Letters

Alignment of Interests – September 2018

Alignment of Interests

Show me the incentive and I will show you the outcome” – Charlie Munger

Alignment of interests is one of the keys for successful investing. At Somar we evaluate the degree of interest alignment to identify long and short opportunities. We pay extra attention to changes in interest alignment to evaluate the risk reward of existing and potential positions. If interest alignment changes, Somar’s opinion of the risk reward changes.

Conventional wisdom evaluates alignment in a binary way: either interests are aligned, or they are not. Somar looks at alignment in a continuum with different degrees of alignment ranging from perfect alignment to conflict of interests.

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On its long investments, Somar looks for the best possible alignment between consumer value, company profitability, management incentives, stock market performance and Somar investor wealth. (Fig. 1) Every single step of this alignment counts, and there can be losses of alignment at each level.

Source: Somar Analysis

Fig. 1

 

Customer alignment is key for any sustainable business value creation. Somar looks for businesses that offer a material upgrade to existing consumer value proposition either through lower prices, wider choice or superior services[1].

Long investments benefit when we partner with management teams that focus on constantly innovating to expand the value they deliver to customers year after year. This could be in the form of product / service enhancements, price decreases or new adjacent businesses.

Some businesses have this alignment built-in. For example, businesses that benefit from network economies offer expanding value to their consumers as they grow. The value of a telecom network, or social network increases, as more people participate in it. Similarly, the value of a food ordering platform like Takeaway.com increases the more restaurants are available there.

Perfect management alignment with shareholders is difficult to achieve. Conventional wisdom has it, that stock option plans are a good solution. While a step in the right direction, it has a big shortcoming: management has none of its capital at risk. As investors, our first priority is to not lose capital. Stock options are granted with no financial commitment from managers who are left with no incentive to protect capital. They share in the upside but not in the downside. (Fig. 2)

Fig. 2

The best way to align management to investors, is to have managers be shareholders in the business and for those shares be a large portion of their net worth. Somar finds these management teams are extremely entrepreneurial and create significant customer and shareholder value. This happens frequently (but not always) when you partner with the founders of the business. 8 of Somar’s current top 10 long positions still have the founders and their team in place. On average this group averages 15.7% ownership of their respective companies. Ownership in this group ranges from 4.2% to 36.8% of total shares. We are happy to have our entrepreneur managers with skin in the game alongside us.

Conversely, none of our top 10 shorts has an entrepreneur leading it. Management teams consistently have less than 1% ownership of the company. If we add the trusts controlled by the descendants of the founding families (with no management involvement on the day to day operations), the average inside ownership rises to only 4.25%.

As your conduit to these opportunities, we are careful to make sure Somar is as aligned with its limited partners as possible:

  • We have our own capital at risk alongside yours. The Ramos family is the second largest investor in Somar. One other member of our team has also the vast majority of his net worth invested in Somar.
  • Our financial success hinges on us delivering substantial returns to you. Our management fee only covers our basic expenses and we are committed to returning to our founders any economies of scale in the form of reduced fees as our assets scale.

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Alignment changes overtime and needs to be monitored continuously. A prolific source of both long and short ideas for Somar are changes in alignment. We have sold long positions fully when alignment has materially decreased.

Substantial management purchases of stock in the open market are strong sources of new ideas for Somar. Not only do they carry the signal that management believes that their company is undervalued, but they also want to align themselves with shareholders in the value creation opportunity ahead. We follow these movements closely and investigate them immediately.

Conversely, when management sells substantial portions of their shareholdings, we ask ourselves whether we should sell too: either get out of a long position and/or build a short position. This year we had a top 3 position had a major shareholder sell down and we significantly decreased our exposure to it materially: it is now outside of our top 10 positions.

Often alignment shifts for reasons other than management buying and selling:

  • Strategy shift away from consumer value creation. E.g. slow innovation and start price increases
  • Competitor introduction of a superior product / service
  • Management turnover
  • Change in management incentives
  • Spin-offs
  • Regulatory changes
  • Growth in fund manager AUM
  • Change in fund manager compensation structure

This happened recently to a company we were long. Scout 24 had a star manager in online classifieds: Greg Ellis. Greg is a pioneer in the industry, having built REA into one of the most profitable and faster growing real estate online classified platforms in the world back in his home Australia.  During his tenure he created significant shareholder value with the stock price growing at 62% CAGR for more than 5 years (Fig. 3)

 

Source: Bloomberg

Fig. 3

 

Earlier this year, Scout 24 made a large acquisition in an adjacent market (consumer lending). A few months later, Greg Ellis asked the board to leave the company at the end of 2018 for “personal reasons”. The CFO also asked to leave by September 2019. This loss of alignment with company strategy and management incentives was a sign to us of potential problems with the core business. Given valuation remained close to our upside scenario, we fully sold our position.

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It is an honor to be entrusted with your wealth. We don’t take it for granted any single day. My family and I fully align ourselves with you and work daily to make sure your money is entrusted to aligned management teams that tirelessly work to create and expand the value they offer to their customer.

 

[1] For further detail on our thinking here please read our letter from January 2018