Author: Rocco Huang
Covestor model: Tortoise and the Hare
Disclosure: Long WMT, VIAB, AZO, NWSA, DG
While dispersed shareholder base and separation of ownership from management have been the norm among modern Western corporations, a small number of publicly traded companies today remain owned and controlled by a single, dominant shareholder.
I’ll define “control” as owning at least 20% of a company’s voting rights. By this definition, Wal-Mart (WMT) is controlled by the Walton Family, News Corp (NWSA) by Rupert Murdoch, Viacom (VIA.B) by Sumner Redstone, Dollar General (DG) by private equity firm KKR, and AutoZone (AZO) by Edward Lampert’s ESL Investments.
Having a controlling shareholder is a double-edged sword. There’s good and bad about it.
We’ve heard a lot about the downside risks. Most recently, Rupert Murdoch was accused of treating News Corp “like a wholly owned family candy store” for, among other things, acquiring his daughter’s TV production company Shine at an allegedly inflated price.
I am well aware of these risks. I own News Corp and Viacom non-voting shares, and the annual proxy statements I receive and the instructions on them (that they are for information only and that I would not need to take any action), are constant reminders of small shareholders’ status in a company with a controlling shareholder.
Most investors are aware of them too, and have discounted them in the prices. At 11/18/2011 closing prices, News Corp’s non-voting shares (NWSA) were traded at $16.32 per share, a nearly 3% discount to its voting shares (NWS). Viacom’s non-voting shares (VIA.B) were traded at $44.45 per share, more than a 15% discount to its voting shares (VIA).
There is no such a thing as free lunch. You have to pay more for a better-protected security. For investors, everything comes down to price. If an investor believes that the price discount he is getting is sufficient to compensate for his risk, then it’s a good investment, even with Rupert Murdoch at the helm.
In this article, I am gong to talk a little bit about two bright sides of having a controlling shareholder, which should be factored into as well when one weighs the pros and cons of an investment opportunity.
(1) A controlling shareholder can be the best friend of small investors. A controlling shareholder has his or her incentives relatively well aligned with the company. For every $1 Wal-Mart loses, the Walton family loses nearly 50 cents. They have every incentive and great power to make sure that CEO Michael T. Duke is doing his best in creating value for all shareholders.
In companies with dispersed shareholder base, very often management effectively supervises itself. If a CEO has been with a company for a while, he very often gets to influence who gets to sits on the board of directors, who sits on the compensation committee that determines his pay, and who sits on the nomination committee that determines who gets recruited to the board.
It is prohibitively expensive for tens of thousands of small investors across the globe to coordinate among themselves to discipline a badly-behaved CEO. Large institutional investors rarely lend much help. With just a few notable exceptions (such as CalPERS, and many shareholder activism hedge funds), they prefer voting with their feet to active confrontation when they don’t like a management team.
Incentive plans consisting of options and equities may help a little bit by aligning the incentives of a CEO with his company, but they are far from enough. A typical non-founder CEO owns only a tiny fraction of his company. If a CEO owns only 0.1% of a company (which can be quite substantial in dollar terms for a large cap company), then for every $1 the company loses, this CEO loses only 1/10 of a cent.
(2) A controlling shareholder can be a buyer of last resort, and provides a floor for stock valuation. Take Wal-Mart (WMT) as an example. According to MSN Money, excluding the 49.3% owned by the Walton family, WMT has about 1.75 billion common shares outstanding, which is worth about $100 billion at the 11/18/2011 closing price of $57.23 per share.
On first thought, $100 billion may sound a lot. But WMT is a large and highly profitable company. According to WMT’s own definition and calculation, Wal-Mart is generating $10.9 billion (in FY2011) and $14.1 billion (FY2010) of free cash flow a year.
Currently they are using the free cash flow to pay dividends and repurchase shares in the open market. In FY2011, WMT returned a record $19.2 billion to shareholders, $14.8 billion of which was spent through share buybacks. Currently, annual dividend is $1.46 per share, implying that the Walton family, owning 1.698 billion shares, is receiving nearly $2.5 billion (before tax) of dividend incomes a year from WMT.
Let’s see what might happen if both WMT and the Walton family believes that WMT shares are undervalued.
Let’s make some simplified assumptions here. Let’s assume that, going forward, WMT is going to buy back $8.5 billion of its own shares a year, and every year the Walton family plows $1.5 billion of dividend income back to the company by buying more WMT shares in the open market.
Well, if WMT’s share price remains unchanged, then within 10 years all of the non-Walton shareholders will have been bought out. The Walton family can own the whole company again and take the company private without incurring any new debts.
You may dispute my little thought experiment with this line of thought:
But that’s not possible! As fewer and fewer shares remain in the open market, WMT’s share price will be driven up to a level that is not a bargain for the the Walton family anymore. They will eventually have to pay a significant premium, as usually happens in a taken-private transaction, or they will stop buying.
But isn’t this exactly what we want?! WMT’s share price would either go up to match its growing earnings power, or the Walton family will find it attractive to take the whole company private!
There is a mental exercise you can try if you find it difficult to image a $200 billion company being taken private. The word “billion” sometimes shut down our brain because it is so remote from our everyday life (for 99.99% of us).
Try this: Just remove the word “billion” and imagine $200 billion as $200. Image your brother and you each owns half of a $200 lemonade stand, and the business is throwing out $13.5 of free cash flow a year. The business uses $8.5 to purchase shares from your brother, and pays $2.5 of dividends to each of you. After paying 40% tax, you use the remaining $1.5 to buy even more shares back from your brother because he is embarrassed about being a street vendor and wants out. In ten years, you will become the sole owner of the business.
Of course, your brother is not short-changed in any way, if the lemonade stand is indeed worth no more than $200. If the lemonade stand is actually worth $400, then you are getting a bargain for being willing to own a boring business that your brother and most people don’t desire.
Suddenly, it sounds very practical now, doesn’t it?
Most important, the time horizon of how this can play out is not remote. A practical value investor does not just look for undervalued stocks. He should look for undervalued stocks with a catalyst in the visible time horizon.
A hardcore value investor may say that market prices are irrelevant and he is happy with an undervalued stock even if the stock market is closed for the next 50 years. Some even emotionally dismiss the concept of volatility risk as pipe dream of pointy-heads from the ivory tower.
Unfortunately, an investor does grow older every year (which is another concept originated from the ivory tower, by biology professors this time), and one will eventually have to retire, stop earning labor income, and draw on his savings. At that moment, market prices are as real as a business’s fundamental.
A stock that is going to be undervalued for a long period of time is risky, because the pain you are going to feel from stock portfolio depreciation is real, and is not academic at all when you stop earning any labor incomes.
For those who argue that volatility always creates better buying opportunities, I hope they are not advising retirees to earn the double-down capital from gathering shopping carts in local Wal-Mart stores in a chilly winter morning.
At that vulnerable moment in the market and in our life, it is precious to have a majority shareholder standing ready to take sell orders from you when Mr. Market is AWOL.
