On Management

I must immediately inform you that, important though management is for any company, I adopt a statistical approach to my investments and generally consider management part of the specific risk of an investment. Like any specific risk, management risk can be diversified away. Ideally, I never invest more than 3% of a portfolio in any one security, and for an all-equity portfolio this gives me around 30 companies, and pretty good diversification. I rarely go below 25 securities (4% of the portfolio), and if small portfolio size forces me to do so, I then turn to Exchange Traded Funds. I suggest you ignore anything said about diversification being “diworsification” and consider diversification your best insurance—and the cheapest insurance you can ever get.

This does not mean that I do not keep an eye on what management is doing, such as:

• how it is developing the business;
• its track record;
• how it allocates capital, especially between research and development, real investment, dividends and buybacks;
• how it deals with crises;
• inflated and unrealistic goals and expectations;
• how, and how fast its members are changing;
• the composition of the board;
• the ego of its members, especially the CEO;
• whether the board controls the CEO or vice-versa;
• the balance sheet it keeps including the number of shares in issue;
• the nature of mergers and acquisitions the company is involved in;
• compliance with corporate governance principles; and, of course,
• compensation and perks, which recently have tended to be excessive in many companies.

In spite of my statistical approach, I am prone to invest more in a stock when I consider it backed by outstanding management, and to shy away when management is mediocre; most of the time, most managements fall in between these two extremes and I rely on the statistical approach to neutralize this specific risk and save my portfolios from serious harm.

Priorities

What do shareholders want of company’s management? Shareholders want management to maximize the company’s cash inflows and inform the investing public about what they are doing. The latter serves two purposes: first, transparency, so that investors “as owners” are kept informed about management’s stewardship of the company, and, second, investor relations, so that capital market participants understand the company and accord it the appropriate (hopefully high) share price.

Management, though, has its own priorities. Management wants to retain power over the corporation, increase the amount of assets it controls, and maximize its own compensation. It wants to maintain allegiance among members of the management team while balancing the interests of the different stakeholders – workers, unions, suppliers, creditors, shareholders, directors, government, regulators, and the community. The extent to which different managements and boards give priority to shareholders’ interests varies considerably although most pay lip service to this as an ideal.

The Agency Problem

While management—the leadership of a company—is extremely important, its nature is fuzzy and ephemeral. It is not only extremely difficult to delineate its contribution to performance but its contribution—both good and bad—tends to be unstable over time, as management personnel change and as their contribution, both individually and as a team, fluctuates. Further, certain managements are good under one set of circumstances, but not under another. A brilliant and tough Winston Churchill rose to greatness in the Second World War but was quite ineffectual, even a bungler, in peacetime and even during other wars.

The “agency problem”, where investors have to put in place others to manage the business, and these others, as we have seen, have different objectives from ours, has three salient facets.

Institutional Abdication

First, in today’s corporations with thousands of shareholders, individual shareholders are practically powerless to influence the affairs of a company. Most investors have to accept the management placed there by others, and have no voice. Corporate power has effectively moved from shareholders to management and other stakeholders. Shareholding is concentrated in relatively few big institutional investors, such as pension funds, investment funds, banks and insurance companies, and this concentration has been exacerbated by the move to indexation. Institutional shareholders often vote according to recommendations made by a company’s management. This has given rise to what is called the “ownerless corporation”.  

The main reasons for this abdication by institutions are that it is very expensive to dig deeply into each individual corporate issue which comes up at general meetings and because managers of institutional investors often have interests which are very similar to those of the managers of companies, including the accumulation of assets (size), access to influential people, and high compensation. Optimizing companies’ cash inflow is a top priority for pensioners, but may not always be the top priority of a pension fund’s management.

Pressure is building for “compulsory stewardship” where institutions would be required to engage with companies on behalf of shareholders rather than be passive “free riders”.

Recently, some efforts have been made in this direction. BlackRock, the world’s largest (passive) manager, has backed an initiative by the Canada Pension Plan Investment Board to foster dialogue between companies and their long-term shareholders. [1] Vanguard, with assets of some $3 trillion, recently wrote to company chairmen with proposals aimed at strengthening the relationship between directors and long-term shareholders, including the setting up of “shareholder liaison committees” to marshal shareholders opinions on strategic issues, social and governance considerations, and executive pay. [2]

Efforts are also being made to centralize voting in order to work around the problem of dispersed ownership. In the US, two proxy advisory firms, International Shareholder Services and Glass Lewis, gather proxies from big and small shareholders and organize block votes. But recently, when these firms advised shareholders against Jamie Dimon’s high pay at JP Morgan Chase, Dimon showed who’s really boss by calling shareholders who voted with the proxy firms “irresponsible” and “lazy”. [3]

Shareholder Friendliness

A second issue raised by the agency problem, related to the modern ownerless corporation, is the extent to which management is shareholder-friendly. Even an ownerless corporation can be shareholder-friendly if it considers shareholders to be the most important stakeholders and acts sensitively to their concerns.

