What happens when the person selling you the story, is also selling you their stock?

Our next speaker is Etienne Flock, Chief Investment Officer from Constantia Investment Partners.

His presentation topic is what happens when the people selling you the story is also selling you their stock.

Constantia Investment Partners is an independently-owned fund manager running a single, long-only global equities strategy.

Their philosophy

is exceptional businesses run by exceptional people purchased at the right price will deliver outperformance over the long term.

Ethem is an award-winning fund manager with 15 years global investment experience.

He previously worked at Melville Douglas Investment Management.

He's a CA and CFA charter holder.

Welcome to the presentation, Ethem.

Well, thank you very much, Angelina, and really enjoying the opportunity to chat with you today.

I'll start us off by acknowledging the bat that the presentation has a somewhat tongue-in-cheek title, as you've already said, what happens when the person selling you the story is also selling you their stock.

Now, before I answer that question directly, I thought maybe we could consider a slight hypothetical scenario for a minute or two.

So imagine that you and I would like to go into business together, something simple like, let's say, opening a coffee shop.

I'd be the person in the scenario running the coffee shop on a day-to-day basis, and you'd be providing the money to get it off the ground.

Now, before you're gonna write the cheque, you probably would have a few questions about me.

Do I know anything about running coffee shops?

Am I honest and hardworking?

How do I intend to pay myself if things go well?

And if things go really well, do I know how to grow a single successful coffee shop into maybe a chain of shops?

In short, you'd basically ask the question, do I want to be in business with this person?

Now, these are very basic questions that anyone involved in a private market transaction would ask before buying into a business.

We very simply say, why do these principles go out the window when it comes to investing in publicly listed shares?

Equity, whether it be public or private, ultimately represents an ownership stake in a business.

shouldn't investors pay more attention to whether the management team of the businesses they invest in are aligned with them?

Now strangely, we find that this is usually an afterthought for most people.

To gain exposure to an exciting story, many people don't even bother looking at things such as how management pay themselves, whether they have skin in the game through personal equity ownership, whether they have had to spend their own money to acquire said equity ownership,

where the management have enriched themselves at Shell's expense in the past, or indeed even whether the board is there to hold management to account.

Now we simply believe that by focusing on these elements and effectively working to identify management teams that sit on the same side of the table as us, equity investors, we can over time meaningfully improve the ability to compound for long periods of time.

We think this is the case because it removes, in our opinion, one of the most common causes of why businesses get into trouble, which is management start working for themselves rather than working for shareholders.

Which brings me back to the initial question, which is what happens when the person selling you the story is also selling you their stock?

Now, on the next slide, I'm showing you the share price of a US business called Carvana.

So for those who don't know, Carvana is essentially a second-hand car dealership.

but they've used technology to build an online platform with national scale in the US.

So this is a classic disruptor story where a new player comes in and upends a traditional and very well established industry and business model.

Now, during 2020 and 2021, when in the US, demand for secondhand cars was through the roof, you can see what happened to their share price.

In the space of roughly 18 months, the stock went from a pre-COVID level of, call it about $100, to a little bit more than $360.

Now, what did management do over this time?

Despite being publicly extremely optimistic about the outlook for the business and using earnings calls to point out and highlight the prospects for the future of the business, management was selling persistently and not in small numbers.

So the light brown line you can now see represents the cumulative dollar value of all the shares sold by management over the past five years.

Between October 2020 and October 2021, the Carvana management team sold roughly 3.7 billion US dollars worth of shares.

Over that period, there was 261 trading days, and the management team were actively in the market for around 205 of those days, or a little bit less than 80%, which you can see in the graph from the downward trending light brown line sort of in the middle there, selling in the market effectively almost every day.

Now, the interesting thing is that these sales are, by law, required to be disclosed by management, which they did.

These transactions were completely visible to anyone who cared to look for it in real time.

So the point that we'd make is that without knowing anything about Carvana as a business, or whether they would be successful in disrupting the secondhand car market in the US, or even the accounting treatment they used for recognizing some of the loans they made to customers who purchased cars from them, or heck, even the unit economics of every sale, it would have been pretty straightforward for anyone who cared to look to see that the management team were not on the same side of the table as shareholders.

They were all in on the story, just not so much on the stock.

So subsequently, the stock dropped from the 360-odd dollar peak to a low of around about $3.60, which is a 99% loss.

It has recovered somewhat year-to-date in 2023.

But the reality is, if you purchase the stock in the latter half of 2020 or 2021, quite likely from management who were selling, you are more than 50% underwater.

So to answer the question, what happens when the person is also selling you their stock, the answer is almost never anything good.

In contrast, here are two businesses we own today, where we think the management incentives and ownership create far more alignment with investors.

On the left, you have a company called WattsCo.

It's a US business.

They distribute air conditioning and other HVAC-related supplies.

The founder of this business, who's now in his 80s, has been with the business for more than 50 years, and he's still on the board.

His son, who's in his 40s, is effectively running the business as the president.

The family owns roughly 12% of the business, which equates to a little bit more than a billion US dollars at risk today in the stock price, and they don't sell.

At the same time, the executive team incentivizes senior management across the company with equity, which in this case, we don't mind, since the structure in which the equity is awarded is quite unique.

The manager gets equity on day one, but only vests upon retirement, which for Wasko is age 62.

