Monday, March 31, 2014

Investment Advice from the World’s Largest Money Manager: Part 2

Investment Advice from the World’s Largest Money Manager: Part 2

In my last blog post, I discussed a research report from Blackrock that explored the new frontier of equity investing that lies beyond the developing markets.  Today, I want to explore Laurence Fink’s letter to corporate CEOs.[1]  Mr. Fink is chairman of Blackrock and has a huge business interest in maintaining the health of long-term investing.  Blackrock’s index mandates, exchange trade funds, and even some of its active mandates hold equities over extended periods of time.  These investment products are highly dependent on good corporate governance, since they don’t sell holdings at the first sign of trouble.  Ironically, Blackrock also offers hedge funds and fund of funds that are the target of Mr. Fink’s concern.
Wye River 1 (1998)
In the letter, Mr. Fink counsels corporate executives to keep their eyes on the long-term interests of shareholders.  Mr. Fink is legitimately concerned that companies will pay dividends, buy back stock, and/or leverage the company in order to placate activist investors or other short-term speculators.  For index investors these types of scenarios are a nightmare, because the short-term appreciation in the stock is unsustainable.  Long after the activists have sold their shares, index investors will still be holders of the company’s stock.  Having failed to invest in research and development, new products, or capital improvements, the company will be a hollow shell.

There are, of course, times when a company should be returning cash to investors either in the form of dividends or share repurchases.  A basic financial principle states that a company should only invest back into the business if it can at least earn its cost of capital.  If a corporate investment returns less than the cost of capital, it simply destroys shareholder value, and a company’s stock will decline.  The financial landscape is littered with companies that poured money into unproductive projects or senseless acquisitions.  In other words, activist investors do, from time-to-time, perform a useful function by pressuring management to cease mindless empire building in favor of productive actions.

However, all too many activist investors are simply rewarded for generating short-term profits.  Their fees and incentives are tied to making money over short periods of time.  If they can drive a quick profit by holding a company and its management hostage, they’ll gladly do so.  Thus the financial landscape is also littered with the carcasses of companies stripped of value by short-term quick fixes.  As institutional investors pour more and more money into activist strategies, I think it is well worth heeding Mr. Fink’s advice.

From an investor’s perspective, the key question is whether the management and the board of directors are maintaining a long-term focus, and whether they are making sound judgments when it comes to deploying capital or returning it to shareholders.  As the largest manager of index products, Blackrock has but one tool for influencing the people who run and oversee companies: the proxy.  According to David Benoit and Liz Hoffman of The Wall Street Journal, Blackrock has taken a more active role in recent years.[2]  As a result, Blackstone should be an ally of activist investors when they pressure a company that has grossly underperformed.  Unfortunately, many mutual funds and institutional investors have become so short-term focused that they don’t take the proxy and corporate governance seriously.  Instead of just writing to corporate CEOs, Mr. Fink should be also be talking to his fellow investors.  Collectively they’re the ones who own the companies.


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