The organizers of a tennis tournament needed money. They approached the CEO of a big company and asked him to sponsor the tournament.
“How much?” asked the CEO.
“One million,” said the organizer.
“That is too much money,” said the CEO.
“Not if you consider the fact that you personally can play one match, sit at the honorary stand next to a member of the presidential family and be the one that hands over the prize,” said the organizer.
“Where do I sign?” said the CEO.
That’s the power of incentives, you see. People do what they perceive as in their best interest and are biased by incentives.
Look at the brokerage business. Stock brokers have a strong incentive to get us to trade. They advise us what to buy and sell. Volume creates commissions. Investment bankers encourage overpriced acquisitions to generate fees. Investment bankers have every incentive to get initial public offerings (IPO) deals done, regardless of the company’s quality. Their compensation is tied to the revenues the deal brings in. Analysts are rewarded for helping sell the IPO. Brokers want to move the stock.
What did Groucho Marx say? “I made a killing on Wall Street a few years ago…I shot my broker.”
Similarly, in the medical field, some psychologists ensure themselves future income by telling their patients that another visit is required. And they don’t talk about the limits of their knowledge. Their careers are at stake. As American actor Walther Matthau said, “My doctor gave me six months to live. When I told him I couldn’t pay the bill, he gave me six more months.”
The long and short of this is that people are driven by incentives. Look no further than corporate executives, the stewards of our capital and trust in companies.
Nowhere are incentives as powerful as in executive compensation, simply because of two reasons –
1. Quantum of incentives here are too big; and
2. People have the power to fix their own incentives.
Now, talking about executive compensation is often a tricky issue because who decides how much is too much? You as an investor surely have no control over how the CEOs of your companies pay themselves.
Of course, corporate governance rules require companies to have Compensation Committees. So, company boards bring in outside experts who tell them that compensation for the peer group’s CEOs has increased. Then the top HR guy, who’s usually a stooge for the CEO, says, “By the way, the CEO really would appreciate it if he was in the top end of the range, because it’s important that the outside world knows that the board supports him.” So there’s a lot of pressure on the Board to raise the CEO’s pay to match the outside world.
In other words, CEOs and top managers still call the shots when it comes to deciding how much they earn. Or what else justifies the ever-widening gap between what a CEO gets paid and what his average employee gets paid?
For instance, the gap between pay for US CEOs and the people who work for them has widened sevenfold in three decades.
Even as far as India is concerned, as per a study conducted by HayGroup, CEOs in India earn 78 times the salary of an entry-level professional, a ratio that has consistently been on the rise. Then, there are variations across industries. FMCG and real estate CEOs in India, for instance, earn around 100 times what the entry-level professionals in their industries earn.
What is more, around 78% of an average Indian CEO’s pay comes to him/her in the form of annual fixed cost to company, benefits, and short term incentives…while the remaining 22% is in the form of long-term incentives. So much for strengthening the long-term focus of the CEOs!
Critics argue that rising pay comes from strong-arming by executives who take more out of the economy than they put back in. They’re abetted by accommodating directors, according to Warren Buffett, who calls them less “Doberman” than “Chihuahua.”
Now consider this. Despite the gloom and doom of the past few years, there has never been a better time to be a CEO of an Indian company. The average compensation of Indian CEOs – both promoters and professionals – has risen sharply over the past few years. In fact, in FY14, a year that was pretty dismal for Indian companies, the CEOs of the top 100 listed companies saw their aggregate annual compensation rise by 12%. As against this, the aggregate revenues of the same group of companies grew by less than 10% while profit after tax grew even slower at 7%.
Now, why am I talking about management compensation and what is its relation to good or bad corporate governance?
Well, when you are investing in a company, it’s of great importance to understand the kind of managers you are partnering with. Only when you do this, you would be in a better position to gauge potential execution risk the business faces.
Partner with people who have had a long track record (i.e., more than 10 years) of successfully managing a business, and the odds that they will continue to manage the business well are in your favour. On the other hand, if you are investing in a business where the managers have taken greater care of themselves than the business, the odds are not in your favour.
In his book, The Investment Checklist, the author Michael Shearn writes about the importance of avoiding the OO3 type of managers “who are passionate about the business but primarily run the business for their own benefit. They do not take shareholder interests into consideration and will often siphon off profits to themselves through egregiously large compensation packages.”
You should be careful investing in companies with these types of CEOs because they typically fail to create a lot of value for shareholders over long periods.
It is important to spend time reviewing the compensation and ownership interest of management, which can be found in the annual reports. You can gain great insight into the character and motivation of managers by understanding how they are compensated. You want to understand if the compensation package rewards for long-term or short- term performance. For example, if a CEO owns Rs 100 crore of stock, and he is paid Rs 1 crore per year, then he is more likely to make long-term decisions. In contrast, if a CEO gets paid Rs 50 crore a year and owns Rs 10 crore of stock, then he will likely value his job more than the value of the company’s stock.
A classic example in the Indian context is that of the promoter of Kingfisher Airlines in India, who held less than 2% stake in the company in his personal capacity, but paid himself crores in fixed salaries, and also splurged on sports teams while there was no money to pay salaries to staff.
Also take a look at Jindal Steel & Power and Indiabulls Housing where the promoters own less than 1% stake in their respective companies, but draw more than Rs 30 crore as annual salaries. The founders of Sun TV have in fact run the company for their own sake, giving themselves around Rs 60 crore salary (each for the husband and wife) in FY14.
Some of the best long-term performing businesses have been run by CEOs with low cash compensation and high stock ownership. These managers generally have a long- term view.
Warren Buffett and Charlie Munger are classic examples here, who earn just US$ 100,000 in annual salaries but hold big stakes in their businesses.
As the CEO of the world’s largest e-commerce company Amazon, Jeff Bezos made US$ 1.6 million last year. Compare this to the founders of the much-much smaller Flipkart in India, who took home US$ 1.7 million despite the fact that the company continues to bleed big time.
Charlie Munger has said –
A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do it.
He also proposes that CEOs receive modest compensation after they have achieved a reasonable level of wealth –
People should take way less than they’re worth when they are favored by life.” … “I would argue that when you rise high enough in American business, you’ve got a moral duty to be underpaid—not to get all that you can, but to actually be underpaid.
He cites Costco as an example, where Munger serves on the compensation committee. Former CEO James Sinegal routinely requested compensation below his peer group. “There’s a lot to be said for the people who have the power getting into a position where they make their money with the shareholders and not off them.”
To conclude, it’s very important for you to look at how and what the managers of the businesses you own are paying themselves. And if they are paying themselves too much as compared to the value they are creating (or have created), remember what Thomas Phelps wrote in his book 100 to 1 in the Stock Market –
A man who will steal for you will steal from you.