Blackmores gets a big bath

This morning is a tough one for Blackmores Limited (ASX: BKL) investors.

Apparently, just about everything is going wrong at the company. Let us count the ways:

— Coronavirus

— Raw materials cost management

— Pricing, product mix and promotional strategy

But hey, other than that…

Now, lest you think I'm enjoying some schadenfreude from the sidelines, I own shares, and I've recommended Blackmores to members of Motley Fool Share Advisor (and we own it in Million Dollar Portfolio).

What a way to cover myself in glory, huh?

When the market opens this morning, we'll survey the damage and determine the next course of action. I don't expect we'll recommend our members sell shares, but if they do, they'll go first, of course. If I want to sell my shares, I have to wait until we change our recommendation for members — then wait another two days, to make sure members go first.

And you know what? I couldn't be happier to work for a company with those rules.

But I digress.

The team at Blackmores have dug themselves into a pretty good hole.

Sure, Coronavirus isn't something they could reasonably hope to avoid.

But the rest?

Looks like an own goal to me.

Actually, more like a brace of them.

How is it possible that there could be an almost-$10 million hit on Cost of Goods, coming out of a newly acquired production facility? 

A failure of due diligence? A miscommunication (to put it politely) between seller and buyer? A misunderstanding of the realities or processes of manufacturing?

And reviewing 'pricing, product mix and promotions'? How is it possible that it got so far out of whack that a full reset is required? Who was minding the shop?

Now, I'm not trying to bag the company unduly.

I used to work there. I use its products. I have a huge amount of respect for Marcus Blackmore and still have friends at the company.

Which is — perhaps more than the money I'll lose — what hurts most.

It feels like defeat has been stolen from the jaws of victory.

Great people. Great brand. Dominant market position.

How does it come to this?

It seems, at least based on the announcement this morning, and the proposed actions by the company's management, that Blackmores is in 'error correction' mode.

Now, to be fair, it's possible the diagnosis is wrong. Maybe the problem was inevitable, and the proposed solution will be ineffective, or worse. After all, it wouldn't be the first political leader who blamed the last lot for every problem under the sun, and CEOs may well feel similar impulses.

And yet.

As a mate said to me this morning:

"They often say it's what happens in the years after a CEO leaves that one understands their true legacy."

I think that perspective is inescapable, and not just at Blackmores.

Tim Cook has done a wonderful job, taking over from Steve Jobs at Apple. Partly, of course, that's Cook's own doing. But in large part, it's thanks to the condition Jobs left the company in.

He created and fostered a culture. He laid out a roadmap for product development that went past his tenure. He mentored a team of successors, not least Cook himself. Yes, Cook could have screwed it up. On the flipside, Cook has also done things that Jobs didn't or wouldn't do.

But he had a flying start.

Cook should get plenty of credit. But we also should remember that any business, today, is the sum total of all of the past decisions made.

Some of the big bank CEOs know that only too well. I don't think anyone really believes that all of the wrongdoing uncovered by the Royal Commission started only when the then-current CEOs took their posts.

Could they have understood and fixed it? Undoubtedly. So they don't get a free pass. But it didn't start with them. They inherited strong, almost unbeatable companies, which had a stranglehold on their markets. But they also inherited cultures, practices and incentives which clearly led to much of what was wrong about those businesses.

Companies, like people, are influenced by nature and nurture.

I'm no psychologist (clinical or otherwise), but I know that undoing years of habit, particularly formed during our childhoods, takes years and years of constant effort.

When it comes to companies, 'nature' is the, well, nature of the beast. The incentives for both people and organisations are clear — the more money we make, the better. And that can lead to, let's say, 'suboptimal' practices.

So 'nurture' is important. Curbing our natural impulses is something we learn as kids, thanks to the impact of parents, teachers and friends. And yes, for those who need extra 'incentive', some things are just plain illegal.

So too with companies. Building the right culture means doing the right things because they're right — whether that's obeying the law, building a reputation as good corporate citizens, or putting up with pain (or just a little less gain) today, for a large gain tomorrow.

I'm not inside Blackmores. I haven't yet spoken to anyone at the company to get their perspective on the result.

But you have to wonder.

How much of what the company is dealing with today is the result of errors of the past?

