by Cole Smead, CFA, Smead Capital Management
Dear fellow investors,
A couple of weeks ago, our firm was in attendance at the London Value Investor Conference. It’s an annual event that hosts investors from across the world with their view of what they find attractive. Author and investor Richard Oldfield reminded me and the audience that my father had presented on Simon Property Group (SPG) the year prior. In effect, the bar was set high.
Our team built a presentation to discuss the attractiveness of oil and coal stocks. It was titled “Fossilized Value in a Crazy World,” and we highlighted what we believe will be rewarding investments in oil stocks like Ovintiv (OVV), APA Corp. (APA), Strathcona Resources (SCR.TO) and coals stocks like Whitehaven Coal (WHC.AX) and Thungela Resources (TGA.L).
For investors who do not work in the investment business directly, there is a commonly used term: P.A. P.A. is short for personal account. You will often hear things from people like, “Oh, I own XYZ stock in my P.A.”
At one point in my presentation, while presenting on the coal stocks, I decided to shame the professionals in our industry for a particular reason. Thungela Resources would be a classic example of what a London-based portfolio manager would have owned in the past. The business has 60% of its market capitalization sitting in cash. It trades at seven times what analysts’ consensus expects this year in free cash flow, producing a little over 10% return on equity (ROE). If they used half of their cash in a buyback, you would eliminate about 25% of the shares outstanding. This would take the ROE to about 13% for a business currently trading at .8 times book value.
Again, it is classically attractive, particularly to a London-based value investor. However, they don’t own this stock for their customers because of issues like climate risks, ESG, or the UNPRI (for a definition, see link: https://www.unpri.org/). In some cases, their customers have come to them and told them not to own coal stocks. In most cases, the marketing people at these firms (who really run these firms) went to the portfolio management teams and told them they would no longer own these because they could raise much more capital by avoiding them and pleasing all investors. Never forget that our industry is good at raising money and not as good at investing, on average.
I told the audience it was a shame they were unwilling to purchase stocks like Thungela, no matter which side of the political aisle they came from. I told them it was a disgrace that they wouldn’t own it for their customers while they instead buy it in their own P.A. I told them this was a conflict.
While we know this conflict is ever-present, I believe it is much larger than one would assume. After my talk that day, about seven individuals came up to me. They were all professionals working in the investment business and they said they were one of those people I spoke of. Their firm doesn’t allow them to own names like Thungela for their customers, so they own it in their P.A. Humorously, I let them know that all we own is our mutual funds alongside our investors. Our funds are our P.A.!
We will call this the P.A. conflict because it is both a spiritual and an ethical issue for our industry. To highlight the spiritual issue, you need to go no further than the first gospel of the New Testament. Matthew 6:21 says, “For where your treasure is, there your heart will be also.”
We should want customers of the investment industry to get good outcomes. Good outcomes come from good processes and aligned incentives. With US markets being the rage of the investment world, we believe that the professionals in our industry own a different portfolio than they recommend to their customers. In other words, they may get a different outcome than their customers. Regulation will never fix ethical issues.
The investment industry used to be dominated by stockbrokers who told you and sold you one thing but did something very different with their own investments. Today, the investment management industry is no different. They tell you and sell you a portfolio but get paid on the value of the assets while many times they do something else with their own investments. It’s just like Solomon said, “What has been is what will be, and what has been done is what will be done, and there is nothing new under the sun.” The idea that we are doing something far better as an industry is a myth, and it just shows how dangerous the P.A. conflict is for investors first and our industry last.
Fear stock market failure,
Cole Smead, CFA
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, CEO and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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