We’ve had lengthy conversations about risks due to technological change and too much leverage on a company’s balance sheet. We’ve also talked about regulatory risks that face the tobacco companies, as well as the risk associated with owning a company that conducts abnormally dangerous activity (e.g. if Southern Co. has any type of nuclear plant issues, those shareholders are going to be entirely wiped out. That may even be the least of their problems. On the other hand, the scope of legal liability for a firm like Colgate-Palmolive is much more narrow).
There is another type of risk worthy of its own discussion–reputation risk, or the degree to which misconduct can affect the core earnings power of an investment.
Although it is not an essential condition, it is more than a side-perk to own shares in a company that is well insulated from reputational risk. I know I’ve raised some eyebrows by saying that Procter & Gamble ought to continue to be held in long-term portfolios even as the growth in EPS has sputtered.
The profits have been stagnant for almost a decade now–P&G made $10.3 billion in net profits in 2007 and is expected to make between $10.5 and $10.9 billion in profits here in 2016. The earnings growth over that time from $3.04 to somewhere in the low $4 range is entirely due to share buybacks that have been significantly funded by debt issuance (P&G had $23 billion in 2007 debt, $31 billion now).
Analysts are only expecting Procter & Gamble to grow 4-6% over the coming five years. So why hold it if the growth has turned anemic and is predicted to continue being so?
Because the earnings quality is largely immune from shocks. If another 2008-2009 comes along, Procter & Gamble is going to be one of those firewall investments still churning out cash and giving it to shareholders because the core products are so intertwined with the regular human experience that they are not subject to abrupt declines.
As it relates to reputation, each business is neatly segregated so that the effects of a scandal are quite minimized. Have an accounting scandal at the corporate office that involves the misstatement of earnings? Well, that will occur under the Procter & Gamble name–people won’t be thinking about that when they purchase Head & Shoulders shampoo. Create razors that cause men to cut themselves when shaving? Any decline in Gillette sales won’t carry over to sales of Tide laundry detergent because the product malfunctioning of the former does not affect the reputation of the latter.
On this particular risk, even Coca-Cola isn’t as well-equipped as Procter & Gamble. About half of the company’s revenues in some form share the Coke name (Coke, Diet Coke, Cherry Coke, and so on) and the business itself shares the name of its signature beverages. Meanwhile, there is no product labelled Procter & Gamble that you can purchase. If there were a contaminated water supply or something that affected some Coca-Cola customers, there would be an economic spillover to the unaffected brands.
In the past twenty years, there has been a trend towards the glorification of asset-light businesses that can generate gobs and gobs of cash flows in comparison to a relatively minimal capital investment. Often, these types of businesses can scale rapidly, and the low reinvestment needs translate into a low-debt balance sheet, lots of dividends, and large amounts of share buybacks. Such businesses have been correctly flagged as an attractive area for investment.
But saying that a company is suitable for a long-term investment is different from saying that it is suitable to allow a meaningful chunk of your net worth to be in a stock that carries heavy reputational risk.
In particular, I have T. Rowe Price (TROW) on my mind. It is an absolutely excellent company. It has no debt, and insane 27.5% returns on total capital. From a “profits created” in comparison to “funds deployed” perspective, it is just as exceptional as Coca-Cola in the 1980s and 1990s. Or Nike today. Profits at T Rowe Price have grown by 16.5% over the past twenty years. A $10,000 investment in 1996 would be worth $167,000 today for a 15.1% compounding rate.
Despite my recognition of T. Rowe Price as a superior business, prudence would demand that it never be permitted to become a large chunk of an investment portfolio. Among people who have owned a collection of stocks for awhile, the Pareto effect starts to kick in–about 20% of the portfolio ends up producing about 80% of the gains. As a result, certain stocks tend to become outsized portions of an investment portfolio due to their superior compounding rates.
If you have held Procter & Gamble stock for the past three decades, it may very well have become 15% to 20% of your overall wealth. At some point–perhaps when it crossed 10%–it may have been wise to start taking the dividends as cash and reinvesting into other businesses. That’s a fine response.
But it’s less wise if a stock like T. Rowe Price starts to become an outsized percentage of your net worth. If there is any deep issue about the firm, it could see its earnings power destroyed overnight. It does have some entrenchment due to relationships with many 401(k) plans, but that’s not enough. People have very little tolerance for product mistakes when it involves an asset management firm compared to the typical consumer products they buy. This is perfectly logical, and something that ought to remain at the forefront of your mind when you contemplate investment decisions.
The recent kerfuffle at T. Rowe Price regarding the vote to take Dell private is a very small issue–no one will be talking about this five years from now. T. Rowe Price argued strongly that Dell shares were undervalued and publicly attempted to persuade other Dell shareholders to vote against the deal. T. Rowe Price owned over 30 million shares, but in order to exercise appraisal rights in which a judge determines the fair value of the stock with no deference given to the buyout price, a procedural hurdle exists for the shareholder seeking to enforce appraisal rights. The first step is that you must vote no against any transaction in which you seek appraisal. By some computer error on their terminal for proxy voting, T. Rowe Price somehow voted to approve the transaction and foreclosed the possibility of an appraisal suit. This cost T. Rowe Price clients almost $200 million, and T. Rowe Price will be using some of its $2.4 billion cash pile to pay that off this quarter.
It’s almost a non-event for shareholders of T. Rowe Price, but it is a good reminder to think about businesses that are the most vulnerable to fast changes in earnings power based on reputational risk. If you could be the owner of the Sequoia Fund, its long-term earnings power from investor fees is now much less after the investor exodus following its 27% stake in Valeant creating substantial short-term losses.
Lots of brands have an ability to overcome scandal. PepsiCo produces “All-Natural” and had to pay up $9 million because it claimed it suggested its product contained only natural ingredients while containing three genetically or synthetically modified ingredients. It had a near-zero effect on PepsiCo’s overall earnings, and even the All-Natural brand has been growing at a double digit pace since the news hit.
Asset management firms don’t have that much leeway. If T. Rowe Price were to repeat its error with the Dell proxy voting a few more times, or make a gaffe on the scale of The Sequoia Fund or worse, there could be a quick investor exodus that drops the assets under management quickly and causes permanent reputational harm. Heck, it’s so bad that funds often rename themselves after a snafu because image rehabilitation in the asset management context is so difficult (look up the Steadman family of funds for my favorite historical example of this.)
Because they scale so quickly, asset management firms have been a great way to build wealth even within a single generation. Most have long-term compounding rates in the 10% to 15% range, and there even two that have long-term compounding rates above 20%. As a long-term holder, it is easy for these stocks to become a large chunk of your overall portfolio in a hurry. Personally, though, I would sell a bit and rebalance once an asset management became more than 10% of a portfolio because the possibility of permanent capital impairment is always there lurking in the shadows in a way that, say, 3M would never be affected.
Originally posted 2016-06-06 23:06:00.
