STEINHOFF: Passive Managers in Glass Houses...!

Terence Craig
Chief Investment Officer

B Bus Sc (Hons), CA (SA), CFA 

The Steinhoff share price collapse began in earnest on 6 December 2017 with the share price dropping more than -60% on the day (see share price chart below). This capitulation was triggered by the CEO’s resignation late at night on 5 December 2017 as a result of a delay in the release of the company’s 2017 audited financial statements, owing to “accounting irregularities” that are now being investigated. A detailed research report was issued by Viceroy Research (“short-sellers”) on 6 December 2017 which highlighted a number of alleged financial manipulations in the Steinhoff financial statements which accelerated the share price capitulation.

Steinhoff has dominated SA financial news ever since (although at the time of writing Capitec was the next company to have a critical research report written by Viceroy, with associated media coverage) and many more column inches will be written as the Steinhoff story unravels. Litigation will happen and will drag on for years. Hundreds of billions of Rand were wiped off the company’s market value and Steinhoff shareholders have suffered a permanent loss of capital. 

Element’s exposure – a recap:As you know, Element did not hold any Steinhoff ordinary shares in its funds, though we did have exposure in four of our Multi-Asset Unit trusts to Steinhoff preferenceshares (SHFF). We exited these positions completely during trading on 6 and 7 December 2017. We were one of the first investment managers in SA to make full and complete disclosure to our clients (and to the public) of the impact of the Steinhoff preference share exposure on our 4 funds. Our fund exposures to Steinhoff Preference shares at close on 5 December 2017, before the share price collapse, ranged from 1.38% to 2.14% in the 4 funds and the full and final impact on performance, after exiting our positions, ranged from -0.73% to -1.11% for the 4 funds.

For every seller there is a buyer – with those buying the share after the price collapsed hoping that there remains value in the company. “Hope” equates to speculation rather than a long-term investing strategy and recent buyers in Steinhoff are speculating with little (or zero) ability to estimate the intrinsic value of the company as there is no clarity on the extent of fraud and its impact on the financial statements on which to base a decision. The cartoon below appears to have captured the essence of Steinhoff (first used in one of our 2007 presentations)!

All Passive Managers were (and are) Steinhoff shareholders

The Steinhoff case highlights some useful similarities in the role of active and passive fund managers. 

The objective of passive managers and exchange-traded funds (ETFs) is to track an index performance (e.g. ALSI) so as to deliver (as close to) exactly the same performance as the index over time. Passive managers ignore share valuations, by definition and increase or decrease share positions only as their weight adjusts in the underlying index, regardless of the underlying companies’ fundamentals.

Active managers make investment decisions based on research and according to their investment philosophy using estimates of company fair values and will be overweight or underweight a share (relative to the share’s index weight) or not hold a share at all, based on their estimates of the underlying company valuations. The pros and cons of active vs passive investing are for another commentary and not covered here, but it is worth remembering that passive and active managers are both shareholders (on behalf of others) of the companies they hold in their portfolios. More importantly, passive managers are always shareholders of these companies and never sell out of the underlying companies that form part of the index that is being tracked.

Element is a boutique active investment manager with a long and established track record of Responsible Investment and shareholder activism. Our opinion is that passive and active management are not mutually exclusive and investors benefit by combining these investment approaches in a well-diversified portfolio, but again we will save this for another article.

Our approach to shareholder activism has been one of focusing, as far as possible, on being proactive and engaging with management on addressing relevant and material issues that could impact on the company’s long-term value and sustainability. Unfortunately, by far the majority of shareholder activism takes place reactively – usually after a share price collapse – with the intention to try and recover value. Steinhoff falls into this category.

