then I don’t think you need to have a regular dividend to constrain them. As an investor, I’d much prefer that companies pay no regular dividends, but rely instead on opportunistic share repurchases and special dividends

Chew: Do you feel that these companies are missing investment opportunities because they insist on paying the dividend?

Hilal: Yes, that’s one concern. Or they could be missing share repurchase opportunities. If a company has a big dividend and their stock happens to be unusually undervalued at that moment, they can’t buy back as much as they would otherwise because they have to fund this dividend. Or they may miss a big acquisition opportunity.

Another important consideration with dividends arises from the fact that a lot of these institutional money managers manage wealth offshore as well as onshore. And because dividends paid to offshore shareholders are subject to with-holding tax, offshore LPs end up getting less of every dividend dollar than domes-tic shareholders. So that’s another reason to cut back on dividends.

Clancy: In practice, regular and special dividends aren’t mutually exclusive; companies could do both.

Ostfeld: I want to take the other side of this argument about the role of dividends. I agree completely with Paul Hilal’s statement that if you have a great capital

Many companies today have higher hurdle rates now than they did before the crisis—and they worry more about “execution” than about investing in their future. That’s all great but when you take that to an extreme, you end up with just a few really good projects and you just keep accumulating cash you don’t know what to do with. I have been arguing for a couple years now that many companies could increase their values by investing more, even if that means lowering their returns on capital.

Greg Milano

The MLP practice of annual distributions and roughly comparable equity issues is essentially a governance mechanism—it’s one that says that if you make a dollar and agree to pay it out in dividends, then you will get it back the following year.

And this mechanism has proven to be very productive—investors have shown themselves willing to assign very high values to these MLPs because they know they have complete control of over those dollars.

John McCormack

to an ongoing dividend. They usually jus- ment opportunities that want to maintain tify this practice by saying that a regular their financing flexibility, you can often Ostfeld: And even if they have the adjust-dividend would chew up 40-60% of their get a more balanced approach by paying ment, they are more likely to use the cash cash flow, which in turn could limit their special dividends from time to time. to buy back stock since they get a boost in ability to seize good opportunities later their EPS, which is typically what drives on that might earn three or four times Hilal: There is another reason that special their compensation in the first place. the cost of capital. And because these dividends are less common. Employee

The Market Reaction to “strategic.” What this generally means is Divestitures that management can’t justify the invest-Mauboussin: One subject in corporate ment on the basis of the cash flows, so finance that doesn’t receive enough atten- they will defend it on the basis of an tion is divestitures. What little research expected increase in market share or on there is on the topic shows that divesti- access to new markets. These businesses tures create a lot of value for sellers. may have some very good attributes, but Why is it so hard to create value they ultimately have to be justified on the through acquisitions? I think a lot of basis of cash flows and cash returns. that has to do with the reality that it’s a competitive sale process; everyone on the Milano: That’s the opening line of the outside can evaluate the cash flow and article I published in CFO! It really both-the price tends to get bid up to the NPV ers me when people say, “You can’t use neutral or even NPV negative point. finance to evaluate this project because M&A creates value in the aggregate; it’s it’s strategic.” My response to that is that just how it’s parsed between the seller unless there’s a pretty good chance that it and the buyer. will someday become financial, then it’s probably not very strategic.

Milano: And in a lot of cases, more than 100% of the benefits went to the seller. Briscoe: You should always be able to provide numbers for the strategy that Mauboussin: Right, and that’s why I you’re trying to execute. And you have to think divestitures are so interesting. In do a careful job of weighting the risks to those cases, sellers invite others to take a do a good valuation.

look at them and provide all the information. And because of the selling process, Active Investors as Potential there is a good chance it will turn out to Partners for Corporate be a winner’s curse situation in which Management someone will bid exactly what it’s worth Milano: Scott, do you ever see corporate or more. acquisitions as a catalyst for an investment, or a reason to become active?

