Saturday, 29 June 2013

Dividends Vs.Share Buybacks

I’ve recently had the pleasure of catching up with the Berkshire Hathaway Annual Report for 2012, which contains an interesting discussion on dividend policy. With dividends being all the rage in our low interest rate environment, this seems like a timely topic. Berkshire has famously never paid a dividend, yet Warren Buffett frequently extols the dividends Berkshire receives from its subsidiaries and publicly traded investments — from such companies as American Express, Coca-Cola, and IBM. This presents a bit of a paradox: Why are dividends right for American Express but not for Berkshire? Is Buffett being hypocritical?
The issue of when and how a successful company should return capital to shareholders — whether in the form of dividends or share buybacks — is far from simple, even for experienced investors and managers. A friend of mine who runs a thriving corporate governance watchdog group once challenged me on whether share buybacks are really very shareholder friendly. To the extent that share buybacks generate incremental value for ongoing shareholders, they do so at the expense of exiting shareholders (i.e., those whose shares the company buys back). Perhaps dividends are more equitable?
Buffett sets up the dividend policy discussion as a series of alternate uses for excess cash generated in a business. Here are the options:

Excess Cash Allocation Decision Tree

At a high level, excess cash can either be retained or distributed to shareholders. If it is retained, it can either be invested in existing businesses (i.e., to “widen the moat” [competitive advantage], to expand, or to acquire a new business). If excess cash is distributed to shareholders, it can take the form of dividends or share buybacks. Each of these four options will provide some long-term return on the excess cash. Theoretically, we should evaluate these returns and select the option that will provide the highest one.
Much has been written on the left side of the decision tree, including Buffett’s criteria for selecting investments and his focus on return on capital. Less has been written on the right side: If a company decides to return capital to shareholders, should it pay dividends or buy back shares?
In the case of share buybacks, the key variable is the price of the stock relative to its value. Return on excess cash will clearly be higher for stock buybacks if a company has an opportunity to buy back its shares at a discount. The greater the gap between the price of the shares and their value, the higher the return on share buybacks would be. Additionally, company management should be in the best position to assess the value of the shares because managers have more and earlier access to internal company information than the market does. Unfortunately, the times when a company generates the most excess cash rarely coincide with the times when its stock trades at the greatest discount. In other words, when times are good, discounts are few and far between. If share buybacks are done at a premium instead of a discount (i.e., where the share price exceeds its intrinsic value), the share buyback will destroy value rather than create it. What should the company do if its stock is fairly priced?
Buffett sets up a hypothetical company to answer this question: The company has a tangible net worth (book value) of $2 million. It earns 12% per year on this tangible net worth, so its earnings in the first year are $240,000. The company has two equal (50%) equity partners. Additionally, the company’s shares trade on a market, where buyers are always willing to buy or sell them at 125% of tangible net. In other words, the company’s price-to-book ratio is 1.25. The company goes through two capital distribution scenarios. In the first scenario, called “dividends,” the company distributes one-third of its earnings as dividends each year and retains the rest. In the second scenario, called “sell-off,” the company retains all of its earnings and one of the shareholders sells 3.2% of his shares each year in lieu of receiving dividends. Here is how these scenarios stack up from that shareholder’s perspective after 10 years (more detailed models are provided below):

