“Perhaps the most important rule in management is ‘Get the incentives right.’”
— Charlie Munger
If you don’t know, Charlie Munger is Warren Buffett’s long-time partner and Vice-Chairman of Berkshire Hathaway. And if you haven’t read his book, Poor Charlie’s Almanack, I cannot recommend it enough. It’s more about psychology and general life advice than it is investing, but it nonetheless had a major positive effect on my investing career. Mr. Munger ends his book with a discussion of 25 psychological tendencies he feels are the most common sources of human misjudgment. The first one on his list, because he feels it’s the most underestimated, is what he calls “reward and punishment superresponse tendency.” In more normal speak, “incentives are extremely powerful.”
On a regular basis I am shocked at how many investors will write about a company and not mention management pay. It is one of the first things I look at and is, in my opinion, one of the most important (and overlooked) parts of an investment thesis. It is human nature to be selfish and act in one’s own interest and many CEOs are incentivized not to act in the best interest of shareholders.
If a CEO owns a small amount of stock and is paid a bonus based on revenue growth, he or she is most likely going to grow the company at all costs. This encourages things like taking on lots of debt to fund growth which hurts the bottom line (and the stock price). On the other hand, a CEO who owns a lot of stock and whose bonus is based on profitability is more aligned with shareholders.
If only it were that simple. While management that owns a lot of stock is great for shareholders, if the CEO owns over 50% of outstanding shares he or she can easily overpay themselves with little fear of being thrown out by activist investors. Even a bonus plan based on profitability can unfairly reward managers who are simply enjoying the benefits of a peaking cyclical industry or a large one-time purchase order. Managers should be rewarded when success is a result of their decisions, not simply being in the right place at the right time. This is a very difficult task and I’m not sure any compensation package is perfect, but below are a few elements of pay packages that I love.
- Violin Memory (VMEM) – Kevin DeNuccio, CEO, took over in February 2014 and requested to take his entire salary and bonus in shares of stock. Violin is required by law to pay him minimum wage so now he is making $10.15/hr and the rest of his income gets paid in stock. Several other Violin executives followed his lead and are now taking their incomes in stock as well. This shows a serious vote of confidence in the company and its stock performance going forward.
- Consolidated-Tomoka Land Company (CTO) – John Albright, CEO, took over in August 2011 and was granted 96,000 restricted shares that vest(ed) in tranches as CTO’s stock price increases from $36 to $65. Earlier this year he was granted more restricted shares with the final tranche vesting when CTO’s stock hits $90. This is the exact incentive shareholders want to see in the CEO’s pay package.
- XPEL Technologies Corp (DAP.U) – Executives and directors all own lots of stock accompanied by low salaries. Ryan Pape, CEO, made $251,408 in 2014. Compare this to the 1,363,602 shares of XPEL’s stock he owns that is currently worth $3.5 million. Owning stock that is valued over 13x his total annual income encourages him to act in ways that increases the stock price and thus aligns his actions with shareholders. I mention the ratio of CEO stock ownership to his or her total annual income in all of my investment write-ups for a reason.
Some investors think all stocks are investable at a low enough price—I strongly disagree. I am very strict on shareholder friendly management—any red flag is an automatic pass for me, no matter how cheap the stock is. Investing in CEOs that are taking advantage of shareholders or are simply not incentivized to act in shareholders’ best interest is an uphill battle. There are tens of thousands of public companies in the world, why invest in managers that aren’t sitting on your side of the table?
Note: All of this assumes you are a relatively small, passive investor like myself. Activist investors probably look at a horrible compensation package and see opportunity 🙂