Brunswick Review Issue 1

Glenn Greenberg And Joshua Slocum

Managing Director and Director, Chieftain Capital Management

It is unwise to give earnings guidance in the sort of market we’re now in, say two directors of Chieftain Capital, unless you’re in an absolutely stable, steady business.

At Chieftain, we think of ourselves as owning businesses, not owning stocks – more like a private equity firm than a hedge fund. We are investors with a concentrated portfolio and we do no short-term trading.

We focus on high-quality companies with strong competitive positions, predictable cash flows and good growth prospects. In our research, we are trying to understand what companies will look like three to five years out, and we are looking for businesses that have a demonstrated ability to invest capital wisely and generate attractive returns for their shareholders.

So as long-term investors, what are we looking for from companies? Even now, we are doing what we have always done, which is to try to discern the good companies from the bad. We seek to answer a number of questions: why is the company’s product or service superior to others’ offerings? What drives the company’s competitive advantage? What are the company’s margins, free cash flow and projected growth rate likely to be in three years?

That said, the current environment has required some modifications to our approach. We must ask ourselves how the future might be unlike the past. For some companies, the game has truly changed and the strong performance of the past five years will never be repeated – even after the current downturn has passed.

We also must focus on liquidity and balance sheet issues at a time like this. We obviously want to make sure we understand companies’ near-term debt maturities and any other near-term liabilities. In this environment, companies need to plan for the worst, and we want to make sure they can fund their obligations. Given the erosion of the value of pension assets, we also want to understand how a company’s pension expense will change and what the impact will be on the company’s cash flow statement – will they have to make a large contribution to the plan?

When we talk to Investor Relations officers, we’re always struck by the fact that the same IR person who can provide detailed information on trivial expense items will have very little knowledge on significant cash flow statement items: changes in working capital, deferred taxes, pension impacts. We tend to be much more focused on the cash flows that a business generates rather than the accounting earnings that it reports. But IR is typically unprepared to address such questions.

Some IR officers are frank and thoughtful, but many think of themselves as a marketing arm to put the best face on the company. Some become annoyed if we seem to be questioning something or doubting what they are saying. The best IR officers, we find, are simply honest and candid.

We understand that many other investors approach stocks like pieces of paper for buying and selling – assets to rent rather than to own – so their questions are centered on what will make stock prices go up or down in the short-term. They ask about weekly revenue trends and current period orders, seldom looking out beyond the next quarter. To many investors, all that makes a difference is a number: “Did they make the number? What’s the whisper number?” You can’t blame IR people if most of their calls and much of their trading volume is generated by people who have only a near-term focus. Yet, companies do have a choice in how they decide to communicate.

The perils of guidance

It is sort of silly to give earnings guidance in the economy we are in right now unless you are in an absolutely stable, steady business. But even in good markets, we question the merits of providing guidance. Once a company says it will achieve $3.50 per share of earnings in a particular year, all the focus is on how they are going to achieve $3.50, and very little attention is paid to the merits of the business or its long-term prospects. Unsurprisingly, all of the Wall Street analysts quickly forecast around $3.50 as well – unless a company is commodity oriented or very cyclical, it is hard to have a radically different view if they have put out a number. More troublingly, guidance skews the way companies make business decisions. We think it makes sense that some companies are moving away from quarterly numbers.

If you must provide forecasts, we would suggest guidance that is thoughtful, honest and consistent. In one conversation with the CEO of a large retailer, we pointed out that their same store sales and top line revenue targets did not go together, and he could not reconcile them – our impression was that he had just picked a top line number he wanted to hit and told his people to make it work. When it comes to guidance, some companies make it up. They give numbers that are 10 per cent lower than they think they can do – it is their best guess minus something so they can beat Wall Street expectations.

We would also avoid intensely detailed, line-by-line guidance, which just ensures that someone will be disappointed. Investors get focused on small things that can be distracting from overall good performance. Guidance conveys a false sense of precision. How can a $6bn company with four divisions and business all over the world bring in numbers within two cents of a target? In the real world, things are messy: volumes move around, things happen. Business is not that simple. There are glitches. We are trying to find franchises where, when there is a glitch, management can make adjustments and get back on track. That is the mark of a good business.

Now the business environment has bagged everybody’s forecasts. Nobody knows what the hell is going on. In our due diligence, we try to move quickly from communicating with the IR officer to communicating with the CEO and CFO – most say this situation is not one they have ever run into. They are all holding their breath, wondering whether this is an inventory correction that will right itself in three or four months or a cataclysmic decline that is worse than anything we have ever seen.

How are we spending our time? We are not spending more time than usual with companies we already own, which are well-positioned and should perform relatively well in a downturn. We are more interested in finding new investment opportunities. We have been very busy sifting through the carnage and talking to companies that appear promising. We are looking for exceptional companies at great prices, but because everything looks cheap, it is all the more important to find the great companies with bright futures.

Competitive strength is vital in a bad economy, in which weak third-, fourth- and fifth-placed competitors will have to close their doors. That will create additional market share for strong companies. We are looking for the survivors. Nobody ever knows what the economy will do. But if you own one of the best companies with a competitive advantage and the ability to gain market share, you will do well. 

Glenn Greenberg is a Managing Director and Joshua Slocum a Director of New York-based Chieftain Capital Management, which was founded in 1984 and currently manages $3bn in a concentrated portfolio of equity investments.