Dividends vs Buybacks

In the dividend scenario, the value of the company compounds at 8% per year (12% return minus a 4% dividend). In the sell-off scenario, it compounds at 12% because no dividends are paid out. After 10 years, the sell-off scenario produces a more valuable company, but because the shareholder sells 3.2% of his shares each year, he owns less of it (36% versus 50% in the dividend scenario). These two factors partially offset each other, but the faster compounding of the company wins out and the shareholder ends up with a slightly more valuable stake in the sell-off scenario ($2.8 million versus $2.7 million).
In addition, the sell-off scenario gives the shareholder greater cash flows in the 10th year ($89,742 versus $86,357) and throughout the holding period ($680,778 versus $665,819). Thus, the sell-off scenario is superior at generating value to the dividend scenario in this case.
These numbers work out in favor of the sell-off scenario because of two key assumptions: First, that the company is able to compound its book value at 12% per year. Second, that the market will value it at 125% of its book value. The latter seems particularly reasonable for Berkshire, whose economic value certainly exceeds its book value, because of the massive and high-quality float generated by its insurance operations, among other reasons. The former assumption is more of a challenge. Although many companies have generated returns in excess of 12% per year for long periods of time, most have not. Berkshire certainly has in the past, but will it in the future? If the return assumption drops from 12% to 9%, it is harder to choose the right policy: The dividend scenario provides a more valuable stake at the end of the 10-year period but lower interim cash flows:

Scenario2-Dividends vs Buybacks

Ultimately, the retain versus distribute decision should depend on internal versus external returns (i.e., what returns the business could expect to earn internally versus what returns investors can expect to earn outside the business). In my view, our low interest rate environment coupled with a fairly to fully valued equity market means equity returns moving forward should be lower than they were in past few years, thereby lowering the bar for retaining capital for internal projects. Against this backdrop, a dividend is really an admission by management that they cannot find projects that would compound value at anywhere near 9% per year, as in the previous model.
Here are the full 10-year models:

Full Models

Friday, 28 June 2013

A Book Review of Quantitative Value, by Wesley Gray and Tobias Carlisle

Financial statement analysis and security valuation are a big part of our training as CFA charterholders; for many of us, they are the most important part. We pride ourselves on the thoroughness, sophistication, and level of detail of our analysis. A friend of mine in private equity explained that his due diligence process for buying a company was so thorough it included learning “the first name of the CEO’s second mistress.” But how much impact does that particular detail have on investment performance? How many of the myriad qualitative facts that we gather about a company ahead of an investment decision actually make a difference?

Wesley Gray and Tobias Carlisle offer a different approach in their fascinating book Quantitative Value. They begin with two simple observations. First, value stocks — as a group and over the long term — outperform growth stocks. Second, value managers — also as a group — underperform simple computer-generated value benchmarks, such as the magic formula, which seeks to buy cheap stocks of high quality. This formula ranks the universe of stocks on two metrics: cheapness (Earnings before interest and taxes/Enterprise value, or EBIT/EV) and quality (EBIT/[net fixed assets + working capital]). Stocks with the best combined ranks (cheapest and highest quality) are selected for the portfolio. Quality, the second observation, is particularly inconvenient for me, as a value manager. My fees would be easier to justify if simple models, such as the magic formula, performed a bit worse, or better yet, did not exist.

