Dirk Lever, AltaCorp Capital Inc.
When you visit buy-side managers, understand that many of them are measured on more than just simple market performance. In this article, we touch on a few performance measures used to rate portfolio managers. Knowing some of the metrics of measurement can help you understand portfolio management motivations. Increasingly, the job of the portfolio manager involves factoring ‘softer’ measurements into the decision making process. Also, more and more portfolio managers are offering funds that take certain social concerns, like the environment, into consideration. These issues arise from fund investor (and government) concerns, which are pushing fund management behaviour. More often than not, portfolio managers (especially larger funds) have checklists to measure various investment criteria; coming up short may mean investment requires committee review and more detailed analysis, or precludes investment.
Risk Adjusted Returns
The concept is simple: the greater the risk one assumes, the greater the expectation of return. But how can one even measure risk within a portfolio in order to determine whether a portfolio manager’s returns were achieved by assuming greater risk, or through superior stock selection, or both?
How does an investor, who sets risk tolerances when buying into a fund, know that the portfolio manager stayed within his or her stated guardrails? There are sophisticated calculations to determine portfolio risk parameters; while most portfolio managers are well aware of the computations, the calculations are often beyond the scope (time or capability) of the average investor. Even pension funds, which subcontract portfolio management to other managers, may not have the time or data to properly analyze performance. Enter pension and portfolio consultants, whose role is ever expanding to measure actual performance against various parameters. Portfolio managers themselves are required to monitor their performance to ensure they are within fund risk limits.
So some investor relations professionals, no matter how hard they pitch their company’s virtues, may run up against portfolio risk parameters that could limit a manager’s ability to invest in the company. Maybe there is a limit to how much risk can be tolerated within the portfolio, thereby limiting exposure to the business.
Concentration Risk
Similar in many ways to risk adjusted returns, portfolios often have limitations on concentration in sectors, as well as individual companies. Even concentrated funds, whose investment mandate is to focus on a particular sector, likely have concentration limitations. Ever wonder why a particular fund is selling your stock even though its managers ‘like your company’? It could be that preset concentration limitations are tripped and the fund is forced to lighten its position in your firm. This happens more often than you may think, particularly when a sector is falling (but your company’s stock is not) or when your company’s stock has risen significantly against the sector.
Also consider that some very large fund managers may not be able to acquire a meaningful position in your company as a significant position may be beyond the portfolio's concentration levels for single company investment, which could be dictated by individual company percentage limits, daily stock liquidity measures and so on.
Board of Directors Composition and Compensation
Though there are many debates as to the appropriate composition of a Board of Directors, some portfolio managers are limited, or even precluded, from investing in companies that do not meet certain Board composition guidelines. Typical guidelines are created around Board member independence; this consideration often will dictate how a fund will vote with respect to directors. Gender and background diversification are other areas that are gaining prominence. More and more, companies are spending time and money to find Board members who match the widest possible portfolio acceptance. If your company’s Board composition does not meet the fund’s requirements, this may preclude investment.
Interestingly, Warren Buffet, one of the world’s most successful investors, does not preclude investment by his fund for lack of director independence. Buffet typically prefers that directors ‘have skin in the game’ and that director compensation is tied to business success. However, Buffet’s ability to monitor business operations and interact with senior management and the Board of Directors differs vastly from the level of access available to most investors.
Management Compensation
Not only is the amount of compensation scrutinized, but the form that compensation takes is increasingly under portfolio manager review (and subject to its votes). The concerns are generally two-fold: the reasonableness of the amount and the alignment of risks. Portfolio managers are concerned about management teams that take on risky strategies which, if successful, will enrich management, but if unsuccessful will hurt investors and not management. This is often why portfolio managers will ask how much stock senior management owns and at what average price. A management team that owns virtually no stock, takes big salaries and has lots of stock options may act differently than a management team with a significant personal stake at risk.
Social Issue Compliance
Gaining more traction are a wide range of social issues reviewed or measured by investors for compliance. Some are doing the measuring themselves, while others are hiring outside consultants. Think sustainability, environment, dealings with foreign governments, treatment of employees, overly aggressive tax structures, corporate structure, corporate reporting transparency, the inclusion of integrated reporting, and a whole host of social issues that could be part of a portfolio manager’s checklist.
The ‘measurement’ is often done independently to avoid portfolio manager conflicts. Few portfolio managers are willing to risk their career on a stock that does not meet portfolio requirements.
Forewarned is Forearmed
Understanding the shifting requirements of portfolio managers can help your company address areas of concern so that it does not get rejected before you walk through the portfolio manager’s door. This is likely of greatest concern to smaller companies that are growing and must make changes to meet portfolio managers’ needs. Sometimes achieving the best returns is not enough.
Dirk Lever is Managing Director, Institutional Equity Research, AltaCorp Capital Inc.