Differentiating by “raging against the machine”

We applaud any investment manager (active or passive) that speaks truth to power and holds those in positions of authority (public or private) to account, particularly when failures of governance are exposed. Andrew Canter (Futuregrowth) is a great example of someone being prepared to stand up and be counted, when he spoke out about corporate governance failures at SA SOEs. However sometimes speaking ‘truth to power’ is not done for the most altruistic of reasons: John Stepek, executive editor of MoneyWeek UK, pointed out in a Jan 2018 article that part of the motivation could be a desire to differentiate themselves from their competitors and build a brand.

"Think about it: passive funds operate in a highly competitive market, where there are few obvious ways to differentiate your product from that of the competition. So if you want to build a brand ...then what do you do? It strikes me that selling yourself as a highly-engaged steward of your clients’ capital – one who won’t put up with self-serving nonsense or unethical practices from corporate managements – is the ideal way to do it."

It appears that some passive manager executives in SA are following this exact strategy. 

Passive Managers on Steinhoff – “Et Tu?”

Passive Managers have been among the most vocal about Steinhoff’s collapse, often using this as an opportunity to take “pot-shots” at active managers. Examples of such comments on Steinhoff, after its share price collapsed in early Dec 2017.

  • "How (did) so many active asset managers in South Africa miss this? 
  • It (did not take me long) to figure out that the structure was obfuscated, that financial items made no sense, that the acquisition spree was not underpinned by any logic...and that debt levels were out of control. 
  • Gross negligence also covers negligence as far as management of portfolios is concerned. Management includes research.
  • Blind faith in the Midas touch of Christo Wiese made many oblivious to the obvious. The landscape is littered with asset managers missing the obvious. The greed (of active managers) is unprecedented."

These are aggressive, accusatory and sweeping generalist statements directed at SA active managers and are worthy of further interrogation. Indeed, these comments highlight some of the material shortcomings of passive managers themselves. Let’s review the facts relating to Steinhoff, using the ALSI as the SA Equity benchmark tracked by Passive Managers and ETFs.

Passive Managers lost money and performance on Steinhoff

  • All passive managers and ETFs held Steinhoff in their Funds and have held these positions for as long as it has been included in SA Equity Indices. At 30 November 2017 (immediately preceding the price crash), Steinhoff was:
    – 11th largest share in ALSI (2.1% weight)
    – 7th largest share in SWIX (2.6% weight)
  • As a result all passive managers and ETFs have lost a material amount of money for their investors owing to their exposure to Steinhoff.
  • According to a UBS note (Jan 2018): – "The fallout in performance of Steinhoff remains fresh in investors’ minds and excluding its collapse last year would have added 2.5% to the overall performance of the All Share for 2017."
Why are Passive Managers not Active Shareholders?

Following a passive approach does not allow a manager to abrogate its fiduciary responsibility to its clients to act in their best interests.

  • If (and it is an if) any passive managers looked at Steinhoff’s financials and concluded they were "dodgy", before the collapse, then why did they not raise these issues earlier with management and/or publicly as active shareholders. Proactive is always better than reactive after material losses have been incurred.             
  • Being a passive manager does not oblige them to be passive shareholders.    
  • Shareholder activism should be an even more essential obligation for passive managers in that they never sell out of any shares (such as Steinhoff) and only adjust their share weights according to index rebalancing.
  • As John Stepek (Executive Editor of MoneyWeek UK) concludes:
    – "As a passive index fund, you have to own what’s in the index. If you track the (ALSI) index, you have to own the stocks in the (ALSI). As a result, you lack the ultimate sanction – you cannot sell out of a company, even if you disapprove of its corporate decisions.
    – And if you’re forced to own shares in a company, then you have no choice but to engage and to consider the long term.
    – So I reckon that there's even more incentive for passive funds to try to score a few high-profile victories and keep the pressure up on managements, than there is on active funds to do the same."
  • A duty of shareholder activism is spelt out in many shareholder codes including UN PRI, King III and IV and Reg 28 of the Pension Funds Act in SA. The Code for Responsible Investing in SA (CRISA) highlights (Principle 2):
    – voting at shareholder meetings, including the criteria that are used to reach voting decisions and for public disclosure of full voting records.
    – Even if passive investment strategies are followed, active voting policies incorporating sustainability considerations, including ESG, should still be followed.
A word on Auditors