As it turns out, we asset managers are not alone. In field after field, from psychology assessments to horse racing, human experts underperform simple automated decision models, even when the experts have access to the output from those models. Why would that be? The authors blame behavioral biases that we all suffer from and suggest that the art of security analysis should really be more of a science. Their goal is to improve on the magic formula, which they argue is one of the simplest and most effective value frameworks available.
To that end, Quantitative Value is organized as an investment checklist: Part 2 seeks to identify and avoid frauds and financially distressed stocks. Part 3 seeks to quantify and rank stocks by quality. Part 4 does the same for price. Part 5 seeks “corroborative signals,” such as stock buybacks and insider selling. Part 6 puts the findings together into a comprehensive model. The authors claim that their model outperformed the magic formula by 3.74% per year from 1974 through 2011 and had a better Sharpe ratio (0.74 versus 0.55) and a slightly lower maximum drawdown. This seems like a modest edge, but it compounds to a massive advantage over the 37-year time period studied.
The book’s greatest strength lies in its systematic and objective approach to a field dominated by mystique and high-profile personalities. As security analysts, we are used to learning from anecdotes and case studies. It is refreshing to see our craft subjected to an unflinching, scientific line of inquiry; the book seeks to draw conclusions not from individual cases (although these are provided) but from what works best over the full set of investment choices in the last 37 years. For example, the authors found that the magic formula derives all of its “magic” from the cheapness metric (EBIT/EV) and none from its quality metric (EBIT/[net fixed assets + working capital]). According to Gray and Carlisle, a portfolio of stocks sorted only on the cheapness metric achieves an astounding return of 15.95% a year and outperforms the two-metric magic formula by more than 2% per year. This finding alone, if true, should be an eye opener for most practitioners. How many of us have achieved a better return over any length of time? How many of our favorite financial ratios and analysis techniques truly add value? In other words, if each of our favorite metrics were consistently applied to select securities over several decades, would it produce a superior, or even adequate, portfolio return? If we don’t know the answer, what place do these metrics have in our investment process?
It is thus somewhat disappointing that Quantitative Value does not apply the same Occam’s razor approach to its own checklist, which runs to five pages on my e-book reader. Some parts of this checklist add considerably more value than others. As mentioned earlier, stocks selected with a single metric (EBIT/EV) can generate a return of 15.95% a year. The full model, which uses dozens of metrics and sub-models, generates a return of 17.68% a year. It seems like a high price to pay, in terms of added complexity, for an extra 1.73 percentage points a year. Perhaps if the authors were as critical of their checklist as of the magic formula the book would be quite a bit shorter.

Speculation versus investment

The word “speculation” is commonly applied to risky investments. And the word “risky” is usually used by the masses to describe investments in assets of low quality or uncertain outlook.
On the other hand, “safe investment” is commonly associated with assets of high quality and/or those with a positive outlook. However, because of these desirable characteristics, so-called “safe investments” usually sell at high prices. And high prices have the potential to turn high quality assets into risky investments.
The more insightful investor knows that:
  • “High quality” and “favorable outlook” are in no way synonymous with “good investment,” and certainly not with “safe investment.”
  • It’s easy to lose money on high-quality assets; people have been doing it for years.
  • Rather than quality, the greatest determinant of a safe (and profitable) investment is cheapness.
  • Buying high-quality assets at high prices can be very risky.
  • Low-quality speculations are usually looked down upon. But widespread derision usually results in low prices, which can make for high return potential (and good safety)
  • Thus buying low-priced low-quality assets can be very rewarding. They may be called rank speculations when they’re made, but they’re often relabeled astute investments when big profits are harvested.
Let me approach this another way: John Maynard Keynes said “a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” What did Keynes mean? Understanding him requires some of the complex, counter-intuitive thinking that must be present if investing is to be understood.

  • People who buy obviously risky assets may be called speculators.
  • People who buy seemingly safe assets are likely to be called investors. But they usually pay prices commensurate with the assets’ apparent risklessness, and when unanticipated risks surface, they can come as a big – and unhappy – surprise. Unfavorable surprises tend to produce investment losses.
I think of investment results as what happens when reality collides with expectations. So-called “speculative” assets are usually the subject of low expectations on the part of the investing crowd. If those expectations are exceeded, profits can result.
But high quality investments are often premised on lofty expectations, and these are subject to disappointment. When that occurs, “investments” can turn out to have carried “risks of which the investor was unaware.”
That’s what Keynes meant. By his standard, I’d much rather be an intelligent speculator than a conventional investor.

Wednesday, 26 June 2013

Wealth Managers: Turn Your Technical Knowledge into a Competitive Advantage

As the wealth management industry continues to expand and mature rapidly, advisory firms face a marketplace with more competition and a dwindling population of high-net-worth prospects who do not yet have an existing advisor in place. This means that wealth managers are continuously challenged to differentiate themselves and their firms as they seek to establish new client relationships.

In this environment, wealth managers—particularly CFA charterholders—who demonstrate a thorough understanding of investment and portfolio management concepts will have a significant competitive advantage.

