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  • ProCervo Thoughts & Musings

Management just want to have fun: why simple companies are trickier than they seem

You may have come across the old adage of “buy what you know/understand” that was most famously championed by long-time star investor Peter Lynch. Warren Buffett advised his followers to “Invest in what you know … and nothing more”. There is a lot to be said for this,


I will cover this topic another time.


Far too often, however, the feeling of “understanding” is lulling investors into a false sense of security - one of the “lazy shortcuts” that I keep ranting against. The most dangerous are small to mid-sized businesses where demand is stable / growing and margins are sufficiently strong to pay a nice dividend. The business model is simple and most people have had some experience with the product/service one way or the other. Waste management, funerals, bakeries, prison operations, that kind of thing. What can possibly go wrong? People need to eat, they always die, and they commit crimes, right? Throw in moats (barriers to entry for new competitors) like long-term contracts or great locations and the company is a sure winner. Peter Lynch would agree with you: “Go for a business that any idiot can run”.


This is where it becomes dangerous. Management is human too. The individuals that make it to the higher echelons in a company can safely be regarded as more ambitious than the average. More often than not, they are also thrill seekers. They may enjoy administering a stable business for a while. They may find some more process improvement opportunities. They may also chase a few new customers. But soon many of them come to the point where they are bored. They may enter new markets, be it geographies or products. They may make eye-catching acquisitions. At its worst, they use their unspent energy to improve their own remuneration.


Research has found that thrill-seeking CEOs (they used private pilot licences as a proxy) were more likely to get their company into hot water, especially with the tax authorities. But even legal activities can harm the company significantly and sap large amounts of shareholder value.


One example is Aryzta (ARYN), a food business based in Zurich, Switzerland. Aryzta came to life when the Swiss bakery Hiestand was merged with the Irish agricultural business IAWS. Management was incentivised to grow sales as quickly as possible but without borrowing too much money (“leverage”). So they went out and bought as many bakery goods businesses as they could find. They got very little pushback even from professional analysts and investors who never thought to ask how these businesses were doing. Hey, it’s bread! What can go wrong? Best of all, management convinced the banks to call the debt something else - Hybrid - and the interest a “dividend”. Investors only saw a Swiss bakery with low bank debt - safe as houses! I have to add that all the activities were disclosed in the accounts to anyone who bothered to check. Still, they had a disastrous effect on the share price which dropped from the equivalent of just over CHF18 to CHF 1.16 at the time of writing.


A favourite is the CEO who is letting properties that she is holding in a personal capacity to the company at inflated rents or unnecessary “service contracts”. Operating companies for hospitals, pubs, gyms and similar outfits are particularly vulnerable.


I am not saying that CEOs of “boring” businesses are intrinsically worse than their peers at more companies. My point is that investors and analysts often get lulled into believing that they understand the business and don’t do their homework as well as they should.


The good news is that investors can protect themselves to some extent and spot CEOs that are not acting in their interest. Annual Reports contain a section on Related Party transactions where conflicts of interest have to be disclosed. It is clearly a red flag if purchases from related parties are significant relative to senior management’s compensation. The components of Management and Supervisory Board remuneration are disclosed In the Corporate Governance section (you can use Ctrl+F “remuneration” in a pdf document). You want to see a balanced set of management objectives that - when achieved together - will increase shareholder value. What you don’t want to see are executives that are entirely compensated for growing the top line (revenue). Using profit or “Earning Per Share (EPS)” is not much better since it can be easily manipulated. Targets that focus on cash such as “Free Cash Flow (FCF)” and investment return such as “Return On Capital Employed (ROCE)” give you much more comfort that management stays focused on looking after your investment.


Another warning sign is when management spends over proportionate amounts of time talking about new business activities. This can indicate that they are distracted from and are potentially spending too many other company resources on their pet project.


So whatever you do, just avoid the trap of thinking that because the main business appears simple and boring, the investment is safe and does not need monitoring.


Stay alert.







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