You've got to name it to tame it

The case for active engagement regarding corporate governance

Photo by Brian Wangenheim on Unsplash

I have two young kids, one who is almost four and another who just turned three months old. Our toddler is admittedly struggling a bit when it comes to sharing the stage with his newborn brother. For the first three-plus years of his life he was the center of attention and enjoyed unimpeded access to his parents. From his perspective, the current situation where there is an uninvited interloper taking away from time with his parents is quite unjust—and he is having some big emotions. Accordingly, my wife and I are desperately trying to figure out how to smooth the transition and make our toddler feel as though he is still very important to us. With that in mind, on my commute to work, I have been listening to some excellent Lovevery podcasts on parenting. There was one particular episode (that I highly recommend for anyone with young kids) that was called Behavior is a smoke alarm that I found very helpful as it relates to our toddler, and that contained some important concepts that can be applied within the investing context.

Taking a step back, being a shareholder is a little like being a parent. Before anyone takes offense to that statement, let me be clear. The intent of that comparison is not to demean anyone or underappreciate the efforts of management teams. It is certainly not true that all companies are similar to helpless children who can’t make it on their own. However, at times, a lot of management teams either need guidance, feedback or stern talking-tos when it comes to corporate governance and compensation. And, just like in the case with children, such conversations need to be handled with care and in the spirit of helping them grow and thrive. In fact, over my career as a “suggestivist” investor, I would say that most of such conversations I have been involved with were fairly positive and constructive. If someone takes major offense to any suggestion that corporate governance, capital allocation or the structure of the comp plan is imperfect, that is a major red flag. Regardless of how feedback is received, I firmly believe that investors have a duty and obligation to maintain an open dialog with the companies in their portfolios regarding those very important topics. As I always say, I can’t tell a company how much salt to put in its pasta water but the fact that I have read hundreds of Proxy Statements makes me a valuable resource when it comes to governance and comp.

Ok, so back to the podcast. The first concept that stuck out to me is the idea that you need to name it to tame it. In the context of toddlers, to understand why there are upset, you have to figure out what the underlying emotion is. Kids don’t necessarily have the language skills or emotional intelligence to explain why they are upset. So, as a parent, you need to figure out what the root cause it. Do they need connection or your attention or are they nervous about something? For example, our toddler had a meltdown over his ravioli the other day. Obviously, the fact that his ravioli was cut up rather than in whole pieces was not the real issue. It was just the tipping point that set him off because he was already dealing with more than he could handle. It turns out he just wanted both of us to focus on him. It was stressful as a parent but getting to the root cause put everything into a much more manageable context.

This is obviously not a Substack focused on parenting advice so how does this apply to investing? Every company will have periodic issues but, to avoid losing money, investors must be able to assess the root cause. Are problems indeed one-offs or is there something more systemic going on? Just looking at operational mishaps or missed performance objectives in isolation may miss a fundamental issue that is hiding under the surface. Maybe the company’s stated performance goals are not being met because the comp plan actually incentivizes employees to focus on something else. In that case, it is the investor’s role to tell management that the comp plan is leading to a lack of alignment. Name it to tame it. Or, a company may continue to make capital allocation mistakes that impair shareholder value because it lacks an appropriate North Star. In this scenario, it is the shareholders’ duty to suggest the company adopt an ROIC hurdle rate for every transaction and investment. The key is to find the root cause and name it, under the heading of being a good partner to management. Sometimes that might be on a private call. Other times it might be in a more public forum such as a 13-D filing. But certain issues require sunlight and to be recognized and, in my experience, many investors simply don’t speak up. Either they are afraid of confrontation or they are worried about losing access to management. However, my sense is that most management teams want feedback on their strategies and execution and, if anything, don’t have enough engaged shareholders to gather a range of helpful perspectives and insights.

The other interesting idea, which is somewhat related to the first one, is that bad behavior is like a smoke alarm. If a child is acting out and you address those actions specifically, it is like pointing the hose at the smoke alarm. Those actions are simply the messenger that is telling you that something else is going on. In other words, the fire is actually in the other room. With companies, the internal issues that become visible from the outside and manifest themselves in poor execution or mediocre performance can be like smoke alarms that are telling you that the culture is on fire. Sometimes that is a 5-alarm blaze that requires a fleet of fire trucks. Other times it is a waste basket fire that can be put out by a small fire extinguisher.

Great cultures consistently produce results that are better than investors ever expected while companies without strong, cohesive cultures perennially underperform. When it comes to the latter, it can be challenging for a public company investor to identify where the fire is and be able to name the root cause. Management teams rarely admit to investors that their companies suffer from deep-seated cultural problems. But it is crucial to recognize that consistent mishaps are not little brush fires that need to be put out individually—as if they exist in a vacuum. Instead, they could be signs of a company culture that has to change. Is there a good way for investors to look past the smoke alarms to determine the severity of the fire? For sure. Especially with smaller companies, speaking with former employees is a must in my opinion. Whether that is through an expert network platform like the one my friends at Tegus have built or by reaching out to people on LinkedIn, the most surefire way of getting a flavor for the culture is by talking to both content and disgruntled former employees. But you have to ask the right questions and be knowledgeable enough about where there could be cultural cracks to benefit from doing those calls. Meaning, you have to know where to look for smoke and fire.

Being a professional investor is also kind of like being a private eye or a journalist. What you see from the outside and what you are told by management could be more noise than signal. The signal is the root cause—of either of success or failure. The deeper you dig and the more unbiased resources you can uncover, the better your chances of distinguishing signals from the noise. From there, I believe it is your job as an owner of the company, however small, to bring any negative signals up with management—for the benefit of all shareholders. It is indeed possible to name without shaming in hopes of taming behaviors that are detrimental to compounding in the long run. If you can do that successfully, it will do wonders for your reputation as an investor and for your relationships with CEOs. You just have to be willing to speak up when you see something that doesn’t seem right.

Everything somehow always comes back to investing,

Ben Claremon