According to Taking on the Role of Lead Advisor: A Model for Driving Assets, Growth and Retention, a 2011 survey conducted by Knowledge@Wharton, the two most cited challenges that clients face when working with an advisor concern technical knowledge:
  • Understanding why my advisor recommends certain investments
  • Getting my advisor to clearly explain why I lost money and what’s being done about it
Boston Consulting Group’s 2010 report Regaining Lost Ground: Resurgent Markets and New Opportunities noted a similar finding:

“Advisors had only a superficial understanding of some products, which made it impossible to decipher their risks, explain them to clients, and ensure their suitability to a client’s profile.” 

The key to exploiting this competitive advantage is to demonstrate to clients how a solid grasp of concepts at each level of the investment process (security- and strategy-level analysis, portfolio construction, asset allocation, and performance evaluation) translates into client benefits.
Here are a few ways that wealth managers can translate their strong technical knowledge into client value propositions and differentiate themselves from competitors.

Linking Portfolio Allocations to the Client’s Overall Plan

Each allocation in a client’s portfolio serves a distinct purpose: diversification, income generation, exposure to unique risk factors, opportunistic trades, relative value, to name a few. When constructing a portfolio, the advisor expects these distinct purposes to coalesce in a way that will achieve client goals.
Despite the wealth manager’s best efforts to keep clients focused on long-term, portfolio-level performance and goal attainment, the (sometimes) bumpy road along the way often requires discussions at the holding or allocation level.
These discussions require the ability to deconstruct portfolio allocations, explain the role they play in concert with other allocations, and tie them all back to the client’s overarching plan. They also require far more detail than such quick one-liner rationales as “We hold 10% in REITs as a proxy for fixed income” or “Emerging markets help hedge against inflation.” These heuristics tend to leave huge gaps between the client’s portfolio and the client’s objectives.
For instance, in the case of a REIT allocation, a richer rationale might be “Income generation helps moderate the equity market risk that you take in your portfolio. Since fixed-income yields are low and the high-yield market seems overpriced, we made an allocation to REITs to increase income generation. Since REITs have far more equity risk than bonds, we also moved into a lower-beta, small-cap equity strategy.”

Incorporating New Strategies

Nontraditional investment strategies are often marketed to wealth managers by demonstrating how such strategies offer incremental portfolio benefits. For advisors who lack a true comprehension of portfolio theory and risk, these offerings can leave them with a sense of more downside than upside potential. Their judgment tends to be clouded by potential relationship risk when considering new, more complex strategies that could benefit the client but would likely leave advisors in the position of explaining results when disappointing performance periods (inevitably) occur.
Wealth managers who fully comprehend the tradeoffs that come with innovative strategies can more confidently embrace strategies that improve the risk–return characteristics of client portfolios.

Communicating Risk

What risks are high-net-worth investors most sensitive to? Answers will vary, but our work with wealth managers suggests that there are two primary risks that deserve to be addressed with constant vigilance: failure to attain life objectives and shortfalls between expected and realized performance.
Gaining an understanding of clients’ life objectives (and the risks they are able to accept in their pursuit of these objectives) can be greatly enhanced with a solid understanding of how risk can be quantified. With an understanding of such statistical concepts as tracking error, standard deviation (and its shortcomings!), and scenario analysis, wealth managers can better communicate potential downside risk and prepare clients for periods of negative returns.
Taken at face value, historical performance, averages, and medians can often be misleading. Track records do a very good job of showing what happened but don’t do a very good job of showing what could have happened. Advisors must possess the skills and tools to understand both the drivers and the underlying market conditions of historical performance.