Briscoe: And that’s another reason companies and management teams should Ostfeld: Acquisitions get our attention take a hard look at all their assets and both on the acquirer side and the target lines of business and then ask themselves: side. On the target side, we have blocked Are we the highest-valued user of these at least four deals because we thought the assets? Do we need to be in this business? target was undervalued and was not get-Is this something more valuable to some- ting a fair price, or because we thought one else than it is to us? the merger strategy of the acquirer And I think the same thought process didn’t make sense. We have also blocked should also apply to capital expenditures. acquirers, although those situations have Managers often justify low-return capi- tended to be pretty complicated. A recent tal projects on the grounds that they are case involved a transformative, cross-

Journal of Applied Corporate Finance Volume 26 Number 4 border M&A deal that involved a mix of cash and stock by a company that had done only one big deal before—and that deal had resulted in a complete write-off.

In my experience, you can usually tell fairly quickly from the outside whether a deal has a high likelihood of success or

not. The deals where we’ve blocked the acquirer were ones where success looked highly questionable to anybody not involved in the deal.

Chew: Scott, do you find a lot of targets willing to accept below market prices?

Ostfeld: Those situations almost always arise from managers’ incentives. For example, we have seen a few cases where managers are going to roll their stock into equity in a private deal; and in those cases, they either see the opportunity to be the CEO or to get a big change-ofcontrol payment and maybe retire—or maybe they’ve just gotten tired of dealing with public shareholders. They may reason that having one shareholder is better than having 1000.

Chew: Lucian Bebchuk at Harvard has a new study that has gotten a lot of attention that shows that the average hedge fund has a longer holding period than the average mutual fund. Does that sound right to the hedge fund representatives here?

Hilal: Our average hold at Pershing for our activist investments is about four years, which is much longer than a normal passive institution will hold a stock.

When we make an investment, we consider ourselves long-term partners with the company. We think and act as if we

Fall 2014 43

own the whole thing, and we plan as if out of the business, we are reducing our we’re going to own it forever. We con- cost of capital and so increasing the value sider each activist investment as part of of the firm—again, while consciously a growing legacy for creating shareholder reducing earnings growth.

value. Before James Gorman took the reins about five years ago, the main focus of Chew: Do you get board seats? Morgan Stanley was matching Gold-man’s earnings growth. But today, after Hilal: Sometimes. It just depends on the five years of shifting the business away situation. And in some cases, we do try from fixed income and other trading to get companies to invest more capi- businesses, Morgan Stanley is getting

tal. One example was a tech firm with recognition from the street in the form a very interesting opportunity to buy a of a considerably higher P/E ratio despite company whose growth was expected to the slowdown in earnings growth.

be flat or possibly negative over the coming years. Although there were a lot of Mauboussin: On this question of active cost synergies and this company could be investors’ time horizon, I think it’s also bought at a very attractive price, the tech important to recognize that, for activist company CEO was afraid the acquisition investors who take pretty large positions, was going to create a drag on his revenue there is a trade-off between control and growth. He was trying to show top line liquidity. When you’re running a diver-growth for his tech industry sharehold- sified portfolio and hence have a fairly ers and the other company with flatter small position in a public company, you or negative revenue growth would have have high liquidity but basically no con-diluted his revenue growth. trol. As head of a corporate division, you We tried to get this CEO to under- have really high control but no liquid-stand that this deal would create ity. Private equity has somewhat more shareholder value by raising his returns liquidity than a manager of a corporate on capital, and that he didn’t have to division—and then activist investors are worry about pleasing the particular somewhere between public companies shareholders that were focused on rev- and firms owned by private equity. enue growth. But he wasn’t responsive to So, for activist investors like you our argument. guys to be taken seriously, you have to say “We’re ponying up a lot of capital, McCormack: Paul, the kind of deal you’re we will be significant owners, we will talking about sounds similar to the stra- be partners with you for a while. We’re tegic change in Morgan Stanley that was not going away tomorrow.” Without that reflected in their decision to buy Citi’s understanding, it’s hard to exert control Smith Barney brokerage. They said, “We that’s viewed by corporate management used to be a fast-growing business, but as legitimate and constructive.

