Director benefits is a complex area to explore but it can provide a clue as to the direction of the investment. Finance expert Julian Hofmann kicks off the discussion around the boardroom fixation on earnings per share and its implications, which is part of understanding “the deep value” of an investment.
Carrying out a check on what directors and managers are taking home at the end of the day, and how incentives work, is an important part of any investment due diligence exercise.
Emoluments, in corporate speak, describes directors’ rewards and incentives, and is given in addition to the base salary at most listed companies and funds.
They aren’t without controversy and, in recent years, there has been a noticeable backlash against excessive executive rewards – particularly if they seem to bear little relationship to actual operational or financial performance.
As an investor, you must understand how the directors responsible for your investment are being rewarded. If things go wrong, they can go wrong spectacularly if the incentives given ultimately work against your interest.
The theory of shareholder value
The theory of shareholder value was first coined by the American free-market economist Milton Freidman, winner of the 1976 Nobel Prize for economics. Friedman was part of the so-called Chicago School of economics that provided much of the theoretical foundation for the free-market reforms carried out in the 1980s in large developed economies.
Friedman’s ideas on business ethics can be summed up so: A company’s primary duty is to its shareholders and, as such, its operational goal is to maximise returns to those shareholders.
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No other business concept, aside from communism’s notion of the complete abolition of enterprise, has caused more controversy than the theory of shareholder value. Partly, this is because it is hard to understate what a radical break this was from previous business practice.
Prior to Milton, standard practice across the western corporate world was that managers received a basic salary like everyone else, and this rarely exceeded the ratio of 20 times the average workers’ wage. Nowadays, it would be hard to find a FTSE 100 company, or a S&P 500 equivalent, where the chief executive and directors aren’t earning less than 150 times the average salary.
This fact illustrates the main problem with all abstract theories; it is not until they are implemented in the real world that we perceive their faults and unintended consequences.
It is why, as an investor, you must pay close attention to how your management is being rewarded.
When incentives go wrong
There are several ways that poorly thought out incentives can destroy shareholder value, tarnish a company’s reputation, or leave management without a job.
Let’s look at a couple of case studies of where things went drastically wrong and assess how shareholders could have acted more wisely.
Persimmon bets the house
By the late autumn of 2018, housebuilder Persimmon (LSE:PSN) had enjoyed a remarkable stock market run. Driven by the government’s “Help to Buy” scheme for first time buyers and historically low interest rates, the company’s shares had risen five-fold in a few years and were riding high on the back of a buoyant housing market.
All was going swimmingly until the share price rise triggered an incentive scheme reward of £100 million for chief executive Jeff Fairburn - and then all hell broke loose.
The controversy arose precisely because the award didn’t seem to reflect anything that Persimmon’s management was doing, rather it came about because of a collision of extraordinary external circumstances – a rampant share price driven by government subsidies, low interest rates and a housing market dominated by an oligopoly.
The whole incident left Persimmon reeling and eventually it had to clear out its entire management to try and rebuild its tarnished reputation.
The interesting point is that at the time that the reward scheme was unveiled in 2012, 85% of shareholders approved it. This illustrates, perhaps, the traditional doziness of institutional investors when it comes to holding management to account.
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While incentives related to earnings per share are the root cause of many issues, sometimes an industry can become too fixated on a certain measure of success, which was the case in the banking industry prior to the 2008 financial crisis.
Banking has a heart attack
One of the most striking aspects of the 2008 banking crisis in the UK was how few of the main protagonists were dyed-in-the-wool bankers. HBOS executives Andy Hornby (retail) James Crosby (insurance) and, infamously, Royal Bank of Scotland chief Fred Goodwin (accountancy), shared a lack of deep connection with the nuts and bolts of banking – simply put, how to lend money long, whilst at the same time borrowing it short. When the system lost confidence in the basic creditworthiness of its biggest institutions, then the entire banking structure crumbled in a morning.
It is a controversial assertion, but I think that history might be slightly kinder to the individuals involved and increasingly critical of the actions of shareholders.
You can sum it up in the old saying: When you buy a dog, don’t be surprised if it barks.
In a sense, the management was doing exactly what the market demanded at the time: chasing the “return on total assets” equation that boosted both a bank’s profits and management’s bonuses. Essentially, the more a bank expanded its balance sheet (loans are counted as assets in bank accounting) the greater the overall profit return – at least on paper. So long as the balance sheet can be covered at the end of the day by taking on short-term money, there are no problems and it’s trebles all round – until the party suddenly stops.
The story has been well told, but there is a clear lesson about how false incentives can work both ways in the market.
DUE DILIGENCE LESSON: If your own understanding of market risk is faulty – you’ll pay the price in the long term.
The concept of shareholder value has undergone a long overdue examination. Even in the US, the home of vast corporate incentives, the emphasis is now on considering all stakeholders when it comes to decision-making. It is also accelerated by the fact that ethical investment concerns are starting to become a serious force in fund management circles. So, there is hope yet.
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