Explaining Performance

Clients of all sophistication levels expect their advisors to be able to articulate the factors that influence portfolio performance. Performance attribution concepts, though complex, can easily be simplified so that they are understandable by any client.
This “translation” is far more effective when the advisor possesses a complete understanding of the math behind performance attribution. It becomes far more challenging when the advisor has outsourced most or all of the investment process to a third party.
More than ever before, wealth managers who demonstrate deep technical knowledge of investment and portfolio concepts will find themselves in a favorable position for competing for new business and meeting the expectations of today’s high-net-worth investors.

Friday, 14 June 2013

Seth Klarman’s Three Methods of Business Valuation

In 1991, Seth A. Klarman published “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.” This book outlined his thoughts and approach to investing.

In this article, I would like to share some passages that I have compiled from Chapter 8 (The Art of Business Valuation) of “Margin of Safety.” These passages focus on Seth Klarman's three preferred methods of business valuation.

Before we jump full-force into these methods of business valuation, let’s start with an introductory quote from Mr. Klarman:

“To be a value investor, you must buy at a discount from underlying value. Analyzing each potential value investment opportunity therefore begins with an assessment of business value…. While a great many methods of business valuation exist, there are only three that I find useful.” (Margin of Safety, pg. 121)

The table below contains these three business valuation methods that Seth Klarman finds useful. This table also contains definitions for these valuation methods, some thoughts as to when it might be appropriate to use each valuation method, and some notes related to each valuation method. Following this table, I have also included some of Klarman’s related thoughts on business valuation and investing.

Valuation Methods
When to Use it
1. Net Present Value (NPV) Analysis
"NPV is the discounted value of all future cash flows that a business is expected to generate." (Margin of Safety, pg. 121)
Going concern value. "Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low. Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis." (Margin of Safety, pg. 135)
"A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor's assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety." (Margin of Safety, pgs. 121-122)
2. Liquidation Value
A) Liquidation Value is the "expected proceeds if a company were to be dismantled and the assets sold off" (Margin of Safety, pg. 122). B) "The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not." (Margin of Safety, pg. 131)
"Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value." (Margin of Safety, pg. 135)
"Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not." (Margin of Safety, pg. 122) "Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value." (Margin of Safety, pg. 131) "Liquidation value is generally a worst-case assessment." (Margin of Safety, pg. 131)
3. Stock Market Value
Stock Market Value "is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market." (Margin of Safety, pg. 122)
"A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense." (Margin of Safety, pg. 135)
"Less reliable than the other two, this method is only occasionally useful as a yardstick of value." (Margin of Safety, pg. 122)

Related Thoughts on Business Valuation & Investing:

1. "Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism." (Margin of Safety, pg. 122)

2. "Often several valuation methods should be employed simultaneously. To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another. Frequently investors will want to use several methods to value a single business in order to obtain a range of values. In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise." (Margin of Safety, pg. 135)

3. The Reflexive Relationship Between Market Price and Underlying Value: "A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses. In The Alchemy of Finance George Soros stated, 'Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.' In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.... Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by the financial markets themselves." (Margin of Safety, pgs. 136-137)

4. "Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal." (Margin of Safety, pg. 118)

I hope this information on business valuation has been useful to you. I know it has been to me.

Mobius: Why the emerging markets growth story is far from over

The Franklin Templeton manager says low levels of debt and an average GDP growth rate of 5 per cent are just two of the reasons why things are looking up for the sector. 

The growth story in emerging markets has not come to an end despite five years of relative underperformance, according to Dr. Mark Mobius, manager of the Franklin Templeton Emerging Markets trust.

Over the last decade, the MSCI Emerging Markets index has returned 298.75 per cent compared with 133.93 per cent and 100.92 per cent respectively from the FTSE All Share and S&P 500.

However, the majority of that outperformance came in the earlier part of the decade, and the emerging markets index is up just 4.54 per cent over the last three years, roughly 40 percentage points behind its developed market counterparts.

Star emerging markets manager Mobius says better economic fundamentals should see the sector return to a high-growth trajectory.

"I assure you growth is not over for emerging markets for three very simple reasons," he commented.