Auditors have in the past proven to be fallable – remember Arthur Andersen and Enron? More recently, in January 2018, the Securities and Exchange Board of India (SEBI) announced that it was banning all firms in the PwC India Group from auditing listed companies (or intermediaries) for a period of two years after SEBI found PwC guilty in the 9 year old Satyam Computer Services fraud. The Satyam fraud looks similar to what appears to have taken place at Steinhoff.

We should bear in mind that The "Big Four" auditors are multinational firms with incentives to grow revenue and profits. History has shown that there exists the odd partner who is willing to turn a blind eye to "aggressive accounting" by companies in order to meet profit targets. Thus I wonder why one of the vocal passive managers had not previously taken the Steinhoff auditors to task for signing off on the accounts of a company where, to quote: "the structure was obfuscated, that financial items made no sense, that the acquisition spree was not underpinned by any logic and too frenzied to be well thought out, and that debt levels were out of control".

Yet the same Passive Manager chose to ignore Deloitte’s role as the auditor of the Steinhoff AFS in its own recent appointment of Deloitte - voted in by 100% of the shares voted at its AGM, which was held on 12 January 2018, over a month after the Steinhoff capitulation began. Ironically this same passive manager fired KPMG as its auditor in 2017 because of KPMG’s complicit role in ‘State Capture’ and replaced them as its auditors with Deloitte. 

Voting at AGMs 

There has been much criticism of passive managers globally when it comes to voting, reviewing company corporate governance and holding management to account. This criticism has been justified as historically there has been little activism from Passive Managers. 

  • "If more and more of the industry is owned by passive investors who are only trying to replicate the index, there is no oversight. There is no governance," (Richard Buxton, CEO of Old Mutual Global Investors, 5 Feb 2017)

Generally, shareholders in companies have two fundamental rights: 

  • The right to receive dividends 
  • The right to vote

Our opinion has been that the right to vote is material for a shareholder, yet this does not appear to be the majority view in the SA investment industry. 

A review of a number of SA passive managers’ websites highlights that there is little to no information about voting as shareholders with respect to the companies held in their index-tracking funds and/or ETFs. No voting records, no voting policies. As passive managers represent near permanent capital, effectively, the lack of voting information should be a material concern for their investors and clients. 

Researching company financials, to ensure votes on company resolutions are based on the facts and sound governance principles, takes both time and resources. These can be material costs for a passive manager, would reduce profit margins accordingly and so a rigorous voting process is often ignored. However, not bothering to vote could be deemed as putting company profits before its fiduciary responsibility to investors.

Nowhere is this more visible than at the 2017 Steinhoff AGM, held on the 14 March 2017 and released on SENS the same day. Element'[s Steinhoff preference shares, held in its funds, were not eligible to vote at the AGM. The F2016 results being voted on at the AGM are now known as being "fraudulent" and cannot be relied upon.

  • At end of Feb 2017 (prior to the AGM), Steinhoff' was the 8th largest share in the ALSI (2.8% weight) and the 5th largest share in SWIX (3.4% weight). 
  • These would have been the portfolio weights for all passive managers and ETFs tracking these SA Equity indices at the time of the AGM. Material top 10 positions – but how many Passive managers and ETFs actually voted their underlying Steinhoff shares at the AGM?
  • 75% of shares in issue voted on resolutions at the AGM (i.e. 25% of shares in issue did not vote).
  • For the shares that voted at the AGM have a look at the “For” votes in the table below, including 100% for adoption of 2016 AFS; 86% for Christo Wiese and 99.6% for Deloitte’s reappointment as auditors.

Scrip lending and Short-Selling – who has the right to vote?

