Incentivising management teams by total shareholder return can lead to “a host of perverse outcomes” and helps to explain why the managers of the Smithson Investment Trust challenged remuneration packages in a third of votes on this subject last year.
Simon Barnard (pictured), who heads up the Fundsmith-run trust, spends a significant amount of time discussing the corporate governance structure of his holdings with management teams. He said remuneration policies in particular were critical to success, pointing to a quote from Berkshire Hathaway vice chairman Charlie Munger stating: “Show me the incentive and I will show you the outcome”.
“It will come as no surprise that the targets we prefer to see reflected in management remuneration policies include simple metrics that will build underlying value in the enterprise over time, such as return on capital employed and growth in free cash flow,” said Barnard.
“What we find incredible is the number of targets that are included in remuneration policies which require outcomes over which management should have little to no control.”
A classic example was total shareholder return, which considers the share price movement of a stock, plus any capital returns in the form of dividends and buybacks.
Barnard said that at first glance such a target appeared to be sensible, as you could argue it closely linked the fortunes of company management teams and investors. Yet he pointed out that while this may be true, the managers can’t do anything about it.
“Imagine a dog walker crossing a field, their dog wildly zigzagging around them,” he explained. “We would relate the companies we own to the walker, clear in direction and making steady progress across the field, while the daily market price is like the dog, moving back and forth quite randomly. How much control can anyone have, moment to moment, over a frantic dog let loose in a field?
“And yet management’s compensation, sometimes a lot of it, is tied to the random meanderings of that dog over very specific timeframes.”
In the best-case scenario, Barnard said management teams would correctly conclude they had little control over the share price, and would simply concentrate on improving the underlying fundamentals of the business.
But at worst, he warned they may attempt to control this figure, adding: “As the key determinant of their compensation, can you blame them? This can lead to short termism by managers, bearing in mind that many of them won’t be around for that long.”
Indeed, the accountancy firm PwC found that chief executives of the largest 2,500 companies in the world had a median tenure of only five years.
“In practice, this could mean a host of perverse outcomes, from cutting long-term product development costs to boost current margins, a spending spree on hastily evaluated acquisitions or, at an extreme, corporate accounting so aggressive that it becomes plainly deceptive,” he said.
“And if you think all this sounds like a misdirection of management focus, wait until you hear about the current trend of management being remunerated based on relative total shareholder return: that is, the shareholder return compared with that of other companies. Don’t get us started on that one.”
Of the 340 votes cast by Barnard and his team in 2021, 41 related to management remuneration, and they voted against the company management on 34% of these.
In the vast majority of cases, they had already debated the policy with the company’s board of directors, to give them a chance to get their point of view across.
Barnard said he was not always one of the “bad guys”, adding that he supported the management teams who he thought were being paid appropriately for doing their job well.
For example, he voted in favour of a change to the policy of Sabre, a travel software provider – even though this put him in the minority among fellow shareholders, and the stock has been one of the trust’s worst performers over the past two years.
Performance of Sabre stock since IPO
Source: Google Finance
“The 2020 remuneration policy initially required management to hit certain revenue and profit targets to achieve their targeted pay out,” Barnard continued.
“However, when the pandemic hit, it quickly became obvious that this would now be impossible. Because of this, the supervisory board, pragmatically in our view, changed management’s targets to ones more appropriate to the situation.”
The new targets included significant cost cutting, and maintaining the liquidity and financial flexibility of the company throughout the pandemic, while also capping management payouts to 50% of the prior totals.
Barnard said these new targets would have incentivised management to behave in a manner that was most beneficial for the company at that point.
“This was perfectly logical to us and so we will never know exactly why other investors voted against it, but our suspicion is that some third-party voting services automatically recommended a vote against, simply because the ‘goalposts’ were moved during the term of the policy,” he said.