To begin with, he says GDP is expected to grow by 5 per cent in real terms in emerging markets, despite the slowdown in areas such as China.

He adds that the elevation of frontier markets into the emerging sector is offering new growth opportunities from fast-growing countries, particularly in the small cap space.

The UAE and Qatar have both been upgraded to emerging market status by the MSCI this week.

The second reason is the strength of foreign exchange reserves in emerging markets, giving their governments the ability to control their own exchange rates and maintain fixed rates when they want to.

The third reason to be optimistic is the markets’ relative lack of debt compared with their counterparts in the West.

Mobius' optimistic stance is in contrast to rival Angus Tulloch, who heads up the First State Asia Pacific Leaders fund. He told FE Trustnet earlier this year that the golden age for emerging markets was over.

Mobius admits there has been a pullback from emerging market debt back into the US, and says this is because investors are looking to profit from the recovery in the world’s leading economy.

However, he added: "That’s not sustainable. People will return to emerging market debt."

Mobius remains particularly bullish on Thailand, in spite of its strong outperformance in recent years – the country makes up nearly a third of the $18bn Templeton Asian Growth fund.

"The weighting is a result of price increases, not as a result of buying more in Thailand," he said.

"We’ve actually been taking a bit off the table in Thailand but we do feel the country will continue on this path of growth. There’s quite a revolution going on in Thailand – an economic revolution. There’s more and more money going into more and more hands."

Mobius’s co-manager on the Templeton Asian Growth fund, Allan Lam, says Thailand is an especially attractive play for income investors.

"Thai stocks have a common feature of very attractive yields," he said. "You can find dividend yields between 3 and 5 per cent."

Thailand-focused funds have done particularly well over the past three years. Three of the top-five offshore funds regulated by the FCA are single-country Thai funds: Allianz Thailand Equity, JP Morgan Thailand and Amundi Equity Thailand.

The FF Thailand fund was the sixth best-performer over the period.

Mobius says that there are even reasons to be positive about Russia, a market that often provokes concerns among UK investors.

Although the country is still dealing with severe corporate governance problems, Mobius says it is moving in the right direction.

"Russia is a very cheap market, probably the cheapest market in the world," he said.

"The big issue is corporate governance, but they are moving to more privatised businesses. It will take time but that is the direction they’re going in. I think we can expect more positive news from Russia."

The manager recently attended an annual conference at Russian bank Sberbank – a major holding in many emerging market portfolios – and said the message was loud and clear: Russian companies need to improve corporate governance to attract investment.

All in all, Mobius runs a total of 17 portfolios, on 11 of which he is listed as the co-manager.

His flagship portfolio, the £2.2bn Templeton Emerging Markets IT, has outperformed the MSCI Emerging Markets index over one, three, five and 10 years.

Over the last decade, it has gained 444.18 per cent, beating the index by more than 100 percentage points.

Performance of trust vs index over 10yrs

Among the trust’s top holdings are Thai bank Kasikornbank, Asian retail firm Dairy Farm International and Brazilian banking firm Banco Bradesco.

Its two highest sector weightings are to financials and basic materials, at roughly 32 per cent each.

The trust is currently trading on a discount of 10.5 per cent, slightly wider than its one- and three-year averages.

It has no gearing. It is yielding 1.1 per cent and has ongoing charges of 1.31 per cent, according to the AIC.

Mobius also runs the open-ended Templeton Frontier Markets, Templeton Latin America and Templeton Asian Growth portfolios.

The soft-closed Frontier Markets fund has consistently been a top-quartile performer in the FCA Regulated Equity – Emerging Markets sector, though the UK version of the fund has performed broadly in line with the MSCI Frontier Markets index.

Over the last year, the fund has gained 28.4 per cent while the index has picked up 30.49 per cent.


Thursday, 13 June 2013

Does Cronyism Compromise Shareholder Value at SandRidge ?

