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The Game of Thrones

'With two eyes you see my face. With three you could see my heart. With two you can see that oak tree over there. With three you could see the acorn the oak grew from and the stump that it will one day become'George RR Martin, from 'Game of Thrones'

As our clients know, RECM's central goal is to provide capital to quality businesses on favourable terms to our clients. It is their capital after all. As a result, much of our work goes into identifying quality companies, quantifying the edge that this quality gives them, and then deciding what terms are favourable enough for our clients – what's the right price to pay to provide capital to the target investee company.

While much of this investigation happens deep in the bowels of the company's financial statements and involves quite a bit of number crunching, readers may be surprised by the amount of effort that goes into analysing the 'softer' issues that apply to an investment. These are the areas where George Martin's third eye would come in very handy – pondering how sustainable the company's competitive advantage really is, what competitors and regulators might be doing to break it down, how suppliers and customers are positioning themselves vis á vis the company and also evaluating the incentives and motives of management and major shareholders.

One of the critical factors we spend a great deal of time evaluating is the quality of management. This may not be readily apparent on the face of it – a quick search on our own website confirms that 'investee company management' does not produce any hits. But if you read between the lines in much of our external communication – the REVIEW, REFOCUS and our various media and client interactions – the importance we give to this issue should become more readily apparent.

We also do our level best to watch out for what we term 'skulduggery' – the many games that providers of capital such as other investors, banks, corporates themselves and their leadership play with their own and their shareholders' capital. Different players play different games, but they all play to gain an edge on other providers of capital. A large part of an analyst's job lies in figuring this out.

Managers should spend their time running their company, not managing analysts

We have incredible respect for the management of the companies in which we invest. It's a tough job, dealing with all the different players and their games. The last thing a company executive needs is advice from 30-year-old investment analysts, that have never actually managed a business in any industry. In fact, if we learned that an executive was following advice about how to operate their business from an investment analyst it would cause us huge concern.

It's also blindingly obvious that the global buy-side industry hasn't done anything to enhance its collective credentials as an 'owner' by its short-term jumps into and out of stocks. Put yourself in the mind of a typical CEO for a moment – how likely would you be to share insightful information with a shareholder (owner) that's likely to be gone from the share register in the next six to twelve months? Personally, I'd be much more likely to pay lip service at best until their actions over several years had proved that they were in it for the long haul and prepared to partner the business.

So there's a dance in communication between chief executives, finance directors, investor relations professionals and public relations companies on the one side, and analysts and investors on the other. It's a dance that's heavily pregnant with the potential for superficiality. This is particularly true when the main topic of interest is the very near term – such as setting and managing expectations for the next set of results.

Management actions speak louder than their words

Given that management has every incentive to pick their words wisely, how does an external party such as us gather the information necessary to assess management and their likely actions?

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Our first step is to communicate with them in a consistent fashion over a period of time. It takes years to earn management's trust by being well-prepared, respectful, mindful and consistently directing questions to the business issues that really matter. Once we've established a good relationship, it becomes easier to inspect, and instigate meaningful dialogue on management's capital allocation track record. We also look at their actions in previous roles within the same company or at previous companies.

We put great store in the information and impression we leave with from one-on-one interviews with management. We're particularly interested in their answers to questions such as:

· What is the essence and purpose of the business? · How do they think about long-term shareholder

value creation? · What is the business strategy? · What is the culture and does it support the

execution of the strategy? · How do they think about potential acquisitions? · What is the history of the development of the

business and its leaders? · What decision-making process does the

business apply to make key judgments? · Who really owns and runs the show and makes

the big calls, and what are their incentives? · How do they think about organisational

knowledge retention and succession planning? · Can the firm make and acknowledge mistakes

and learn from them?

Annual reports have become less valuable tools, although they are still important

It used to be a very insightful exercise to study a company's annual reports and results announcements. There were often snippets of wisdom to be found from senior management and chairmen. Unfortunately, nowadays communication is increasingly superficial due to the interventions of public relations firms, ghostwritten annual reports, and the exhaustive compliance sanitising and corporate governance checklists any corporate communication undergoes before it's released to the public.

While annual reports have significantly increased in size and supposed transparency over the last 15 years, they're generally far less capable of fulfilling their true purpose – providing relevant insight to business owners. It's a sad case of the triumph of

the mediocre. It's ironic that increased corporate governance has led to longer, but less useful documents. Boilerplate dominates substance when the regulators get too involved. As a general rule of thumb, the thicker a company's annual report, the less useful it is.

