The great taskmaster

02 Jul 2018

Professor Brian Kantor

Chief strategist and economist, Investec Wealth and Investment South Africa

The greater the risk of failure, the greater must be the required return.

The success of any business enterprise is measured by the return realised on the capital entrusted to it. The managers of an enterprise will rationally direct the capital provided them to particular business purposes in the expectation of a return on the capital invested that exceeds its opportunity cost, that is greater than the expected return from the next best alternative project with similar risks of success or failure. The greater the risk of failure, the greater must be the required (breakeven) return.
 
The only returns that can be measured with accuracy are those realised for investors in listed and well-traded companies.
  • Returns come explicitly in the form of capital gains or losses and dividends or capital repayments received.
  • Risks to potential returns are measured by the variability of these (monthly) returns over time that hopefully have a consistent enough pattern.
Consistency furthermore identifies the returns from a company as more or less risky compared to the pattern of average returns realized on the stock market – the so called ‘Beta’ of a stock.
 
These measures can then form the basis of a required risk-adjusted return for a company or an investor to aim at. The so called ‘Alpha’ of the total return equation is the extent to which the company shares perform better (or worse) than the market and may account for much of realised returns.
 
The more superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company.
These concepts are useful when judging the competence of company managers in deciding and executing on projects. To the extent that share market returns are mostly alpha (under the control of the manager of the company) and not the result of market wide developments over which managers have no influence, then determining the contribution of managers to realised returns becomes a consistent process.
 
Those buying a share from a willing seller are mostly gaining a share in the established assets and liabilities of an operating company – a share that the seller is willingly giving up – at a price that satisfies both.
 
They are not providing extra capital for the firm to employ. By establishing a price for a share they are however providing information about the market value of the company’s operations and so by implication the terms on which the company could raise further share or debt capital, should they wish to do so to supplement the company’s own savings to be invested in ongoing projects. 
 
In essence, secondary share market transactions, through their influence on share prices, convert the internal rates of return realised by (and expected of) an operating company, into expected market returns. The more superior the expected performance of an operating company, the more investors will pay up in advance for a claim on the company. The higher (lower) the share price the lower (higher) must be the expected returns for any given operating outcomes.
 
Only surprisingly good or disappointing operating results will move the market.
In this way through share price action (higher costs of entry into the investment opportunity) those companies and their managers that are expected to generate way above average returns on the capital that they invest in on-going operations and projects, may in reality only provide market-related average returns to share owners over any reporting period, say the next year or two.
 
The further implication of these market expectations, incorporated into share prices, is that only surprisingly good or disappointing operating results will move the market. The expected will already be reflected in the price of a share or loan.
 
The implications of these expectations – and their influence on share market returns – for company managers and their rewards (provided by shareholders), seem obvious. Managers should be rewarded for their ability to exceed targets for internal rates of return that are set presumably and consistently by a board of directors, acting in the interest of their shareholders.
 
Looking now at companies or agencies that invest in operating companies (buying their shares, rather than operating the businesses themselves) – be they investment holding companies or unit trusts or pension funds – they can however be judged by the changing value of the share market and other opportunities they invest in. Their task is to earn share market beating risk adjusted returns. They can only hope to do so by accurately anticipating actual market developments.
 
Predicting the future is hard, but they do have one key advantage in this endeavour. The managers of a listed investment holding company, for example Berkshire-Hathaway, are endowed with permanent capital by original shareholders that cannot be recalled. This allows them to invest capital in operating companies for the long run.
 
The market place is always a hard task master.
But the market place is always a hard task master. Past performance, even good investment management performance, may only be a partial guide to expected performance. The capabilities of the holding companies’ managers to add value by the additional investment decisions they are expected to make today and tomorrow – not only the investments they made in the past – will also be reflected in the value attached to their shares.
 
Therefore, conglomerates and investment holding companies can stand at a discount or at a premium to the market value of the assets they own. The difference between the usually lesser market value of the holding company and the liquidation value of its sum of parts – its net asset value – will reflect this pessimism about the expected value of their future investment decisions.

 
A lower share price paid for holding company shares compensates for this expected failure to beat the market in the future – so improving expected share market returns. It is a market reproach that the managers of holding companies should always attempt to overcome, by making better investment decisions.
 
And by exercising better management of their portfolios, including converting unlisted assets into potentially more valuable listed assets and also by indicating a willingness to unbundle successful listed assets to shareholders when these investments have matured. And they should be rewarded appropriately when they succeed in doing so.

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