Nationstar Mortgage Holdings, Inc. (NYSE:NSM) is an interesting company in a sector dominated by REITs. While the company is not a REIT, the operations it engages in make the company a comparable investment to REITs, with the exception of the tax status. Because the company is paying taxes, unlike the REITs around it which function as pass-through corporations, it is at a relative disadvantage for investors utilizing tax-advantaged accounts and seeking exposure to the sector. However, the company does have several strengths worth noting.
I analyzed NSM in a unique way. For this report, I focused on the company's internal controls and policies that are designed to protect shareholders. The information was compiled primarily through two documents, the 10-K and/or Proxy statement. To give investors fair warning, the documents from NSM are not easy to read. Relative to other companies of similar size, these statements were more difficult to read. Regardless of the difficulties, I dug through the documents to look for shareholder protections. I'm looking for companies that are structured to ensure that management doesn't steal the equity. "It hasn't happened yet" simply isn't good enough for me. I want the structures and policies in place to ensure that it won't happen. I want to be proactive about protecting my investments.
So, how did NSM do? I've prepared a chart covering several of the most common conflicts for the REIT industry. Remember, NSM is not a REIT, but its operations resemble a REIT. Table 1 may look a little complicated, but I'll walk you through how to read it.
This chart has numbers, letters, and colors. What does it all mean?
Green means I found strong evidence that the potential conflicts were not present or effectively mitigated.
Yellow means the evidence was insufficient for me to declare that there was no potential problem there.
Red means I found strong evidence that the potential for conflicts of interest was present.
Numbers indicate the page number on which I found evidence. There may be evidence on multiple pages. If the evidence on a single page is sufficient to make a decision, I only list that page. Sometimes it takes multiple pages viewed as a whole to reach the required level of evidence.
The letter K or the word Proxy is listed to let you know if I was looking at the 10-K or the Proxy statement when I found the conflict and recorded the page number.
With that cleared up, I'll move on to the individual findings.
The chairman and CEO are different people. No problem here.
External manager structures
NSM is internally managed. That's good for shareholders that like to be protected.
Not arm's length
The company's transactions are at arm's length. No one gets to sabotage the company.
The golden parachutes are present, but they are also way below the industry average. The average is about 3 years of compensation. One year is much better by comparison.
I couldn't find solid proof that this wouldn't be used to determine salary levels, but they are probably in the clear.
Adjusted "Equity" definition
This doesn't appear to be a problem, but many investors don't know what it means, so I've taken to including the description and an example. This part is reproduced from an earlier article:
"Many REITs that create external manager structures provide themselves a payment based on the book value of the equity. At first, that might seem okay. The executives would have an incentive to grow the equity so they could be paid more in later years, and they wouldn't get paid for taking on excessive leverage. Sounds good, right? Most REITs redefine the term "Equity". They don't all use the exact same definition, but most definitions include that Equity will not include adjustments for changes in AOCI (Accumulated Other Comprehensive Income) or Retained Earnings or Loss.
In practice, that means the best way to increase their compensation is to continue issuing shares. To give an extreme example:
Company Imagination earns 0 dollars in net income. They pay out 1 million dollars in dividends. They issue stock for 1 million dollars. Under the "Adjusted Equity" definition, their value of equity has increased by 1 million dollars and they will proceed to pay themselves a percentage of those one million dollars every year."
The one thing the company did that I really dislike is the indemnification. I understand why companies do it, but it is not absolutely mandatory to have indemnification in order to attract talent. The same argument is frequently made about the average level of parachutes. Three times the annual compensation simply isn't needed to attract talent. Several companies, including NSM, have proved that. In short, the managers have a contract from the board of directors that says they won't be liable for anything they do wrong. There are only a few restrictions where the law enforces liability, but generally speaking, the management has been preemptively cleared of any wrongdoing.
I'm going to harp on this more, because the way they handled the indemnification was distasteful. They didn't include any reference to the indemnification in the body of either the 10-K or the proxy. So how did I find it? In the list of exhibits that are attached, there is a filing of "S-1/A" filed on February 24th, 2012. In that filing, exhibit 10.52 provides a copy of the indemnification agreement. I referenced page 159-K, because that is where I found the reference to the other document so I could search it. It should not be this hard to find out about the indemnification agreements. These agreements are the norm for the industry, so I'm only harping on NSM for doing a poor job of disclosing them.
Other employment / No meaningful restrictions / Competing employment
The company also failed to explain its non-compete clauses in the executive employment agreements. Unlike the indemnification, this is great news for shareholders. Since it didn't explain it well, I went digging through its filings looking for copies of the employment agreements. These non-competes are done well enough that I'm reproducing an image of part of the document. Note: The original image includes the executive's full address. Out of respect for his privacy, I have removed that part. If you so desire, it is publicly available information in the documents.
Here are links to those documents:
The wording in these non-compete clauses is excellent. It looks like it had a quality lawyer designing these. I can sleep well at night knowing the managers aren't going to be engaging in conflicts of interest. These are some of the best non-compete clauses I have ever seen.
NSM has done a great job at mitigating and avoiding the potential for conflicts of interest. The safety it is providing to shareholders deserves a premium in the metrics compared to other stocks. Wouldn't you want a discount if you were buying a company that was filled with opportunities for the management to take the equity you paid for? In the same way, I believe companies that intentionally create safeguards for investors deserve to be traded at a premium. When you can acquire ethical companies without paying the premium, you have found a good investment opportunity.
I'm considering NSM a viable investment with an excellent score on the company's ethical controls. I would consider paying a small premium to other companies to have management that I can trust. I won't release a price target until I'm able to run its financial metrics. I want ethical companies, but I'm not paying a huge premium. I want a great company at a fair price.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of "outperform" and "underperform" reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.