Again, to be fair, it might be the case that the new CEO is giving the company the time-honoured 'big bath' accounting treatment. Get every possible piece of bad news out in your first set of results, so that you have a clean slate.

Maybe.

Either way, you have to ask how well a company is positioned any time a CEO leaves. Are they passing on a pristine vintage car, lovingly (re)built and always garaged? Or a tired old sports car, flogged to within an inch of its life, and with a motor that desperately needs a rebuild?

Again, I can't tell you which of those Blackmores is.

(And, as I write this, shares have commenced trading and are down 15%. It could have been worse. We're going to keep the shares as a Buy at Share Advisor because we can't go back and sell at Friday's price (shares were in a trading halt Monday and Tuesday), and we think the brand and latent business potential is sufficient to expect the company to be market-beating from here. As always, the future's uncertain and we could be wrong. But we think the probability is on our side.)

But what I do know, with 100% certainty, is that executive remuneration is deeply flawed.

No, not the absolute dollars being paid. They're unconscionable, but not in a way that meaningfully hurts shareholders (most of the time).

What's most flawed is the way incentives are offered and paid.

Remember my mate's comment:

"They often say it's what happens in the years after a CEO leaves that one understands their true legacy."

Let's assume he's right. (Spoiler: He is.)

If your legacy — and your shareholders' futures — are more bound up in the years after you leave a company…

… but you get paid your bonus based on last year's performance…

Does anyone see a problem?

Shouldn't the past-CEOs of our big banks be incentivised — or otherwise — based not on what they bank earned in the last year of their tenure, but based on the state in which they left the company?

Shouldn't Steve Jobs' legacy be viewed in terms of not only what he built when he was there, but the enduring impact of what he created for his successors?

Now, I'm under no illusion that I have influence in the corridors of power. But you know what's frustrating? I wrote about this very thing in May of 2018.

I wrote, in part:

"No CEO is going to appoint me as their compensation consultant, of course, because, well, I'm going to look after the interests of shareholders. But here's what I'd do:

"Second, all bonuses would be paid out in five, yearly, instalments, over the following five years, and only if the company continued to perform. That way the CEOs are incentivised to make this year great, but not at the expense of next year and the year after. And they're incentivised to make sure their successor is well chosen and well trained."

I didn't expect anything to necessarily change, as a result, but it frustrates the hell out of me that CEOs are still walking away with bonuses — and reputations — that may not be deserved… and that shareholders are carrying the can.

The problem for shareholders, of course, is that it's very, very hard to know which is which. In one version of the past, Jobs left Apple in a mess, and the banking Royal Commission never happened. How different those two reputations might have been.

It's one reason that, as investors, we look for high insider ownership. It's something we liked (and still like) about Blackmores, ironically — Marcus Blackmore owns the single largest stake in the company, and cares deeply about it, both for his and his father's legacy and because he believes in what the company does.

As you can see, that won't always save us from (what we hope are short-term) disappointments, or even permanent losses — investing remains a game of probabilities.

But it's one way we try to put the numbers in our favour (and, we should say, it's something that, on average, continues to serve us well).

You may not always agree with them, but it's hard to say Gerry Harvey, Graham Turner, Rupert Murdoch, ARB's Andrew Brown, Dicker Data's David Dicker and plenty of others aren't trying to deliver the best result for their shareholders over the long term. After all, each man has a majority of his wealth tied up in the company he controls.

(Dicker Data shares — a recommendation of Motley Fool Everlasting Income, and Motley Fool Hidden Gems, by the way, are up 4.5 times in value in the last 5 years, showing how such a strategy can really pay dividends, if you'll excuse the pun.)

Insider ownership is not enough, by itself, to make for an investment ownership. And, even in the presence of other factors (a strong brand and international opportunity) it's not a guarantee, as we've seen today.

But it has been — and remains — a very strong correlation in research done by others, and in our own results at The Motley Fool, both here and in the US.

In the meantime? Here's hoping at least some companies take up my suggestion.

Let's pay CEOs — very well — but based on not only their performance but more so on the performance of their successors. Then, whether the future is bright or bleak, we couldn't wonder if they'd been appropriately focussed on the things that matter most to shareholders.

Fool on!