‘Quality Shareholders’ Review

Coming out on November 3, 2020

I was approached by Columbia University Press to write a galley review for Professor Lawrence Cunningham’s latest work: Quality Shareholders: How the Best Managers Attract and Keep Them. The book is expected to be released on November 3, 2020.

Professor Lawrence Cunningham (@CunninghamProf) is acclaimed for his work on Warren Buffett and Berkshire Hathaway. If you want to better understand Buffett and the Berkshire organization, he’s the guy. His most famous work is The Essays of Warren Buffett: Lessons for Corporate America, currently in its 5^th edition, is a must for investors. Professor Cunningham is also on the board of Constellation Software, (CSU.TO), a company that I had the misfortune to watch its stock rise for years without ever investing.

I was approached to write a review for the blog. So here it is.

In his new book, Quality Shareholders, Professor Cunningham touched on a concept that I had in mind for a long time – that certain shareholders, Quality Shareholders (QSs), are more beneficial to have than others. The idea that there is a Quality Shareholder (QS) class is what this book is about. The concept in my head wasn’t as articulate. It needed a little polishing. I like how Professor Cunningham lays it out. The book brought clarity and structure to the concept. QSs are defined as shareholders who buy large stakes and hold for long periods. They see themselves as part owners of a business, understand their businesses, and focus on long-term results, not short-term market prices.

QSs is the shareholder group that management should attract. The book’s focus is on how the best managers attract and keep them. It’s even written on the cover page.

This is not a college business textbook. This book is about what works. It’s grounded in common sense. It’s a pretty straightforward read. Professor Cunningham would provide a concept, like economic profit, explain why it works then provides real life business examples. The book is divided in three parts with sub segments and there’s a flow to it. You can read it from the beginning to the end or jump to the sections you need to polish up on. It’s one of these books that you keep on a shelf nearby for references.  If more companies had better shareholders, we would have better capital allocation practice, therefore we would have a more efficient capital market. And a more efficient capital market leads to a better society.

When I was two-thirds into the book, I realized something. This book is more than just about attracting quality shareholders. It’s really about how you should conduct your business. If there was a corporate self-help section it would be on the shelf. The book could be called “Better Business Conduct” or “Smart Corporate Habits” but it doesn’t have the same ring to it. After all, you want the book to look good on the desk. The book talks about attracting QSs and it does that but it’s too narrow of a description. It’s bigger than that. QSs are what you get if you follow a certain course of actions. And these actions are related to good corporate practice, behavior, and governance.

The book may have been written in the nick of time. Indexers are dominating corporate America. Technological innovation, especially AI, is propagating transience. Activists are becoming more influential. The current investment world is built for short-term thinking, indexing, and rapid trading.

More than ever the topic of quality shareholders needs more attention. We need to have a conversation about QSs. We need more of them and part of the book’s aim is to light up that spark. The book explores dozens of corporate practice and policies that shape the shareholders base to attract long-term committed owners.

What’s a Quality Shareholder?

Quality shareholders can be defined by these characteristics:

• They are long-term shareholders. They believe in the vision and management. They stick around for a long time.
• They are concentrated owners. They own blocks of shares.
• They are studious shareholders with a focus on operations. They are not indexers or complacent.

Or you might prefer Warren Buffett’s definition, those who “load up and stick around”. Tom Gayner from Markel, a QS himself, calls them the “right owners”.

The other shareholders segments are:

• The Indexers (~40%+ of public equity): They are today’s dominant shareholder cohort — funds buy small stakes in all stocks in a defined index such as the S&P 500. While they offer the masses low-cost market returns, owning small stakes in hundreds or thousands of companies, indexers cannot understand the vast majority of their holdings.They may hold for long periods but never concentrate.
• The Transient (~40%): Sometimes hold large stakes but never for long and don’t invest the time understanding the particular business. A rising portion of transient trading is directed to AI.
• The Activists (~5%): They tend to have higher average concentration – betting large on their targets – but shorter holding period. Although some activist shareholders qualify as QSs, most do not because of their more combative public engagement, which distinguishes its members from the QS pack. Plus having a substantial cohort of QSs offers the benefit of counteracting the downside of other shareholder groups who gain from the “megaphone effect.”

What distinguishes QSs from other shareholders is principally duration and concentration. They hold their investments far longer than average and concentrate their portfolios far more than average. Indexers might hold for long periods but never concentrate, and transcients, which may occasionally load up, but rarely long. With a cohort of QSs, they offer the potential for superior returns.

QSs will not, of course, rubber-stamp any management proposal, nor should they. The QS will act in the best interest of the company – whether that means challenging management or cooperating with it.

While anyone can buy stock in a public company, that does not prevent companies from sculpting their shareholder base to attract some shareholders and repel others.

Who are some of these QSs? Appendix A and Appendix B provides a list of individuals and companies that are QSs with samples of their investment philosophy. Notable individuals are Chuck Akre, Seth Klarman, Chuck Royce and companies like Baillie Gifford, Cedar Rock Capital Partners, Gardner, Russo & Gardner, Giverny Capital and Ruane, Cunniff & Goldfarb are some of the names I’m familiar with. There is also a list of companies that attract QSs. I would like to expand on the investors and companies but I feel it’s out of the scope of this post. Maybe it’s material for a different post.

Why Have Them?

I already highlighted some of the reasons why you would want to attract QSs on board. Here are some of the essential functions of a QS: sounding board, constructive critic, champion of the long-term and ultimate arbiter of capital allocation and business value. They view their portfolio company management teams and boards of directors as partners. They engage with them to ensure the greatest value for shareholders over the long term. QSs add value by introducing directors for the board and can serve as unpaid advisors. Evidence suggests that companies dominated by QSs tend to enjoy stock prices that are less volatile and more rationally related to business value.

