This article was published on Livewire Markets, 23 June 2020
The FY20 annual reporting season is fast approaching, and with it brings an abundance of company annual reports. In order to conduct thorough company analysis, we believe investors must read the annual report in detail. In this article we focus on the remuneration section of the annual report.
When it comes to the remuneration of a company’s board and management, we believe there is a risk/return profile to the downside, meaning the risk is higher than the return. Put simply and in isolation, the risk to shareholders of a lower quality remuneration framework can far outweigh the return to shareholders of a company adopting a higher quality remuneration framework.
In our view, a lower quality remuneration structure often has a heavy focus on a short-term targets and may lead to a ‘get rich quick’ mentality, where decisions by the board and management may directly contrast with decisions made for the long-term benefit of a company. The ramifications to shareholders can be detrimental.
The ‘lollapalooza effect’, a term coined by Charlie Munger in 1995, is a concept that several smaller scale factors of human biases, tendencies and/or actions, when acting together, can lead towards a certain (and often very significant) outcome.
“Really big effects, lollapalooza effects, will often come only from large combinations of factors” - Charlie Munger
A real-life example of the ‘lollapalooza effect’ that is referred to in Ben Carlson’s book ‘A Wealth of Common Sense’ is the eradication of tuberculosis. Tuberculosis was reported to be eradicated only through a combination of other drugs being used in unison, essentially working together to create a cure. Within financial markets, Munger believes the ’lollapalooza effect’ can result in herd mentality. As investor behaviour and thinking compounds upon other investors behaviour and thinking, extremes in market volatility can occur.
So how does the ‘lollapalooza effect’ relate to remuneration framework of a company’s board and management? We would argue that the adoption of a higher quality remuneration structure is one of the many inputs required to create a business which can compound shareholder capital over the long-term.
One of our core NAOS Asset Management investment beliefs is a strong focus on shareholder alignment, which we believe is of particular importance when investing a universe of small or micro-cap companies. In our view, strong shareholder alignment must not only consider existing management and board shareholdings, but the structure of longer-term incentives which aim to strengthen this alignment on a forward-looking basis.
“Show me the incentive and I'll show you the outcome” - Charlie Munger
Most likely you’ve heard of this famous summation of behavioural economics. If we consider this quote in the context of a remuneration framework, then the outcome must have a relationship to building value for shareholders. Below we do not outline what a lower quality remuneration framework may or may not look like. Instead we outline our thinking behind the typical areas of the remuneration framework and how they can be structured to be of higher quality and in the best interests of shareholders:
Base Pay
Base pay is generally viewed as an essential component of any remuneration deal. Sure, there are exceptions (such as Elon Musk who doesn’t take a salary at Tesla) but we believe that base pay should be a proportional reflection on the company and to the overall remuneration package.
Base pay for directors and management teams will vary by numerous factors including industry, company size, company profitability and historical results. For example, a CEO of an ASX100 company may justify a significantly larger base pay structure than a loss-making micro-cap company.
In our view, a higher quality framework for base pay is keeping it relatively flat and relatively low. We take a positive view when a board of directors receive part or all of their base fees in shares as it creates alignment with shareholders. A board which thinks and acts as a shareholder, in principle, is a good thing.
‘At Risk’ – Short Term Incentives
These incentives are typically structured (sometimes tiered) as a cash payment based on annual financial metrics. Common targets include revenue and/or EBITDA, but a higher quality framework is perhaps less focused on a certain revenue figure and focused more holistically towards the items at the ‘bottom end’ of the income statement (e.g. net profit margins or EPS outcomes). Furthermore, a higher quality framework may include metrics associated with the balance sheet or cash flow, such as net leverage ratios or EBITDA to cash conversion and include a portion of remuneration paid in shares, not just as a cash payment.
‘At Risk’ – Long Term Incentives
How management and boards of companies are remunerated over a 3-5-year period is critical. We believe a higher quality long term incentive (LTI) structure would have components relating to the long-term EPS compound annual growth rate (CAGR) and/or long-term TSR (total shareholder return), with remuneration delivered via shares rather than cash, with vesting terms regarding continued employment.
Within the small and micro-cap universe, many companies are yet to implement LTI structures, or the current structures may not be appropriate for a listed company with responsibilities to a wide range of external shareholders. We believe that long-term alignment through an appropriate LTI structure provides comfort to shareholders and should be a priority item for boards to implement as soon as practically possible.
A remuneration report may publicly disclose the hurdle rates required to achieve the implemented target, e.g. 10% EPS CAGR over 5 years. Under the previously mentioned Munger principal of incentives relating to outcomes, knowing these hurdle rates can be valuable in understanding the board and management’s view of the medium to long-term earning prospects of a company. This in turn can provide investors with a useful tool in assessing a company’s fair value.
Employee alignment
Alignment with shareholders doesn’t simply need to stop with the board and executive management level, it can extend down throughout the entire organisation and can be a valuable input into building a successful company culture, which can lead to greater business outcomes and shareholder returns - another example of the ‘lollapalooza effect’.
HEICO Corp (HEI.NYSE) is a family run aerospace and electronics company, which according to Forbes Magazine, has generated a 47,500% total shareholder return since 1990 (>30% CAGR), and has long been preaching employee alignment by matching a portion of employee retirement contributions in the form of free shares. This has translated to many employees becoming multimillionaires and the tenure of many of their 4,000 employees is unsurprisingly lengthy. This alignment through effective employee remuneration is just one factor of many which has seen HEICO become an incredibly successful company.
Closer to home, there are examples of both small and large companies providing employee alignment through the ‘gifting’ of shares to employees for tenure milestones, matching of personal share purchases by the company, or providing incentive payments in the form of company shares. In our view, an opportunity exists for more ASX listed companies to adopt such ideas.
Non-traditional and non-financial factors
Non-traditional and non-financial factors can also be effective components of a higher quality remuneration framework when considered in conjunction with financial metrics and are important aspects of the overall health of a business and its culture. In fact, you could argue that non-traditional and non-financial metrics are key to generating a long term positive ‘lollapalooza effect’ for a company and its shareholders. Some of these factors may include:
We believe non-financial metrics such as ESG factors are likely to be of increasing importance with regard to how boards and management teams are remunerated. This trend is already gaining momentum globally.
In our view, there is no one-size-fits-all model for remuneration, rather general principles to be followed to achieve higher quality outcomes for employees, management, directors and shareholders. For investors, this is an area of company analysis which should not be ignored. Shareholder aligned remuneration can be a powerful input in creating a much larger output.
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