By Rob Worthington-Smith
7 May, 2018
In an article in Business Day (Providers of index trackers need to verify companies’ free float), Johny Lambridis, portfolio manager at Prudential Investment Managers, shows how company managers can manipulate a company’s free float to bring it into the JSE Top 40, thus making the share a target for passive investors through index tracking funds. The larger the company appears, the higher the compensation executives can justify.
According to Lambridis, not only does the JSE index committee rely on annual disclosure by the companies themselves, but the information disclosed is rarely checked by passive fund managers either. An example offered by Lambridis is the Resilient group, which advanced money to its BEE partner to accumulate the maximum amount of Resilient shares it could (under 10%), before such a shareholding would be excluded from the Resilient group’s free float. The company further has a second BEE entity owning another 3% in Resilient.
The point Lambridis makes is that fund managers using the free float as a benchmark will struggle to find Resilient stock, because at least 13% is tied up in the BEE trusts, but not removed from the free float. The resultant pent up demand probably put Resilient in the Top 40 index in December 2017, based on its free float capitalisation. Passive managers would have been required to buy the share at its then price of R145, only to have to sell again at around R65 per share at the JSE’s March rebalancing. The consequence for passive investors of index funds is estimated at at least 0.4% of portfolio performance.
If manipulation of free float to inflate a company’s value though inclusion on the JSE Top 40 in order to justify higher executive compensation is a material issue, where would this issue appear under FarSight’s list of governance issues?
The governance section of the FarSight model is concerned with, amongst other issues, the fair treatment of minorities and the alignment of insider interests with minority shareholder interests. The model lists four issues:
- Board balance and effectiveness
- Audit independence
- Leadership selection and preparation
- Remuneration incentives
- System integrity
An effective and balanced board is designed to ensure that members make decisions aligned to shareholders’ interests, so knowing the company may be vulnerable to free float manipulation would immediately draw attention to board balance and effectiveness, possibly causing it to be upweighted and scrutinised on assessment.
However, the most direct category for the issue would more likely be under remuneration and incentives. Here we have a case where executives may be manipulating the company’s free float not in the interest of shareholders, but rather in the interests of potential inflated remuneration for themselves – the consequence of the company being regarded as larger in capitalisation that it actually is.
To read the full text of Lambridis article, see https://www.businesslive.co.za/bd/opinion/2018-05-07-providers-of-index-trackers-need-to-verify-companies-free-float/
The FarSight Model of Leadership Maturity
From our research into decades of corporate reporting, and noting the significant difference between how mature leaders report against these five actions compared to immature leaders, FarSight developed a model for assessing leadership maturity in terms of how well companies respond to their most material issues. Every two months we analyse a sector of around eight companies on the JSE and submit our findings to the asset management industry through our channel partner, Legae Securuties, the first B-BBEE Certified Stock Broking firm in South Africa. Summaries of these findings, and how the model works, can be found at www.FarSightFirms.com
* Rob Worthington-Smith is the founder of FarSightFirms.com. The FarSight model analyses leadership maturity based on the IIRC’s Integrated Reporting Framework, an international standard designed to guide companies towards better reporting of their value creation story. In the SA asset management market, FarSight has an exclusive working partnership with Legae Securities.