In his writing in this chapter, Graham displays some semblance of being an “activist” investor, urging investors to make their presence felt at annual meetings, and a plea that shareholders pay careful attention to the proxy material sent to them. Graham was not entirely opposed to the idea of an individual shareholder or small group attempting a hostile takeover of a poorly managed company, believing that “only by the assertion of control by an individual or compact group” could poor management teams be changed.
Much of what Graham wrote in this chapter has been modernized and is largely irrelevant under today’s financial regulations, but Zweig provides some additional insights that remain valid today.
Commenting on Commentary on Chapter 19
Zweig reminds readers that owners of stock are owners of business, yet as Graham bemoaned, they often fail to act that way. Most shareholders give their wealth away to someone else to manage (i.e. they make the investment) without validating the stewards (i.e. management) are proper stewards of that wealth, often finding that management has wasted his wealth.
So how can we be more intelligent owners? It starts with two simple questions we can ask about the companies we own: (1) Is the management reasonably efficient (are they running the business profitably given its size and relative to its competitors)? (2) Are the interests of the average outside investor given proper recognition?
And if management isn’t doing a good job, hopefully you have explored whether the company's governance has any mechanism for shareholders to replace them. In today’s marketplace many prominent companies have divorced economic ownership from control. In Graham’s time the governance model was shareholders elect the board of directors who appoint and replace management. In today’s environment with many dual-class structures, the founder (often CEO) controls the board of directors and management.
The important takeaway from this is that knowing the governance structure is an important factor to consider before buying a stock and thinking about alignment of interest. Does the founder have substantial wealth at risk, is there any independent oversight, how is succession handled, etc.?
None of this is to say dual-class structures are bad, let’s be realistic, most shareholders are owners through mutual funds and ETFs and generally feel like they have no practical influence on any individual company, but with any governance structure the goal is to avoid risks that could lead to the inability for your capital to continue to compound.
As for owners getting their fair share of earnings, both Graham and Zweig argue that a management decision to retain earnings rather than pay it out to shareholders isn’t necessarily valuable, with Zweig citing how often early 2000s tech companies argued against paying out their profits whilst ultimately putting that cash to work in unproductive ventures. The point is you should question whether “management knows better than the shareholders how to use the money” rather than defaulting to an assumption that “daddy knows best.” The takeaway is that management should distribute excess capital unless it can demonstrate a compelling reason to retain it. That compelling reason can be a track record of strong returns on invested capital.
In terms of how to distribute capital, gone are the days of dividends being the primary means of returning capital, now buybacks play a major role in returning value. Remember however that when a company buys back its shares it is essentially saying they believe that owning their own stock is the best investment available to them at the time and as we’ve discussed when considering any stock purchase, the price matters.
If you want to evaluate management of a company you invested in today, perhaps you can ask one simple question, “If I owned 100% of this business, what would I do with the cash?”
Remember shareholder returns aren’t solely about what the business earns, but also about what management does with those earnings. Governance sits a level above that and is an important consideration.
Next we’ll move to one of the most important chapters in the entire book, one focused squarely on the concept of “Margin of Safety”.
“The most dangerous untruths are truths slightly distorted.”
-G.C. Lichtenberg
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