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  • Chris Mayer

Quality Shareholders

So, what’s a quality shareholder and why does it matter?


A quality shareholder (or QS) is one who buys large stakes (relative to their capital) and holds for a long period. QSs stand in contrast with two other classes of shareholders: indexers and transients. Indexers hold for long periods but do not concentrate. And transients, who sometimes hold large stakes, never stay for long.


You may quibble with these definitions. (Indexers arguably do concentrate. Have you seen the S&P 500 lately?) And definitions are often fuzzy at the margins. But the general idea is that a QS is a shareholder who is going to study the business, think like an owner, load up and hold for years and years. The rest don’t.


These categories come from a new book by Lawrence Cunningham titled Quality Shareholders: How the Best Managers Attract and Keep Them.


Cunningham’s premise: the type of shareholders a public company has matters -- it can even be a source of competitive advantage. Corporate managers should cultivate and attract QSs by adopting certain practices such as publishing long-term performance metrics, stating capital allocation policies and designing shareholder friendly board selection criteria, voting arrangements and executive pay packages.


Nowadays, it seems, there are few QSs out there. Indexers dominate. And Cunningham has compiled some interesting stats related to this shift. He says indexers own up to 40% of public equities. (I’ve heard even higher estimates, depending on one's definition of indexer).


What’s the consequences?


One has to do with corporate governance, or lack of it. Cunningham writes that even after increasing their “stewardship staff,” the big indexers don't have a lot of people looking at the companies they own. Blackrock has 45 people covering over 11,000+ companies; Vanguard 25 people, 13,000+ companies; and State Street 12 people, 12,000+ companies. This small group of people supposedly cover over 4,000 annual meetings and cast votes on 30,000+ proposals.


Contrast this, Cunningham says, with the credit rating agencies and QSs. Moody’s employs 12,000 people. Capital Research, which has a far smaller portfolio of companies than any of the indexers, employs 7,500.


So what happens is the indexers rely on advisory firms. The two biggest are Institutional Shareholder Services (ISS) and Glass Lewis. Together they control 97% of the market. But they, too, operate with small staffs and small budgets relative to what they have to cover.


ISS has ~1,000 employees and Glass Lewis ~1,200. Yet, as Cunningham points out, they address an enormous market. ISS has 1,700 clients, who in turn manage $35 trillion in assets. That staff of 1,000 has to cover 40,000 annual meetings. How well do these people really know these companies? Not well, I'd imagine. Anybody who has spent time trying to understand a business knows it takes a lot of time and effort, often sustained over a period of years.


(And firms like ISS can do bizarre things because they just want to check a box. They’re not thinking. Hence, they famously withheld votes for Warren Buffett on the Coke’s board because he owned too much stock; he wasn’t “independent.” There are other examples of weird decisions in Cunningham’s book.)


As a manager of a public company, you don’t want these kinds of shareholders, Cunningham maintains. You also don’t want transients because they’re focused on short-term issues like quarterly earnings. They’re overly worried about where the stock price is.


As Cunningham says, “corporate projects require time to develop, implement and evaluate… Proof of corporate strategy usually manifests over years not quarters.”


You want QSs. Cunningham presents a lot of anecdotal evidence to support his view.


Consider the case of Airgas. A competitor, Air Products, bid for Airgas. The bid was $5.9 billion, a big premium over the stock price. But management maintained the long-term value was greater.


Yet, almost half of Airgas’s shareholders were transients. They voted to take the offer. A court battle ensued and a judge ultimately agreed with Airgas. In 2015, Airgas sold out to Air Liquide for $13.4 billion - more than the double Air Products’ bid four years earlier.


If they had more QSs, maybe they could’ve avoided the court battle and more easily fended off the hostile bid. Of course, management teams are not always right. Presumably QSs would recognize a good bid.


Sometimes managers are proactive in seeding a QS base. Cunningham tells the story of CEO Paul Polman at Unilever. In 2009, he took the reins. The old Unilever delivered quarterly earnings guidance, following the demands of a large transient shareholder base. And Polman saw that division managers often cut R&D and other projects to meet guidance.


Polman wanted to change that. He dropped the quarterly guidance and instead focused on communicating clearly with shareholders his longer-term vision for the company. Unilever would no longer focus on maximizing short-term gains.


At the first the share price dropped as the transients left. But Polman began to cultivate QSs. As of late 2017, Unilevers’ top 50 owners owned the stock for an average of 7 years. (And investors had a nice run with Polman as CEO.)


Cunningham talks about good practices firms should adopt to attract QSs. The book covers important tools like the CEO’s letter to shareholders, the annual meeting, proper performance metrics, capital allocation priorities and much more.


QSs can also add value to a firm as a sounding board, as a valued critic and as an arbiter on capital allocation, among other things. If nothing else, the presence of a lot of QSs seems to indicate a firm that may have its act together as far as governance, capital allocation, etc.


I’m going to skip through these practices to get to some names -- both of QSs and the companies that attract them. Cunningham uses various filters and creates a list of QSs. To give you a flavor, here are some of bigger ones:


Berkshire Hathaway

Gates Foundation

Southeastern

Blue Harbour

Scopia

Lone Pine

Lyrical

Glenview


If you pay attention to these kinds of things, this list is no surprise. Then Cunningham creates lists of firms which have a lot of QSs. This is an interesting part of the book. For example, here is a list of some names from the Russell 3000:


Seaboard Companies

Brookfield Property

Enstar

Markel

Constellation Software

Graham Holdings

Alleghany

Cimpress


Pretty interesting, and again, a lot of these are no surprise. Among larger caps, there is Stryker, Visa, Roper, Fortive, Microsoft, Danaher, Intuit and Berkshire.


I think this could make an interesting filter to sift through stocks and find ones you might want to dig into more, or just to narrow down the field.


The quality of a company’s shareholders seem to matter, but just how much is hard to prove empirically. For one thing, there is quite a bit of judgement as to who gets the QS tag and who doesn’t. Besides there might be a QS within a bigger firm that isn't a QS. And no firm stays the same forever. Perhaps a QS can lose the label. Or another can gain it. Then, too, there is the question of how many QSs do you need to get the benefits? 20%? 40%? More? Finally, there can be a chicken-and-egg paradox to this. Meaning, firms can attract QSs, but there must be examples where a QS, or QSs, changed corporate behavior.


Anyway, the evidence is anecdotal. A quality shareholder base seems akin to one of those things like a company’s culture. You can’t really put numbers around it. And even the word “culture” covers a variety of different things to different people. But few long-term investors would say a "corporate culture" isn’t important.


I put quality shareholders in this same bucket. As with corporate culture, it seems like it matters. And the fuzzy nature of it may be a good thing -- it means there is room for old-fashioned research by human hands to add value. Something that a bot or algorithm can’t quite suss out. Maybe.


As I get older (and, I hope, wiser) as an investor, I find myself giving much greater weight to fuzzier concepts such as culture and governance and competitive positioning. The numbers ultimately have to make sense, but these qualitative factors underpin my investment decisions in a way they didn’t when I was younger. Experience (i.e., being burned when these factors were absent) have taught me to pay attention. Cunningham’s book adds to that often-neglected library of qualitative things to pay attention to.


Thanks for reading!


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Published November 11, 2020

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