As the year comes to an end, I can’t help but look back retrospectively on the things I’ve done as an investment professional and how those experiences shape the way I look at investing, activism, and business today. It’s difficult to describe what life was like at Relational Investors doing high profile shareholder activism in sleepy San Diego. I could probably write an entire book on my experiences, but for the sake of brevity I’m going to apply Tren Griffin’s 25iq.com approach and share a dozen things I learned working for Ralph Whitworth (and the more behind-the-scenes co-founder David Batchelder) at Relational Investors.
While Ralph Whitworth is probably best known for having Paul McCartney and The Rolling Stones play private parties in San Diego, he is also (in my completely biased opinion) the best in the business when it comes to shareholder activism and working with boards to improve companies.
There aren’t many articles that dive into Ralph’s thinking and why he’s so effective so hopefully this helps shed some light.
Disclaimer: These are my opinions and wording based on my experiences. Most of these lessons are obvious (hiding in plain sight) if you’ve studied Ralph’s past investments.
Dozen Things I Learned From Ralph Whitworth On Investing, Activism, And Business:
- Integrity is everything.
- The decisions made today have compounding value (or costs) long-term.
- Never underestimate the power of a single voice and its ability to drive change.
- Markets are very good at evaluating AND valuing a company’s ability to deploy incremental capital.
- DuPont model helps frame and prioritize key issues.
- Good capital allocation takes a long-term view on ALL (R&D, M&A, buybacks, leverage, capex, etc.) capital deployment decisions.
- 3 year plans aren’t about predicting the future, but about seeing how management thinks they can execute against uncertainty.
- Executive compensation is the company’s rudder. It dictates where the ship goes.
- Focus on being helpful and adding value. The best engagements turn adversarial situations into long-term positive relationships.
- Embrace letting others take the credit.
- Debate in data, not words.
- Know when to walk away and when to dig in.
1. Integrity is everything.
This is one of those no-brainer principles that comes under a lot of pressure in the real world when billion dollar outcomes – and millions of dollars in personal gain – are at stake. While many see compromising integrity a slippery slope, Ralph Whitworth sees a cliff. How you conduct yourself should not come anywhere near that cliff. Folks with incredible accomplishments have seen their hard-earned reputations crumble apart due to a lapse in judgement.
This principle is especially important when in contentious activist situations and working through tough turnarounds. Investors, companies, regulators, and legislators are all closely monitoring how you conduct yourself given the stakes. Everything must be above board and poor judgement not only reflects poorly on the individual but will also negatively impact the goodwill and reputation of an entire organization. Integrity is everything. Never forget that.
2. The decisions made today have compounding value (or costs) long-term.
Activist investors typically have very clear agenda items they want to accomplish when engaging companies. These agenda items can range from better transparency with investors to a complete strategic review of the company and its business portfolio. While the agenda can vary in magnitude, they all have the potential of producing material consequences long after an activist has exited an investment. In short, near-term decisions can have large, long-term consequences.
As an activist investor, it is extremely important to be both critical and thoughtful of the recommendations being made to ensure they are indeed in the best long-term interest of investors and the company. No process is perfect, but being long-term value focused and mindful of the consequences of the recommendations being made has rightfully given Ralph the positive reputation he has today even among the harshest critics of activism.
The compounding impact of decisions is also a linchpin of Ralph Whitworth’s investment philosophy:
Decisions made by management today have compounding consequences in the future. It is why – for better or for worse – the most innocuous headlines or statements can have market moving reactions as investors digest and attempt to extrapolate the long-term consequences of the news. Many of Relational’s best investments involved identifying bad decisions (from the good) and working with management on reversing course (before it’s too late). It’s tough work and few folks are capable of effectively taking it on, but the results speak for itself.
On a personal side note, management teams capable of making positive compounding decisions should never be afraid of activism. As Keith Rabois noted:
“Public market investors are very long term horizon investors for companies that earn credibility.”
Investors are willing to give management teams a long leash for those who have earned it.
3. Never underestimate the power of a single voice and its ability to drive change.
A key component of the activist playbook is to engage in -or threaten – a public proxy fight with the goal of adding a slate of directors to get a desired agenda completed. While Relational was not afraid of getting into a proxy fight, the preference was to quietly engage management teams and Boards behind-the-scenes to drive change and – if necessary – take a single board seat in lieu of a large, messy fight.
The reason Relational was open to taking one seat is because both Ralph Whitworth and David Batchelder are extremely effective at working with other Board members to drive change. They only needed a seat at the table.
I’ll be frank and acknowledge there were moments I didn’t think anything could be done with a single Board seat only to see Ralph move mountains to get things done. It was during those moments I realized to power of a single voice and in turn gained a greater appreciation to why Silicon Valley goes all in when they find a founder capable of moving mountains.
4. Markets are very good at evaluating AND valuing a company’s ability to deploy incremental capital.
As Marc Andreessen astutely points out, a key concept in Ralph Whitworth’s investment philosophy is the nonlinear relationship between multiple and incremental deployment of capital. If management is pursuing long-term value dilutive projects, the market will apply a punitive multiple on their poor capital allocation decisions. Simply put, if there’s an expectation management is going to deploy $1 in cash flow to generate $0.80 in value for the foreseeable future, the market is going to value that $1 at $0.80. On the flip side, some excellent management teams will actually get a premium for the capital they deploy because the market is confident in their ability to execute and generate risk-adjusted value.