One of the most shareholder-friendly moves is for a company to pay steadily increasing dividends out of steadily increasing earnings. Although some companies do this, in recent years we have seen a massive increase in share buybacks at steadily increasing prices which, unlike dividends, go to reward departing shareholders at the cost of long-term investors. Buybacks also absorb shares issued to managers as options and increase earnings per share, thus boosting management’s compensation. The proffered reason for this is to avoid the double taxation of dividends but one cannot help but notice that while companies spend millions on lobbying for various matters, the removal of the double taxation of dividends is never one of them (unless I have missed this).

Buybacks in 2015 have already exceeded those for 2008, 2009, 2010 and 2012, and are expected to reach $993 billion. Since 2009, companies have spent $2.4 trillion on buybacks. [4]

Cost Of Management

The third agency issue we’re dealing with here is the matter of management compensation. Excessive management compensation is currently a hot topic, and with reason.

Even if a company gets a Grade A in observing modern corporate governance principles, such as those promulgated and monitored in the good work by the Canadian Coalition for Good Governance [5], it can still manage to grossly overpay its management and directors due to cross-directorships, use of compensation consultants, benchmarking, and the idea that you have to pay “top quartile” money in order to be able to recruit and retain excellent managers.

As someone brought up reading Peter Drucker (who believed that if CEO’s pay exceeded 20 times what the average employee made, this would lead to employee resentment and reduce morale), I was particularly interested in a recent study about CEO pay. The authors note that while US respondents believed that an ideal ratio was 7:1, they estimated the actual ratio to be 30:1. As it turns out, and as we know, this is far off the mark since the actual pay ratio of CEOs to unskilled workers in 2012 was 354:1. This ratio was up from 20:1 in 1965. [6]

Between 1978 and 2013, US CEO compensation rose at more than double the rate of stock market growth and actually was the driving force behind the rise of the “1%”, largely executives and those in finance, and the main targets of protest movements such as Occupy.

Recently, shareholders expressed anger over executive pay in various general meetings, including those at Barrick Gold, JP Morgan Chase, HSBC, BP and WPP.

Shareholders and legislators are trying to introduce various remedies, such as clawback of bonuses if performance lacks, binding and non-binding “say on pay”, and payment in shares which executives must hold for long periods, certainly after their departure.

Research Of The Unexpected

Let us take a short tour of recent management research:

The more CEOs are paid, the worse their companies’ stocks do over the next three years. Performance is worse the higher the incentive pay CEOs get compared to their peers. Performance also suffers the longer CEOs occupy that position. [7]

Studies since 1990 have either failed to demonstrate a positive relationship between executive pay and corporate performance or detected, at best, a weak correlation. [8]

Share option schemes given to management not only encourage risk-taking by management, but attract executives who were prone to risk-taking behavior in the first place. [9]

Many of the skills CEOs possess are specific to a company and are not transferable. This raises big questions about “star CEOs” and their pay especially since all the transfers analyzed by these researchers resulted in failure. Companies are not comparable and benchmarking of executive pay is just a way to inflate executive salaries. In other words, “if you don’t pay them, you won’t lose them.” If you lose them, they fail elsewhere. [11]

While going public is supposed to increase a company’s ability to take on bigger projects which will eventually lead to higher cash inflows, “the average investment rate among private firms is nearly twice as high as among public firms, at 6.8% versus 3.7% of total assets per year.” (The researchers controlled for size and stage of the life cycle.) [12]

Tough Job

I don’t want to belittle in any way the difficulties of managing a company and, in today’s world, it is difficult to imagine investing in a company and having it run successfully by managers paid at a small multiple of median employee pay, as was the case for many years in the past.

CEO turnover is getting faster, with the average term served by CEOs getting shorter in the face of short-term shareholders and financiers with short-term horizons. Being a CEO is a high-risk, high-profile and often thankless occupation.

Especially for public companies, your decisions as CEO are analyzed, criticized and often considered with some suspicion by analysts, the press, shareholders, and other stakeholders. One bad strategic decision—often the result of compromise—and the CEO is on his way out.

