November 22, 2017
What We’re Reading This Week
There are a lot of people that talk about exchange-traded funds reducing competition in the marketplace and incentivizing companies to reduce competitiveness. Or, rather, not incentivizing companies to stay competitive, which is somewhat similar.
Think of two large companies inside of an index fund. For example, Apple and Microsoft are the two largest positions in the S&P 500. S&P 500 index funds like the SPY must, by their very nature, own the underlying positions. Apple makes up 4% of the SPY. It’s estimated that passive investments own between 10-15% of every security in the S&P.
So, as passive investments gain additional investors they will continue to increase their ownership. Index fund opposition suggests that this reduces competition. If Microsoft and Apple have substantial ownership by index funds (who will always own the stocks the index tells them to own), then they have less to worry about in terms of losing shareholders. In fact, some argue that they are incentivized to increase prices together because investors want all the companies of a specific industry to make money. When Apple and Microsoft charge more for phones or computers, the shareholders make money and as passive investors, they don’t care if a customer leaves Apple for Microsoft; it’s all the same to them. This argument sort of makes sense on the surface. And while I haven’t seen evidence of this in the market, I sort of wonder if it will bear out in the future. Personally, I doubt it.
However, I am concerned with short termism in the marketplace. A public company works for the shareholders, pure and simple. If they don’t perform, people vote with their feet. This leads many companies to operate on a quarterly basis, not giving enough consideration to the long term. But what if the investor is an index fund? They won’t sell their shares if they disagree with management. They will however, vote their proxies. The CEO of Vanguard recently discussed this at Ritholtz Asset Management’s Evidence-Based Investing Conference:
“We can’t sell when we are in an index. That’s actually a big benefit. Suddenly these companies realize we’re permanent shareholders. We’re going to be around even longer than management. We don’t care about (some random) activist fight. We want to make the best decisions for the long run. And by the way we own five or six or seven percent. And we vote. Once they realize we vote the shares, it’s surprising how many people find their way to Malvern to talk to us.”
While cost is a current market driver in the fund world, I would like to think that one day investors will consider how investment companies vote their proxies.
“The company has tried to characterize this as a major win for the company. It’s actually a major win for the shareholders.”
Activist Bill Ackman was trying to get three candidates elected to the board of directors at ADP in order to enact changes at the company. Changes the company stated were already in place. Interestingly, one of the reasons Ackman lost was that Vanguard did not vote in his favor.
ADP stock is up 6.4% since Bloomberg first reported Ackman’s position in the company. It’s an interesting situation. People purchase Ackman’s fund because they expect him to go into a company, stir up turmoil, and enact change. ADP has become more shareholder-friendly; it is advancing technology and growing its margins. Did APD do these things to get Ackman off its back or was this business as usual? Also, did Ackman do his job? It is very hard to tell. One scenario looks a lot like the other, at least from a stock price perspective. A poorly run company can be purchased by Pershing Square (Ackman’s company), enact a lot of change, and improve. Also, a well-run company can be purchased, enact a lot of change, and improve even more. That change may or may not be caused by Ackman. He really only needs to take credit for good things done at a company. It’s sort of a self-fulfilling prophesy. When you are wrong you can just sort of blame management for not listening to you.
You might notice a little bit of a theme today. First, the notion that “reduced competition” via passive investment funds might be a good thing because it only reduces short term competition and second, investment companies really do have an impact on board seat votes (either through activism or opposition to activism). Finally, we will talk about voting in general.
Tech companies especially seem to have embraced a trend of not letting their broad shareholders vote. Facebook is probably the most public example of this but Snapchat is the most recent that comes to mind. Recently, they announced poor earnings and a future app redesign. Shares declined.
CEO Evan Spiegel stated, “There is a strong likelihood that the redesign of our application will be disruptive to our business in the short term, and we don’t yet know how the behavior of our community will change when they begin to use our updated application.”
Put differently, we are changing our app and you probably won’t like it…at first. Yes, people can still vote with their feet, so to speak. And they have, the company has dropped 10% since its IPO. However, shareholders can’t with, well, their votes.
Spiegel believes that the changes are “substantial long-term benefits to (the) business.” Clearly, shareholders disagree. You have two opposing forces here. One, people that purchased the stock who think they know how to run the company and would do it differently and two, the guy who has been running the company. Taking voting rights away from shareholders is one way to ensure that management has the flexibility to do things they think are right. Personally, I think there are benefits to both systems: letting shareholders vote and not letting them vote, mainly because owners and shareholders tend to be wrong in equal proportion. Ultimately though, if you disagree with Snapchat’s management you can just choose not to buy the stock.
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