“We look for companies that are trading at discounts to their intrinsic value—despite the fact that they have low financial leverage, strong defensible core businesses, and growing cash flows. Invariably this discount exists because investors do not expect management to effectively reinvest the projected profits. This negative expectation is typically caused by a poor history of investment outside of the core franchise and/or from chasing growth within the core franchise in the face of maturing industry conditions.” – Ralph Whitworth
For those who read my primer on revenue multiple and gordon growth model, hopefully you already have a good foundational understanding of the chart above and the non-linear impact low returns have on a company’s valuation multiple. The key takeaway of this chart is valuation multiple will stay relatively resilient, but as companies get increasingly desperate to re-ignite growth and pursue more value dilutive projects/acquisitions, multiple drops like a waterfall.
As an activist investor, if you can work with the company to be more thoughtful and disciplined about how they deploy incremental capital it will cause the company’s valuation multiple to rapidly re-rate to higher levels. Good activist investors are not anti-innovation spend and only looking to maximize cash flow to pop the stock price. In fact, most smart investors would love to maximize the amount of capital spent on innovation if it drives strong risk-adjusted profitable growth long-term.
5. DuPont Model helps frame and prioritize key issues.
If poor capital allocation causes multiple contraction, how do we analyze a business to identify and prioritize key issues to fix the problem? One method is to apply the DuPont Model.
There are many good resources online that walks through ROE and the DuPont Model, but the key thing to understand with DuPont model is it helps deconstruct the drivers of return into components, and helps investors find/prioritize the right questions to ask and areas to due diligence:
- Profitability: Are the company’s strong returns driven by generating superior margin? Or are margins below expectation despite having a great franchise? Why is that the case?
- Operational Efficiency: Does the business have superior operations vs. the competition? Are dilutive acquisitions or bloated cash balance killing the company’s asset efficiency?
- Financial Leverage: Is the company under levered? Should the company issue debt and buy back stock?
Those interested in seeing how to pragmatically think about DuPont should read Shervin Pishevar’s evaluation of Munchery and how the company’s margins, cost structure, and operating efficiency potentially positions the company to win big long-term in the food vertical.
6. Good capital allocation takes a long-term view on ALL (R&D, M&A, buybacks, leverage, capex, etc.) capital deployment decisions.
There is sometimes a misconception that activist investors only want companies to lever the balance sheet and repurchase large sums of stock. While this approach can potentially generate a near-term pop in stock price, good capital allocation should treat share repurchases like any other long-term capital spending decision. The goal is to benchmark all capital deployment decisions on a risk-adjusted basis and allocate spending to the highest and best use. More often than not, buying back stock generates the highest risk-adjusted returns over a multi-year period but that doesn’t mean superior returns can’t be found via internal investments or M&A. It’s all about taking a balanced view on capital allocation.
7. 3 year plans aren’t about predicting the future but about seeing how management thinks they can execute against uncertainty.
Establishing a 3-year plan is a controversial topic in Silicon Valley. How can anyone possibly predict that far into the future? (There’s a reason businesses with resilient recurring revenues get a strong valuation multiple) While no one can predict the future the fact is all companies are making multi-year investment decisions in an uncertain market environment. A 3-year plan helps the Board benchmark how management thinks they can execute against uncertainty, and hold them to a certain level of accountability. It also provides the compensation committee a reasonable basis to set compensation hurdles, and helps the board evaluate all capital allocation decisions including strategic alternatives.
8. Executive compensation is the company’s rudder. It dictates where the ship goes.
Generally, the easiest way to understand how a company thinks about their capital allocation and long-term strategy is to look in the proxy and examine the company’s executive compensation plan. A revenue growth focused compensation plan will potentially drive management to pursue dilutive deals to drive top line growth. Other plans are completely disconnected to any long-term strategy and rewards management regardless of what they do.
While there are always exceptions to the rule, structuring executive compensation to align with disciplined capital allocation is one of the best ways to ensure management and shareholders have long-term alignment.
9. Focus on being helpful and adding value. The best engagements turn adversarial situations into long-term positive relationships.
One of the main reasons Ralph Whitworth is so effective with a single Board seat is his ability to get past contentious situations and work with Board members to drive change. Exactly how he works with other Board members varies but what’s important to understand is that most Board members -especially in complicated turnaround situations – want what is best for a company and are very much open to feedback and insights that will help drive the company in a positive direction.
It’s no coincidence that Ralph’s proactive engagement style have led many to consider him one of the best when it comes to corporate governance.
10. Embrace letting others take the credit.
A key pillar to quiet/friendly shareholder activism is a willingness to work with management teams behind-the-scenes and allowing management to implement an activist agenda item on their own terms. It’s a win-win outcome for everyone involved and more importantly it drives shareholder value without the messiness of a large, public fight. More often than not, activist and management teams are very aligned and the smart thing to do is to let management execute on their plan.
11. Debate in data, not words.
As an investor, odds are we’ll never have the same knowledge base and product sense as an executive who is in the trenches everyday. While we may be short on industry expertise, it does not change the fact we can still add value by doing thoughtful, data driven analysis and showing management how their strategy impacts their valuation.
By debating with data, investors are also able to have thoughtful conversations with management and better understand why – or why not – their data is misleading from the big picture.
12. Know when to walk away and when to dig in.
This is probably the hardest lesson I learned from Ralph and I’m still trying to wrap my hands around it. Knowing when to walk away and when to dig in is more art than science. Sometimes it’s as simple as what a CEO doesn’t say or the discovery of a new incremental data point that looks harmless on its own but is material when applying a mosaic approach to investing.
Some fights are not worth the pain but others require digging in no matter how painful the outcome.