A CEO has to think and act strategically while keeping strict focus on the next set of financial statements, monitoring the implementation of their decisions, ensuring that they are getting relevant feedback from all the different parts of the organization, balancing the interest of all the different stakeholders, leading and inspiring to action, ensuring cohesiveness, refraining from micro-managing, delegating without abdicating, setting increasingly difficult goals for different teams, and being innovative.

Whatever happens in a company always seems to be the CEO’s responsibility, the result of her good or bad decisions, and it is incredible how credit is always shared while blame tends to stick. Big problems bubble up to the top and always seem to arrive at the worst of time.

All top managers are paid well, but people focus on what the CEO gets. What a CEO gets is usually only a relatively small portion of total management costs. Furthermore, the CEO lifts all the other top managers with them, but the other managers often stay in the shadows, and are hardly ever criticized. (One exception to this happened when Oracle recently gave its top three executives more than $35 million each.)

What Is CEO Pay?

Measuring CEO pay is not straightforward.

There is first the concept of “total pay” which the Securities and Exchange Commission (SEC) and Canada require companies to report. Companies do not like to report this figure. One obvious reason is that the figure is often high but another is that not all that’s included in total pay is certain to be actually earned by the CEO.

CEOs are often paid with stock options, restricted shares and stock awards, and whether these will actually be earned or not (in other words whether they will vest) depends on the conditions attached to such compensation, for example, a certain number of years of service, or profit performance. If these conditions are not satisfied, this compensation will not vest, and will not be earned. Even if earned, the amount of compensation often depends on the share price at a particular time.

Companies therefore compute a figure of “realized pay”, which is more indicative of what the CEO actually earned through cash emoluments, bonuses, vested compensation and other compensation which the CEO qualified for during the year.

A new measure called “actual pay” is now being planned by the SEC, which is likely to include the realized pay items plus some others such as changes in pension benefits. Actual pay is likely to fall between total pay and realized pay.

As I write, the SEC has just enacted a rule which requires public companies to disclose the ratio of CEO annual total compensation to the median compensation of its employees as required by the Dodd-Frank Act. Disclosure of this ratio should help investors be informed when voting on “say on pay”.

Company Visits

Much is sometimes made of company visits as a way of understanding a company’s management. When one visits management, however, personal factors come into play—personal chemistry, egotism, attempts to influence, the extent to which one feels welcome or unwelcome, who in the hierarchy one gets to meet, and similar factors.

There is a story about Harold Geneen, who built ITT into a major multinational conglomerate:

Once, he was given the annual report of a key-maker to look at. He seemed intensely interested for a few minutes, but then suddenly tossed the report aside and said to his aides, ‘What’s next?’ ‘You don’t like it?’ a staffer asked him. ‘No, I don’t,’ Geneen replied. ‘Did you happen to look at the chairman’s picture? I don’t like his eyes. [12]

One hazard is that you may get to like an incompetent management and dislike a competent one. Another is that you may get to like a competent management but for some reason it fails to deliver.

This often happens when a manager with a good track record in another company joins a team but the other managers block the newcomer to prevent him or her from shining.

I don’t put much store in the much touted honesty of eyeball-to-eyeball communication because I have seen and heard too many top managers lying without batting an eyelid.

However, you may indeed be able to gain some understanding of how a company is being managed by speaking to management, especially if you manage to successfully gauge attitudes and team dynamics, and elicit unstated assumptions.

If it is a small company, you may manage to speak to one of the top managers, who may be willing to discuss the business with you. I learn a lot in this way, especially by asking them about their main competitors and the main challenges they face.

With a big company, if you are a small investor, and a persistent and lucky one, you may at best get to meet someone in PR. Executives are usually extremely busy and are unlikely to give a small investor the time of day.

If you are an institutional investor, you have a much better chance of getting a good view, and you usually also get the benefit of discussing your impressions with your team to help calibrate your human reactions. Good managements are usually keen to have institutional investors understand their points of view to garner voting support.

Investment analysts also visit companies, and their job is to write reports about companies as investments. Some reliance can be placed on their reports but one has to keep in mind that analysts show a lot of herding behaviour since an analyst does not usually want to stick their neck out, usually change their opinions late rather than early, and depend for their insights and livelihood on access to information and to management.

Each Tree By Its Fruits

Although similarities abound, each management, and each company, is different. The best way to assess a management is to study how it behaves. Here are some areas to look at:

– In a crunch, which side are they on?

• Does management keep costs down?
• Does management control labour costs or does it give in too easily?
• Is management on shareholders’ side or on the side of the other stakeholders?

