For long term outperformance in investing it is necessary to have a rigorous, logical process that is followed with discipline. This is not easy. It is also not enough to ensure outperformance in the long run. In addition to a good process, investors must also give due regard to the role of human psychology in markets and businesses. One particularly overlooked aspect of human psychology is the impact incentives can have on the decision making of a firm’s management team.
Charlie Munger, Vice Chairman of Berkshire Hathaway, once commented “[w]ell I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.” In his famous The Psychology of Human Misjudgment speech, he continues to expound the importance of incentives by talking about how they changed the behavior at Federal Express, and it is worth reproducing in full:
One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.
When investing in a publicly listed company, one would hope the executive team is incentivized to act in the best interests of shareholders. But this is not always the case – especially where executive compensation is largely tied to EPS growth.
There are countless examples of companies that tie executive compensation to metrics such as earnings per share (EPS) growth. In the U.S., companies are required to file a form DEF 14A, a document that provides details about the amount and type of executive compensation. The Montaka team regularly reviews these documents because they provide an insight into the incentives that will motivate, and ultimately guide the behavior of, the management teams of companies we analyze.
A management team that’s incentivized to produce strong EPS growth may sound like they will act in a way that’s beneficial for shareholders. Such an assertion rests on the assumption that EPS growth is always positive for shareholders. However, there are issues with using increases in EPS as a yardstick for shareholder wealth creation, given the potential for an unscrupulous management team to make value-destroying decisions in an attempt to boost EPS.
There are a number of ways to manufacturer EPS growth that can actually erode value for shareholders:
- EPS as a metric in no way accounts for the level of capital required to produce that EPS increase. Reinvesting high rates of capital into the business can lead to earnings growth, although this is unattractive if the company is generating low returns on the capital it invests. For example, companies that embark on an acquisition-led growth strategy are typically able to grow EPS at very high rates. However, this growth comes at a cost, given the capital required to fund these acquisitions. Acquisitive growth can burden the company with high indebtedness or dilute existing shareholders when equity is raised for an acquisition; EPS growth fails to capture these outcomes.
- EPS can be boosted in the short term by share buybacks, which may divert capital away from more productive uses.
- Manipulating earnings through aggressive accounting measures can prop up EPS in the short term, and this may be used by management to meet EPS targets so that management can meet their remuneration hurdles.
- Management can report what’s called non-GAAP EPS, where they have discretion to exclude expenses such as stock based compensation or “one-off” expenses (even though these might not always be one-offs).
We view non-GAAP EPS numbers with skepticism and make our own adjustments to derive what we view as the “economic earnings” of the business. However, our economic earnings numbers are not the numbers used as the performance metrics for company executives, and we are always wary when a large portion of management compensation is tied to adjusted EPS growth.
A more suitable performance metric might be the return on invested capital, as it accounts for the level of capital required to grow the business. Also, linking compensation to free cash flow growth is another way to limit the potential for earnings manipulation shenanigans, and this metric also accounts for the capital cost of any growth achieved. Either way, investors should pay close attention to the incentive structure for management teams when assessing investment opportunities.
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.