To be fair, there are still some listed companies that speak openly and honestly to their shareholders, but this list is shrinking. We maintain a list of such companies from around the world and read their reports avidly, whether we have an ownership interest or not.

Vivendi and Dell offer two contrasting case studies

Vivendi and Dell are two shares that have been, or are currently, held by the RECM Global Fund. They also offer good examples of how we try to assess management and how skulduggery can cut down an investment thesis.

Vivendi

French-listed media conglomerate Vivendi was a top ten holding in the Global Fund at the end of December 2013. Vincent Bollore, the chairman and CEO of Bollore Group, was appointed as Vivendi's vice-chairman in 2013. Mr Bollore's great grandfather founded Bollore Group in 1822 as a logistics business in Africa and since then it has grown into a diversified conglomerate. Mr Bollore has a reputation in France as a corporate raider and shareholder activist, similar to legendary US investor Carl Icahn, but with a distinctly European flair. Bollore Group is itself a listed company we admire greatly that has delivered excellent long-term returns under his stewardship. In 2011, the Bollore Group sold two digital terrestrial television stations to Vivendi in exchange for Vivendi shares, becoming the largest shareholder in Vivendi.

We already liked what previous Vivendi chairman Mr Fourtou was doing to unlock value at Vivendi and our judgement at the time was that Mr Bollore had joined the Vivendi board to speed things up. This has since come to pass, with Vivendi announcing the sale of SFR – the number two cellular operator in France – to Numericable, for €13.5 billion in cash, 20% of the new combined entity and a potential earn-out of €750 million. Vivendi retains the Universal/Canal+/GVT media asset rump. This transaction supports our investment thesis and we believe is in our clients' favour.

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Dell

Michael Dell is famous for having founded and built the information technology company that bears his name into a global powerhouse business and brand. At one point in early 2000, when the Dell share price was at nearly $60, the company was priced by the market on a price-to-earnings (P/E) multiple of almost 90 times.

Nine years later, during the market collapse of 2009, we were fortunate to be able to acquire Dell shares below $10 per share for our clients at a P/E of just five times. Our assessments of the intrinsic value of Dell suggested to us that the firm offered good value. And there was a solid cash underpin to its value that equated to $6 per share. We wrote in detail about our investment in Dell in 'Freebasing Free Cash Flow' in REVIEW Volume 14, October 2010.

Around the same time, several well-respected investors and money management firms – including Carl Icahn and Southeastern Asset Management – acquired significant positions in Dell and started engaging with the company's board to unlock value.

It seems that Mr Dell agreed with the view we shared with the other minority shareholders.

With hindsight this was unfortunate, as he eventually succeeded in raising enough capital to take his company private. This he did in 2013 at a price below $14 per share. In the process, he squeezed out minority investors at a discount to a fair intrinsic value, and at a huge discount to the premium a buyer would have had to pay for control. A win for him and a loss for our investors!

While many of the company's minority shareholders put up a fight, both in public and behind the scenes, this ultimately had no effect.

One of Mr Dell's arguments was that it would be easier to implement a business turnaround if the business wasn't listed and in the public eye. We strongly disagree with this point of view. We find it remarkable that management is typically very happy to raise capital from the markets at lofty multiples despite the increased transparency that listing demands. Yet the same management seems to consider being listed as a drawback whenever the share price is truly cheap.

One of the lessons we draw from our Dell experience is to never underestimate the incentive and ability of a business owner and leader to take their company private at a discount. In future, we plan to intensify our research into management's past behaviour in similar situations.

Chart 1: Dell Share Price and PE Multiples

Source: Thompson Reuters Datastream

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While we weren't impressed with the outcome of our investment in Dell, it's hard to write off the investment as an unmitigated mistake. Our clients still made money from their investment in Dell. But the way things ultimately played out is an excellent example of skulduggery at play in public markets and highlights how careful minority investors need to be when evaluating the incentives and motives of all of the pieces on the chessboard.

Soft skills are just as important as quantitative analysis

When evaluating a potential investment, we believe analysts need to hone their ability to see with their 'third eye'. It's ultimately a matter of acknowledging that there's a game of thrones at play and we need to deliberate and consider all

angles, incentives, motives and pathways. While we won't always get it right – as our experience with Dell shows – it's nevertheless important to pay attention to the softer side – the art of investment analysis.

Daniel Malan