Also when you have an activist trying to rip your company apart, having some QSs to counter balance their influence is important. It doesn’t mean the activist’s cause is unfounded. It just means “hey let’s sit down and work something out that’s rational” which is a better approach than screaming into a microphone.

If you are not sure of the benefits of having QSs then invert the situation. That’s an idea I borrowed from Charlie Munger (“invert, always invert”). Think of what could happen if you didn’t have quality shareholders but only indexers, traders or speculators. Let’ say you are off on your quarterly numbers, or you have unexpected issues (that never happens), they will bolt on you and tank your stock price. This will result in higher financing cost or possibly open the door for a takeover.

Cunningham provides the example of Unilever, which was focused on the quarterly results, a very short-term approach to the management of a company. That wasn’t working out. Eventually the CEO dropped quarterly guidance and the stock dropped because the transient bolted. But QSs liked the new long-term focus approach and two years later the stock recovered the loss and went up from there.

Phil Fisher analogy (author of the famous book Common Stocks and Uncommon Profits) had a good analogy. Phil Fisher once compared companies to restaurants. Over time through a combination of policies and decisions, they self-select for a certain clientele. Are you serving fast food or 5-star dining? Two different crowds. The message is you get the shareholders you deserve.

What actions can you take?

Professor Cunningham dedicates a whole segment (Part II) to “Quality Engagement”. It’s the part that discusses strategies of shareholder engagements attractive to QSs. Several seem obvious yet are overlooked; others may involve a more conscientious commitment.

Among easy steps any company can take at low cost but few do: corporate mission statements, annual shareholder letters, and annual shareholder meetings. All three are staples of corporate life.

Among strategies requiring greater commitment is bucking the tide to abstain from quarterly earnings guidance and conference calls in favor of longer-term focus. A related step is to adopt, publish, and discuss honest long-term performance metrics, such as economic profit and return on invested capital. And track these over the long-term.

Above all, management should make a conscious commitment to what QSs value most: effective capital allocation. This refers to the idea that treats every corporate dollar as an investment put to its best use.

There are more of these ideas. The point is your corporate action and communication will attract the shareholders you deserve. I’m reminded by the old saying “birds of a feather flock together”. You attract what you deserve. It’s the same in life. Your partner in life, your circle of friends. How often do you see a smoker hanging out with a group of fit people? Not often. But if it happens you can tell it doesn’t fit. It’s the same when it comes to shareholders.

Drawbacks

Not every book is perfect so let me focus on drawbacks. A common pitfall of books on corporate strategy and research is overemphasizing successes and related practices to extrapolate advice. In general this involves selecting a few success stories, identifying commonalities and prescribing emulation. Such efforts intentionally can overlook causation. The successes may not be caused by commonalities at all. Why certain things happen is complex. There are so many factors at work. It’s never just one thing.  In this case Cunningham identifies scores of companies boasting high relative density of QS, observe commonalities, and suggest that other companies adopt some of the commonalities. Yet it is possible that such commonalities had little or nothing to do with the resulting shareholder base, which instead is greatly influenced by randomness or happenstance.

There is a whole chapter on shareholder voting. It touches on different mechanisms of voting such as dual class, time-weighted voting and other novel approaches. Shareholder voting can be a complicated subject once you dive in. Each approach has its pros and cons. Professor Cunningham proposes his own approach. He calls it “quality voting”. Quality voting refines time-weighted voting to account not only for duration but conviction. That is quality voting grants additional votes to shares owned for a long time in large stake. For example, two votes per share could be granted to shareholders allocating between 1% and 5% of their portfolios to the company and three votes per share to those allocating more than 5%.  If time-weighted voting implicitly assumes that longer-held shares cast higher-quality votes, the hypothesis follows that shares owned by those with greater exposure will also have such merit. He also provides illustration with duration and concentration multiples to show you the mechanic. There are some advantages to the approach such as a company can adopt it without changes to the law and the company can design the details and tailor the arrangements to suit.

I agree with the principles that duration and concentration should be rewarded. It’s all good on paper but you lose me in the nuts and bolts. Trying to implement this sounds like a giant mess. Sometimes the best approach is the simplest approach; one share, one vote. It has its flaws but it’s the simplest and everybody gets it.  The thing with quality voting and other voting arrangements is the administrative cost will be a burden.  A big one.  Most shares are held in the name of depository nominees rather than ultimate owners, complicating the task of tracking ownership concentration. What if you have more than one brokerage account, the record-keeping and calculation can be complex, especially for large institutions investing through multiple funds. I can foresee potential problems like what if you keep the duration but your concentration varies over time. It’s not worth the administrative complexity. While the intentions are good, there are always unforeseen consequences. And you know when something is complex there’s always going to be people trying to beat the system.  In a sense, if you take steps suggested in the book, you wouldn’t have to juggle all these complex corporate voting structures.

The books’ aim is to focus on attracting quality shareholders and there are not a lot of them.  They are a shrinking group. Maybe there’s nothing we can do about this or maybe the book could have touched on how to nurture more of them? Or is that what every other investing book try to do, it’s just that they don’t call it “how to be a quality shareholder?” Or maybe it’s called The Essays of Warren Buffett.

Summary

This is the part where I tell you the book is great and you can pre-order your copy here. This is a good book. I learned a lot. The book deserves a place on your shelf. It’s a reference. Highlight stuff. You will go back to it.

The book fulfills its goal to help companies attract high quality shareholders. The book doesn’t reinvent the wheel, it brings it back.