now we’re making a decision to reduce our earnings growth and take a lot of risk Ostfeld: We don’t exert control or influ-out of the business.” And by taking risk ence decision-making because of the

44 Journal of Applied Corporate Finance Volume 26 Number 4 ownership stakes we have. We exercise inf luence by offering arguments and proposals that are viewed favorably by a majority of the shareholders. And so we have to come up with ideas that are likely to work over the relatively near term as well as the long run because not every shareholder has the same time horizon. There’s a natural governance safeguard in our system against short-sightedness. If all we were doing was coming in and “gutting” companies for the next quarter’s gain, then the large institutional investors who often support us would say, “These guys will be gone in no time and will destroy value. I don’t want to support them.” But that’s not what happens. We typically gain the backing of these investors because we have built a reputation for getting their support for advocating sensible, long-term policies.

Chew: But, Scott, as I’m sure you know, what you just said runs completely against the grain of the popular percep-tion of what hedge funds and private equities do to and for the companies they invest in. And based on what you’ve just told us about your MO—and on Bebchuk’s findings that I mentioned a minute ago—it seems to me that the managements of public companies who feel underappreciated by the market should be seeking you out. They should be saying, “We want somebody like Warren Buffett on our board. We want somebody who’s going to be a long-term holder who becomes our proxy for the market. This way we won’t have to try and reach all those faceless individuals out there. We can talk to somebody who represents the market and has this debate

The kinds of investors who hold your shares can end up affecting your performance and value. And what you tell the market can affect the kinds of investors who choose to buy your shares. If you want to attract more sophisticated and longer-term investors, think about ending earnings guidance and talk about your investing and financing and internal governance policies instead.

Don Chew

about what we need to do in terms of our give them advice based on the best inter- So, we are now more welcome than investment policy.” ests of the shareholders and who will be in the past. But we still have to deal with around long enough to reap the benefits, the demonization of activist investors Milano: Have you ever had a manage- or suffer the consequences of the advice. that Don referred to. And, of course, ment team come to you and invite you An outside consultant will want a fee and there’s an industry of management in? a banker will want a transaction fee. We’re defense specialists who want to portray not getting a fee from anybody. We just us that way.

Hilal: We’ve had management teams want the shareholders to win. And there that have reacted very positively to our are CFOs and CEOs that recognize that Briscoe: But if I’m a CFO, why should I approaches. And I’m sure this has hap- and actually welcome the conversation. treat any shareholders differently? In other pened to Jana and the other top shelf words, I shouldn’t care who the share-activists that are known as thoughtful. Briscoe: And, at that point, the consul- holder is. If they have even moderately When such investors buy a stake in a tants go away. significant holdings, I should be commu-company, we almost always immediately nicating with them. And communication

Chew: John, you may say that—and it’s So, my point here is that the kinds an admirable position to start out with. of investors who hold your shares can But that doesn’t change the reality that end up affecting your performance and probably only about 5-10% of your value. And what you tell the market can investors are worth talking to. What affect the kinds of investors who choose do I mean when I say that? About ten to buy your shares. If you want to attract years ago an accounting prof at Wharton more sophisticated and longer-term named Brian Bushee studied all U.S. investors, think about ending earnings institutional investors and classified guidance and talk about your investing them in one of three categories: (1) and financing and internal governance “transients,” which have lots of small policies instead.

positions with very high turnover and are said to account for about 60% of U.S. Briscoe: I agree with you, in the sense investors; (2) “quasi-indexers,” which that it’s only the third category of have lots of small positions but long investors—the dedicated holders— holding periods and represent about 30% that will engage in a meaningful of the total; and (3) “dedicated holders,” dialogue about things that matter, people who take large positions and hold about corporate strategy and financial them for a long time. and governance policies. As for the And, John, if I were making a momentum types and the indexers, you recommendation to your investor can try to reach out to them, but they do relations group, I would suggest that not respond.