One of the ways Investment Managers, Pension Funds and other Equity investors can earn additional income, which can be material, is from scrip lending (lending the underlying shares held in their portfolios to a third party).  

As passive managers represent near permanent capital in a company they are better positioned to lend scrip than active managers. The lending/borrowing is done on a contractual basis, usually for a defined period, with the borrower putting up collateral upfront for the shares that are borrowed, paying a fee (usually a basis points percentage of the value of the shares borrowed) over the contract period to the lender and being obliged to return the equivalent number of shares at the end of the contract. In addition any dividends or interest earned by the borrower while holding the shares is normally paid back to the lender as an equal amount of “manufactured” interest or dividends. 

The disclosure of scrip-lending income by lenders and the equivalent expenses by borrowers is usually less than transparent to shareholders and/or clients of both parties. The income and expenditure relating to scrip lending is usually included (i.e. hidden) with other income/expenditure items such as “Brokerage” or “Other Income/Expenses” in financial statements and is seldom disclosed as a separate line item on its own. It would be useful for investors and/ or clients to know how material this income is for a lender.

The borrowers of these shares (scrip) are investors (usually hedge funds or proprietary trading desks of investment banks) who want to sell shares "short" – based on expectations that a share price will fall (i.e. they are "shortsellers"). The borrowed shares are sold in the market with a view that they will be able to buy back the shares at a later date at a lower price – with the difference between the selling price (high) and the buying price (low) being the profit made on the transaction, less the costs of borrowing the shares.

Viceroy Research, which released a critical research report on Steinhoff on December 6 2017 and contributed to the share price fall, is a classic short-seller. Its most recent research report released in late January 2018 was critical of Capitec – particularly its accounting treatment of arrear debtors. SA investors are not used to aggressive shortsellers in our market – we will need to become used to their approaches, particularly companies with "aggressive accounting policies" that are unsustainable over the long term. Short-sale targets are usually companies where the short-seller believes the share price to be materially overvalued – or in Steinhoff’s case, where the profits appeared “too good to be true” and had been manipulated.

Scrip-lenders, in the pursuit of another income stream for themselves, tend to forget the bigger picture in that the borrowers of the shares are betting against the same company held in the lender’s underlying portfolios. Viceroy Research was only able to take a short position by finding Steinhoff shareholders willing to lend their Steinhoff shares to them for the trade (in return for fee income of course). It would enlightening to know how many SA Passive Managers, vocal or not, had loaned their Steinhoff shares for the benefit of short-sellers, including Viceroy.

In Element’s opinion, the most material downside to scrip-lending is that the lender transfers the title of the share to the borrower which includes the voting rights on the share. As highlighted above, lenders seldom deem a voting right to be material – particularly when compared with the income stream earned on the share from lending. 

Our concerns with respect to all lenders, including passive managers, is that the income stream from lending is prioritised over the lender’s fiduciary responsibility to its investors and/or clients to practice sound corporate governance by voting the shares at meetings.

A lender has to recall the shares on loan in order to vote them, meaning the borrower must close out his position early (and possibly at a loss) in order to return the shares. This seldom happens in practice. 

Using the Steinhoff AGM (above) to illustrate this point:

  • 25% of issued shares did not vote at the AGM on the 2016 AFS and associated resolutions. Why were these shares not voted and how many of these shares were lent out with the borrowers not bothering to vote?
  • Passive managers should be cautious about berating active managers for having “blind faith in Christo Wiese” if they did not vote against him at the last Steinhoff AGM in March 2017.
  • What would be even worse is if the passive manager could not vote against Christo Wiese as a result of having transferred the voting rights attached to their Steinhoff shares to a short-seller (such as Viceroy).

There are many lessons that have been learnt from the Steinhoff implosion and many more will be learnt in the months and years to come.

Here are two of them: 

  • It appears that "Steinhoff" may be German slang for "train smash".
  • "Passive managers in glass houses should be wary of firing AK47s!"

All the best for 2018.