After more than five years of strong equity markets, particularly in North America, some signs of excess are starting to appear.
A few weeks ago, a Chinese internet company called Alibaba went public in New York, representing the largest initial public offering (IPO) in history. Initially priced at $68 per share, this raised $US 25 billion for the company and assigned an overall value of $160 billion to the firm’s total equity capitalization. Since then, the share price has appreciated a further $20.
As attractive as this investment must seem to many, this company has significant governance and structural risks. First of all, the shareholders do not get to vote for the company’s board of directors. Instead, this privilege is held by 30 managers at the firm who are presumably friendly to Chairman and founder Jack Ma. This factor alone caused the Hong Kong Exchange to deny the IPO a listing on its exchange. Secondly, the internet assets in China are not actually owned by Alibaba, but rather by a series of Chinese holding companies that have contractual arrangements with Alibaba. While Alibaba contractually owns rights to the revenues generated by these holding companies, they are nonetheless “subject to substantial uncertainties under Chinese law”, as quoted in the prospectus. That sounds pretty risky to us.
Alibaba represents the latest in a string of technology companies that have employed dubious corporate governance practices. The excitement, prospects and scale offered by the technology industry have been the equivalent of a gold rush over the past 15 to 20 years. As memories of the 1999-2000 “tech wreck” fade into memory, the successful survivors in this sector have generated strong returns and, in some cases, immense wealth. This allows many companies in this sector to stretch the bounds of good governance. For example, when GOOGLE recently split their shares 2:1, the new shares issued were non-voting, further concentrating the control of the firm’s founders. It took years for Microsoft and Apple to concede that perhaps paying out some of their cash hoards in increasing dividends may ultimately benefit their shareholders.
We seek to invest in companies that feature the best possible governance structures in what we realize is an imperfect world. We favour companies that feature one share, one vote structures and have a board of directors that are not obviously populated with friends of senior management. According to the Economist, there are 564 publicly traded companies in North America that feature multiple share voting structures, not a modest number!
Our views are supported by empirical research confirming that companies with multiple voting share structures and weak boards suffer from lower returns, higher share price volatility, weaker accounting controls and damaging transactions with related parties. To state the obvious, it’s a good idea to avoid these kinds of investments. We will achieve better returns for you in the longer run if we stick to the better governed companies in our available universe. Fortunately, there are many such opportunities for us to invest in.