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.
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 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.