they spend most of their time trying to identify and make contact with this Closing Thoughts: Back to School third group of people. I would also argue Hilal: Speaking of dedicated holders, that you might be able to increase the Columbia Business School has a value value of your shares just by getting them investing program—and it’s an entire to buy and hold your shares. One of the curriculum built around thinking about interesting findings of Bushee’s study is shareholder value. But Harvard does that companies with a disproportionate not, nor do Stanford, Kellogg, or any of share of dedicated holders have less the other schools. And I think the study volatility than companies with lots of of finance would benefit from producing momentum types. Companies with more insight into how value investors do dedicated holders also tend to provide their work, and the kinds of returns they more historical, but less forward-looking actually produce.

information (such as quarterly earnings guidance), so companies can influence Clancy: It’s interesting to me that the who holds their shares by how and University of Chicago’s efficient mar-what they choose to communicate. And ket hypothesis has lived on for such a perhaps the most interesting finding of long, long time. By contrast, what seems all: Such companies were significantly ingrained in the DNA at Columbia is less likely to cut their R&D budgets to that the market can be inefficient, right? meet a quarterly earnings target. If you fundamentally believe it’s inef-

46 Journal of Applied Corporate Finance Volume 26 Number 4 ficient, you look for the inefficiencies.

Great capital allocators at companies look for those inefficiencies and try to capital-ize on them very quickly. That doesn’t get taught in most business schools.

Chew: In fact, Paul, I think both schools are right about market efficiency. Our financial markets are intensely competitive, as the Chicago School suggests, so much so that 80% of professional fund managers still seem to underperform the S&P 500 in most years. But at the same time, I think the program at Columbia is right about the existence of these dedicated holders—and right about their methods, and the ability of many of them to outperform the markets consistently. As my friend Ray Ball at the University of Chicago likes to explain this, “This kind of outperformance is completely consistent with market efficiency if you view the theory the way I do—that is, as the returns or payoff for providing valuable information in a highly competitive market.” And as Paul Clancy was just suggesting, the people at the core of this Columbia program— the Warren Buffetts and the modern-day Grahams and Dodds—do appear to be providing valuable information to the market—and getting handsomely rewarded for it.

Mauboussin: I’m part of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, so I welcome both Paul’s and your comments.

Warren Buffett has this great line: “I am a better investor because I am a businessman and a better businessman because I am an investor.” And I think that is the key to all this. The very successful CEOs

in Thorndike’s book that Greg men- of strategic planning, and corporate tioned at the outset thought about the m a n a g e me nt s w ho v ie w c a pit a l world as investors. They thought about deployment as a byproduct of, rather intrinsic and market values every day. than as a driver of, strategy may be It was a dynamic process. They didn’t missing an opportunity to shape their believe they had to grow costs at all or future by withdrawing capital from that they had to continue doing some- value-destroying activities and finding thing simply because that’s what had higher-valued uses for it. As our panel worked for them in the past. has I think made ver y clear, it is quite possible—and in fact it should Milano: Let me wrap this up by first be considered one of the primar y expressing my appreciation to each responsibilities of top executives—to of you for devoting your time to use the alternatives for deploying capital discuss this very important topic. I we’ve just discussed to propel strategy have thoroughly enjoyed it. Capital and value creation in ways that lead to deployment choices are at the very core overall corporate success.

Journal of Applied Corporate Finance • Volume 26 Number 4 Fall 2014 47

ADVISORY BOARD EDITORIAL

Advisors LLC Massachusetts Institute of Richard Brealey Technology Alex Triantis London Business School Stuart L. Gillan University of Maryland University of Georgia Stewart Myers

G. William Schwert of Technology Christopher Culp Glenn Hubbard University of Rochester University of Chicago Columbia University Jerold Zimmerman Alan Shapiro University of Rochester Howard Davies Michael Jensen University of Southern Institut d’Études Politiques Harvard University California de Paris Steven Kaplan Clifford Smith, Jr.

University of Chicago University of Rochester

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