Perverse incentives: The Undercover Fund Manager

There are few forces more powerful than incentives. As usual Charlie Munger says it best:

Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.

Charlie Munger

The business world is laced with inappropriate incentives. This often leads to bad outcomes. Being aware of these incentives can inform investing strategies and improve the chances of investment success.
 

Executive remuneration

Executive remuneration packages vary widely but in my view, the common thread is that they tend to incentivise the wrong sorts of behaviours.

As a general rule Executive remuneration is characterised by the following:

The Executives are extremely highly paid – the average FTSE 100 boss will receive around £3.5m annually, about 120x that of the average employee.

They tend not to hang around very long (a few years typically), which further reinforces the desire to maximise remuneration.

Short term profit and share price (<3 years) matter much more than long term profit and share price in determining remuneration.

Total remuneration over the course of their tenure tends to far exceed the value of their direct shareholding in the business – most remuneration policies have a minimum shareholding requirement, but usually this is pathetically low, like 2x annual salary.

Most companies pay the bulk of remuneration in bonuses and share options, meaning salary is often the smallest component.

The problem with remuneration structures like this are numerous:

Profit and share price can both be manipulated in the short term. Profit can be juiced by cost cutting and creative (but legal) accounting practices, for example. An example of the latter is excluding the cost of the share option from adjusted profit!

The share price can be supported in the short term by overtly positive public messaging in conference calls, investor relations meetings, result statements etc; while glossing over or ignoring problems/challenges.

The desire to support the share price incentivises executives to spend more time on investor relations and less time on running the business.

Profit and share price are both outputs. Maximising long term business value requires a relentless focus on inputs – e.g. customer and employee satisfaction, quality of product/service, operational excellence.

Company management should focus on the playing field, rather than constantly checking the scoreboard.

Share options are not the same as direct share ownership. Share options are a one-way bet on the share price. Their value can be maximised by actions that increase short term share price and profits but imperil long term business prospects, like large acquisitions or risky expansions.

The primary driver of business value is return on capital (how well the business deploys its cash flow), not earnings.

Few remuneration structures incorporate a return on capital measure. In other words management are actively encouraged to fritter away the company’s cash flows in order to grow earnings, without regard for the return those investments are generating.

There is very often a trade-off between maximising short term and long term profits. The investor Tom Russo talks about having “the capacity to suffer”. An example might be incurring losses on a new factory or in a new territory before the investment eventually pays off years down the line. Most remuneration policies actively discourage such investments.
 

Other unhelpful incentives

Remuneration is far from the only example of perverse incentives in action.

Even if remuneration policies were sensible, I still think management teams would try to maximise short term share price and profits. Most investors are an impatient bunch.

The average holding period of retail investors has declined inexorably over the last few decades, encouraged by the ease of online trading and accentuated by the recent advent of apps like Robinhood, which allow commission-free ‘investing’.

This encourages one to see stocks as electronic bits of paper to be incessantly traded, rather than enduring part ownership stakes of real businesses.

Many fund managers aren’t much better. Like company CEOs they tend to be incentivised on short term performance measures. The pressure to out-perform the benchmark year-in year-out naturally leads to a narrowing of time horizons.

This means investing has become a game where most participants are trying to guess what share prices will do over the next few months. What a company will be earning in 10 years’ time becomes irrelevant when your performance is judged on the next quarter.

Another example of perverse incentives is auditing, which has been thrown into the spotlight again by the Wirecard debacle. Auditors are paid by the company they audit. They are more likely to get the same gig next year if they are lenient and don’t ask too many questions.

Conflicts of interest like this prevail throughout publicly-listed businesses. Remuneration consultants are hired by the companies they advise – it takes a brave consultant to suggest a reduction in pay!

Board members are supposed to be independent from company management, yet it is common practice for the CEO and FD to sit on the Board.

This encourages a cosy relationship between the ‘independent’ Board members and those they are supposed to be holding to account. In the US it is quite common for the CEO and Chair to be the same person.

Outside of the boardroom, employees are frequently incentivised in many unhelpful ways. In large businesses, being perceived to do a good job is usually more important than actually doing a good job.

Internal politics matter greatly, meaning who you know is more important than what you know. When it comes to reporting problems or areas for improvement, employees are usually best advised to stay quiet, or else risk being alienated.
 

Implications for investors

I think the most important thing for investors is simply to be aware these incentives and conflicts exist. It will lead you to be more sceptical of what companies say and do.

A healthy degree of scepticism won’t turn you into a great investor overnight, but it should help you to minimise mistakes.

Company accounts and audit reports should be taken with a large pinch of salt. Keep a constant watch out for red flags like changes to accounting policies and odd-looking exceptional items. And remember, if it looks too good to be true (e.g. Wirecard) it probably is.

Investors can gain a significant edge simply by adopting a longer term investment horizon.

A large business might be covered by 15 analysts but they’re all trying to do the same thing, namely predict the next quarter’s earnings and interpret short term news flow/noise.

Why play that game? Instead of wasting time worrying about the share price, spend that time thinking about what might drive business performance over the next decade.

Just as investors can gain an edge by adopting a long term investment horizon, so can companies. The problem of perverse incentives is often removed or significantly lessened when a founder or their family retains a large influence.

Even where perverse incentives exist, some company management teams manage to overcome them and run the business for the long term. These businesses possess an enormous advantage and investors would be wise to allocate their capital accordingly.

Look for management teams that admit mistakes. Candour, humility and willingness to discuss problems are all indicative of a business that is more open to challenge and more inclined to tell it to investors straight, rather than trying to dress things up to look good.
 

Article originally published by Undercover Fund Manager
 

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