Investing expert Charlie Munger, Warren Buffett's right hand, warns us that we should always pay attention to the power of incentives. While well-crafted incentives can promote good management that leads to strong returns for investors, poorly crafted incentives can lead to mismanagement that can cause our investments to plummet.
So I'm concerned that SandRidge Energy has given its board incentives to serve management's interests rather than shareholders' interests. Here's why.

What do shareholders get in this quid pro quo?

In its 2013 proxy, SandRidge disclosed that it signed a three-year contract to rent commercial space from an entity that is partially owned by board member Roy T. Oliver. Under the contract, SandRidge will pay $510,000 in annual rent, minus the cost of any renovations it makes to the property.

The disclosure indicates that the board believes the terms of the contract are fair market rates. While I don't see a particular reason to be concerned about the price the company is paying for the property (given the limited information that is provided), I am concerned about the possibility that this business relationship may create a "quid pro quo" relationship between SandRidge's management and Oliver, who may be grateful for SandRidge's patronage.
And Oliver's gratitude could be risky for investors. Note that Oliver is classified as an independent board member despite this business relationship. He was a member of SandRidge's compensation committee in 2012, and is currently a member of the nominating and governance committee. Oliver's presence on these committees puts him in a strong position to help CEO and Chairman Tom Ward secure attractive compensation packages and recruit board members that would be charitable to management.
Note that the presence of this business relationship doesn't mean Oliver will make decisions that favor management over investors. However, management's willingness to engage in these related-party transactions can give board directors incentives to curry favor with management in hopes of getting something in return down the road, even at the expense of shareholders.

Stealing our Thunder

SandRidge also disclosed certain business dealings with NBA team Oklahoma City Thunder, in which Tom Ward owns a 19.23% interest, and board director Everett Dobson owns a 3.85% interest. Interestingly, Dobson is also categorized as an independent board member despite this business relationship, and is the chair of SandRidge's audit committee.
In 2008 SandRidge signed a five-year sponsorship agreement with the Thunder, costing the company about $3,275,000 annually. When the team qualified for the playoffs last year, the same sponsorship agreement required the company to pay out an additional $612,000. In 2009, SandRidge entered a four-year agreement to license a suite at the Thunder's home arena.
This sponsorship decision could be good for the company in that it provides a valuable marketing opportunity. However, the fact that two board members have sizable personal financial interests in the Thunder makes me worry that this decision could be at least partially driven by the board's willingness to help Ward and Dobson line their own pockets at the expense of shareholders.
Given the abundance of marketing opportunities that are available, I prefer my companies to avoid even the appearance of such misconduct. The willingness to engage in questionable deals like these suggests to me that there may be a larger pattern of shady dealings.

Don't forget that Chesapeake Energy also sponsored the Thunder while then-CEO Aubrey McClendon also held a sizable stake, and that this shady dealing was part of a larger pattern in which McClendon mixed personal interests with business interests in ways that were arguably detrimental to shareholders. Also, like Chesapeake, SandRidge offered its CEO and chairman the opportunity to take a stake in company-owned wells. But Ward's perk was even more lucrative than McClendon's. Ward had the ability to take a 3% stake in each company well, while McClendon had to settle for a 2.5% stake.

Other questionable dealings

Besides the Thunder, SandRidge has financial relationships with two other businesses in which Tom Ward or his family have a sizable stake -- TLW Land & Cattle and WCT Resources. According to the disclosures, SandRidge paid these companies more than $2.5 million in 2012 in royalties, lease payments, and asset purchases. The proxy failed to provide any information about how these deals were priced and whether SandRidge was getting a good deal.

The Foolish takeaway

I believe an abundance of related-party transactions, and the board's repeated approval of management's decisions that can put their personal interests at odds with the larger business interests, should raise a red flag for investors. It can reflect a view among board members that the company belongs to company insiders rather than shareholders. At SandRidge, I'm concerned that this is exactly what is occurring.