Understanding company management credentials

“Stockholders as a class are king”, wrote Benjamin Graham in his 1949 edition of The Intelligent Investor^[1]. He insisted that shareholders “can hire and fire management and bend them completely to their will.” Then Graham deleted this section, which has been omitted in subsequent editions of The Intelligent Investor ever since.

Graham had become disillusioned with the ability of shareholders to rectify the ‘agency problem’ that exists between them and corporate management. He pointed out that shareholders are owners of a company. They own the profits. They own property. The CEO works for the shareholder, and yet shareholders do little or nothing to ensure that managers act in their interest. Graham complained that when managers act against shareholders, “shareholders are a complete washout” that “show neither intelligence or alertness”. What was he fussing about? If he was alive today, what would he tell us about the signs that management was acting in, or against, the interest of shareholders? This edition of ‘Graham’s lost dream’ will pay particular attention to the two Cs - Compensation and Candor.

The ‘Agency Problem’ between managers and shareholders

Before exploring this issue further, it important to lay down what we mean when we say ‘agency problem’. In this case, the ‘principal’ are the shareholders. The ‘agent’ are the management. The agent should act in the best interests of the shareholders’ because, as noted, they own the company. When this service breaks down and management becomes self-serving, shareholders are faced with an ‘agency problem’. We will now go through different areas of management, outlining scenarios where management acts like the principal or the agent.

CEO pay and compensation

You want to invest in a company where management's pay and compensation is tied to the company's performance. This is perhaps the best way to ensure that managers act as agents. Probably the best evidence that the interests of managers and shareholders are reconciled is when management has a substantial shareholding in the company. If the company goes downhill, the net worth of the people running it falls too. Pat Dorsey from Morningstar^[2] prefers to see managers' pay that is made up predominantly of bonuses, rather than fixed salaries.

Furthermore, Jason Zweig warns against managers with stellar salaries, suggesting that these companies are "run by the managers, for the managers." This is one of the reasons that Coca Cola shareholders are up in arms. CEO pay at Coca Cola has rocketed, and shareholders have complained that the “board is asking shareholders for approval to transfer approximately $13 billion from all our pockets to the company's management over the next four years."

Interestingly, Warren Buffett has failed to vote against the Coca Cola pay package. Perhaps it is therefore ironic that Graham’s greatest disciple is being labelled by shareholders as one of the ‘complete washouts’ that Graham criticised back in the 1940s.

So how much is too much? Dorsey notes that “There’s not necessarily a strict limit here, though I personally think an $8 million cash bonus is silly.”^[2] At the same time, shareholders should “look at competing firms to see what their CEOs are paid.” In fact, Buffett has defended his stance towards the pay package, insisting that “I don’t think [CEO pay] is out of whack with what the value is of an outstanding executive could bring.”

When assessing the pay and compensation structure, there are a whole range of red flags to watch out for, including:

Moving goalposts: Some companies outline that managers' salaries are tied to a performance benchmark (ie, profits or earnings per annum), but the firm then moves this benchmark if the company is likely to fall short of the initial target. This breaks the tie between pay and performance and enables managers to act like agents of their own interest.

Rewards for ‘empire building’: This incentivises managers to undertake acquisitions which can harm shareholder value either because the company issues more shares to fund the takeover, or because the acquisition is a failure.

Excessive use of stock options: Even if they are distributed beyond the boardroom, stock options dilute existing shareholders equity. Options are convertible securities and therefore increase the number of shares when exercised. Stock options can also be used to give a single shareholder, or a ‘concert party’ of shareholders, disproportionate control over a company.

Candour

An agent should never hide something from the principal. However, if management is not being clear about something, then they probably have something to hide and the agent-principal relationship may have broken down. Start with the annual reports. Are they trying to make their financial results transparent or opaque? If 'non-recurring' charges keep recurring, or 'extraordinary' items crop up year after year, then Zweig warns that you should question whether management is putting shareholder's long-term interests first. A red flag certainly flies when a company provides no information around crucial areas. For example, Merck changed the way it reported its drug sales figures in 2001, but wouldn't provide comparable date for past periods.

Jim Slater even advises investors to test management's honesty at AGMs. Examine how well CEOs field questions. How direct or vague are the answers? Management should also be open and honest when they have made a mistake. As Pat Dorsey points out, "CEOs who bury mistakes might be burying other things as well". For this very reason, Dorsey likes to see annual reports which highlight successes but also acknowledge and explain shortcomings. The ShareSoc Company Scorecard also has a ‘shareholder friendly’ section, where investors are asked:

• Do the directors gladly talk to individual shareholders and respond to written questions?

• Do the directors give presentations to individual shareholders or allow them to attend analyst meetings?

So there are ways that shareholders can check whether companies are being run by the right people, in the right way. The pay and compensation structure should be set up such that management are incentivised to drive company profits and thereby improve value per share. We also look to see whether management is being candid about their failures, not just their successes. But there is more, which will be explored in a second edition of ‘Benjamin Graham’s lost dream’, which will look at governance and how to assess management’s track record and integrity.