Us shareholders are incentivising bosses to act against our interests


Originally published at:
Executive pay has long been a hot and controversial topic as its growth has far outstripped the pay of ordinary workers or inflation, but what shareholders should really be worried about, is its structure is encouraging bosses to go hell for leather in generating short term returns which fly in the face of the needs of most long term shareholders argues Robert Davies. This is the time of year when many companies have reported results for the previous year and have sent out their reports and accounts to be approved by shareholders at forthcoming AGMs. The Remuneration reports usually get most attention and are always going to be a sensitive topic, but it sometimes seems as if directors are deliberately trying to provoke shareholders to react by the scale of their rewards, which, increasingly, are dominated by bonuses and usually paid in shares. Few people would argue that the interests of executives should not be aligned with those of the owners of the business and making executives shareholders achieves that. However, blurring the distinction between the two can create conflicts that may be counter-productive. Although it might not always seem that way executives are appointed by the shareholders to run their businesses on their behalf. The interests of the owners (typically pension funds) are clear. They want a business that will thrive and grow over the long term, i.e. many decades. In contrast executives, the appointed agents, rarely stay in the top job for more than a handful of years, if that. So there is a big discrepancy in the time horizons. That is fine when the principals clearly instruct the agents on how they want the business run and pay them accordingly. What do you think? Join the conversation by clicking on the forum below……… However, increasingly the remuneration policies seek to blur that distinction by doing everything to encourage the agents to be more like the principals by giving them free shares as part of their bonus packages. Even worse, there is a rising trend to make those bonuses dependent on the total shareholder return (TSR), albeit over a few years. That compounds the incentive of executives to do something in the short-term that will increase the share price. Yet, as most market observers know, share prices and equity markets respond to a whole variety of factors. Indeed, incentivising CEOs by targeting TSR implies they can control share prices. That is something the FCA surely cannot wish to encourage. There are ways to beef up share prices but they all have consequences. The most obvious is to increases earnings per share, which these days are almost invariably defined as adjusted earnings per share and that gives ample scope for the adjustments to be favourable to the agent doing the adjusting. Another way to boost short-term returns is to expand the balance sheet by taking on debt and pushing the business faster than its organic growth rate. Alternatively, prices could be cut to increase market share or research on new products could be reduced to improve cash flow. Easiest of all is to reduce the number of shares through share buy-backs, perhaps funded by debt. Why take the risk of developing new products when you can increase EPS, and hence your bonus, by using the corporate balance sheet you control? While all these efforts may indeed increase EPS in the short term they may not necessarily be in the best interests of the long-term viability of the business. That is where the conflict between agents and principals arises. Cutting back on research on development prejudices future growth. That may not worry the recently retired CEO but it will upset the shareholders. Taking on additional debt to boost, say marketing, is a fabulous way of speeding up growth, but eventually it has to earn its cost of capital. If it doesn’t it is a drag on earnings. Share buy-backs are a good short–term stimulus to EPS but if the purchases are made above book value (a company’s net asset value) they have a negative effect on the balance sheet. That can cause problems if business conditions worsen and the company starts to look too highly geared. So the prudent long-term investor, or fund manager acting on his behalf, may not agree that aggressive targets for EPS growth are in his interest even if they suit the executives. In the same vein share buy-backs above book value are not always an obvious way of making investors wealthier. Instead of agents being targeted for things they cannot control, like share prices, they should be incentivised to manage things they can. These should be clear, simple business objectives like new products and expansion into new markets. The risk of linking bonuses to financial outputs is that macro-economic factors can play a much bigger role in profits and cash flow than anything executives do. Rising house prices helps building companies in the same way that falling oil prices hurt oil companies. Managers have no control over those external factors and their bonuses should not be tied to them in any way through profit, cash flow or return on equity targets. Building more houses, or finding more oil is what executives are paid to do. They should be rewarded for that in cash, not shares. If they want to own shares they can buy them in the same way as other investors. After all, you wouldn’t pay your window cleaner with shares in your house would you? Robert Davies is a fund manager at Valu Trac Smart Dividend Fund.  


Looks like the whole article has been posted as a forum post. Accident surely?

Interesting thoughts on executive pay and issuing share options. I read something about Donald Trump’s rise in America partially being down to the inequalities the current remuneration system creates because it incentivises the managers to chase short term returns as you say @robert_davies and not invest for the long term, including recruiting staff, paying for R&D, building factories in America etc.

I think you might be on to something here.


When I’m thinking of investing in to a fund or an investment trust one of the things I look for is to see if the fund manager invests their own fund so I’m not sure I agree with @robert_davies view that they shouldn’t be rewarded in shares.

Sure I’d prefer to see them buying shares with their own cash but at least if they own shares in the company they’re financial interests are aligned with mine as a shareholder.

Also, while I agree that managers of FTSE 100 or 250 companies don’t stay in the job for too long these days that’s not the case with investment trusts where they are there for decades sometimes.

I do agree though that the investment timeframe for many companies is too short and especially so in America, though I think the UK is nearly as bad.