– How and how much do managers pay themselves?

• “Envy effects corporate compensation. People want to be paid like movie stars rather than archbishops. I don’t think it is necessary. Most would occupy top position at lower compensation rate. It is terrible to civilization. It brings extreme envy into the population at wide.” Charlie Munger
• Option grants to management and employees.
• Total compensation packages.

– Do they behave appropriately?

• “If you rise in life, you have to behave in a certain way. You can go to a strip club if you’re a beer-swilling sand shoveler, but if you’re the Bishop of Boston, you shouldn’t go.” –Charlie Munger

– Does management believe?

• Number of shares held by insiders.
• Insider’s purchases and sales.
• Timing of purchases and sales of company shares.
• Were shares obtained by exercising options or paying cash on the market?
• How long have shares been held?

– Is management protecting equity?

• The number of shares in issue.
• Changes in shares outstanding year by year.
• Reasons for share issues.
• Return on capital versus leverage.

– How is management succession planned?

– How is it executed?

– What is the atmosphere in Annual and other General Meetings like?

– How does management allocate capital?

• Do acquisitions make business sense?
• Does management pay too much for acquisitions?
• Does management pay dividends?
• What use is made of retained earnings?
• What is the extent and timing of share buybacks?

– The usual: track record; sales, margins and profitability vs. industry; financial prudence; honesty; integrity; passion for the job; balance between long- and short-term; ego-trips and delusions.

Insuring Against Bad Management

As an investor, risking your capital in the hope of future returns, you are unlikely to regularly be able to form a clear picture of management. Management is human, elusive, and able to dissimulate, and to a large extent it controls the degree of transparency of the corporation. Save for required legal and accounting disclosures, management controls what you see and what you don’t—and has a great amount of leeway even when disclosure is required.

In building an investment portfolio, you have working for you the fact that most managements have average ability and often neither perform brilliantly nor abysmally. There is safety in ordinariness.

To protect yourself against what Peter Lynch describes as the idiot nephew who one day takes over the company you’ve invested in, there is really only one insurance: diversification.

Paul V. Azzopardi BA(Hons)Accy., MBA, FIA is a Portfolio Manager and an Instructor at the School of Continuing Studies, University of Toronto, where he presents the “Choosing Income Investments” course in the Fall at the Mississauga campus. He is the publisher of ETFalpha.com, a newsletter with clear-cut recommendations and commentary for ETF investments. Paul can be contacted at email@paulvazzopardi.com.

The opinions expressed here are not investment advice and are solely Paul’s and not those of his employer/s. The mention of securities is only by way of example, and not a solicitation to buy or a recommendation to sell.

Paul and various clients are long: HSBC, BP

REFERENCES:

(All dollar figures in US dollars unless otherwise stated.)

[1] “Compulsory Stewardship by Passive Managers Moves Closer”, Steve Johnson, Financial Times, April 26, 2015.

[2]       “Vanguard Letter to Chairmen Promotes Better Governance”, Chris Flood, Financial Times, April 5, 2015.

[3]       “Dimon Hits out at ëLazyí Shareholders”, Tom Braithwaite, Financial Times, May 27, 2015.

[4] “Getting High on Their Own Supply”, Oliver Renick and Michael P. Regan, Bloomberg Businessweek, July 20, 2015.

[5] Canadian Coalition for Good Governance, www.ccgg.ca

[6] “How Much (More) Should CEOs make? A Universal Desire for more Equal Pay”, Kiatpongsan and Norton, Perspectives on Psychological Science, 2014.

[7] “Performance for Pay? The Relation Between CEO Incentive Compensation and Future Stock Price Performance”, Cooper, Gulen and Rau, 2014. (SSRN reference: http://ssrn.com/abstract=1572085)

[8] “Executive Pay: The Problem with Agency Theory”, in “Performance Pay – New Ideas on Directorsí Remuneration” published by the High Pay Centre, paper by Alexander Pepper, London School of Economics.

[9]       “A Model of Person-pay Interaction: how Executives vary in their Responses to Compensation Arrangements”, Wowak and Hambrick, Strategic Management Journal, 2010.

[10]     “Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution”, Elson and Ferrere, 2013. (SSRN reference: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2125979)

[11]     “Comparing the Investment Behavior of Public and Private Firms”, by Asker, Farre-Mensa, and Ljungqvist, 2011. (NBER Working Paper No. 17394)

[12]     “Financier – The Biography of Andre Meyer”, Cary Reich, John Wiley & Sons, Inc., 1997