The managers are entitled to vote their shares, they can receive dividends in the interim, but they cannot sell a single share until the day they retire.

This creates a very different long-term mindset and it shows up in how the business is run.

Games Workshop is another business we own in the fund.

It's a UK-based manufacturer of plastic tabletop miniature figurines that people use for wargaming.

It's obviously a very niche business selling to hobbyists, but their customers are incredibly loyal.

In fact, someone once described the business to us as the only publicly traded religion in the world.

Now, one of the things we like about this management team is that they need to invest two thirds of their post into the stock at prevailing market prices and then hold each tranche they so acquire for a minimum of three years.

So when it's your own money being spent to buy shares in the market, people tend to think and behave quite differently in our experience when it comes to running the business.

The company also has a scheme where employees can allocate a portion of their monthly salary towards buying stock in Games Workshop, which we like because it spreads the ownership culture around.

And the interesting thing about how this is structured is that employees need to commit to this monthly saving for three years before they qualify to buying stock at a discount for management.

The management team is also very disciplined with capital allocation.

They have a line in their proxy materials stating that value is primarily created through not destroying it.

which means this is the management team that is not going to use its excess cash to try and build an empire and thereby inflate their pay.

If they can't reasonably reinvest the cash to grow the core business, they simply pay it out as a special dividend.

So we boiled down our philosophy to the phrase that you mentioned at the start of the presentation, and you can see again at the top of the slide here, exceptional businesses run by exceptional people and purchased at the right price.

Practically, we start by looking at management and their incentive.

When we initially look at a company, we frequently and almost always begin by reading the actual proxy statements first to get a sense of the alignment the management team might have with shareholders.

To be very clear, we like high quality businesses as much as the next person, which you can see on the left hand here.

However, if you think about it logically,

You're going to own a high quality business generating lots of excess cash for a long time.

The last thing you would want is a management team that is not aligned with you, since the temptation to use that cash to create value for themselves instead of shareholders is going to be absolutely enormous.

And while we readily admit we place an incredibly high premium on partnering with an aligned management team, we also like growth.

Investing in the world's most honest buggy whipmaker is unlikely to be a winning strategy over the very long term, but we see growth as an outcome of management choosing to reinvest the excess cash of the business and hence our focus on management and their incentives.

Now, this approach has worked well for us since our inception in August 2019.

Despite the volatility of markets over the past four years and the fact that there's been quite a few rotations between the various styles that have been in and out of favor, we've just

quietly compounded along by partnering with highly aligned management teams in charge of quality businesses.

And so that's our story.

Everyone wants to own a quality business, but we just think an enormous part of that equation is understanding if you're buying into the proverbial coffee shop with a management team sitting on the same side of the table as you.

We believe that by weeding out the types of behavior that leads to misaligned incentives, we are left with businesses that have a far higher probability of compounding over time.

So with that, very happy to answer some questions.

Thank you, Evie.

I've got two questions for you.

The first one being, what are some of the things you look for when assessing a management team?

It's a very good question.

It's not quite as simple as simply looking at insider buying and selling, though that can sometimes be a valuable signal.

And let's be clear, infrequent insider selling in isolation is likely to be a very poor signal.

For example, Warren Buffett disposes some of his Berkshire Hathaway shares.

It's effectively to give to charity.

We consider many things.

I'll give you one example.

We look at the types of targets that are set for management to earn a big payday.

We prefer to see targets that are linked to fundamentals of the business, such as free cash flow per share or return on capital.

What we don't like is remuneration tied to how the stock performs relative to a market or sector benchmark.

Because if you think about it, that type of target just creates a huge incentive to get the stock price up.

And if we're being

Frank, there are many things a management team can do to accomplish that over a short-term period of, say, three years, whilst actually hamstringing the business for the longer term and leaving continuing shareholders high and dry.

Another one we would look at is the board and how the board is structured, how they're paid, and whether they will really challenge management.

We own another business called Constellation Software, where board members, in fact, not only the management of the business, but board members,

are expected to reinvest their after-tax board fees into the stock at market prices.

And again, we think that's a lot of skin in the game right there.

And where are you finding good opportunities right now, Ethan?

Well, for the first time in 15 years, money costs money again, right?

So I think to us anyway, that means a lot of the financial engineering that could only work with rates at rock bottom is effectively no longer feasible.

So many of the businesses we own end up being owner-operated or founder-led.

In our experience, these people are generally more conservative with debt.

They're more judicious about how to spend cash in growing the business.

So as things slow down and many financial buyers of businesses, for example, private equity, stay back because the IRRs just don't look as attractive with long-term rates at these levels,

We believe that many of the management teams we partner with will and can take advantage of this environment and use their balance sheet for value accretive M&A.

In fact, we've already seen it this year to date with businesses such as Heiko and Constellation Software.

Now, to some extent, these businesses can create value independent of the macroeconomic cycle or backdrop.

And if we do get a big slowdown or sell-off, being partnered with, in our opinion, aligned capital allocators who are cashed up is a reasonably low-risk approach to navigating the world, in our view.

We are finding such opinion markets right now.

I would say it's probably worth highlighting the industrial sector where we're seeing a lot of opportunities like that.

Well, thank you for the presentation and the Q&A.

Good to see you.

Take care.

Thank you very much, Angeline.

Have a nice day.