While some investors may see the fuss about remuneration as ‘full of sound and fury and signifying nothing’, others understand that, like most things in the world of company valuation, the more you look the more you see.
And in a time when corporate communication is carefully guarded and controlled, for those who know where to look, the remuneration report is an open back-door into many aspects of how the company and its directors really think.
So let’s look at five fundamental questions that the remuneration report can answer, if you know what you’re looking for.
#1 To what extent has management ‘captured’ the Board?
The absolute amounts on offer to the CEO and the executive team should be of interest to any investor, but not because of the simple politics of envy. Rather, the amounts on offer tell a great deal about the power that the executive has over the Board and ultimately how effective the Board will be in overseeing the actions of management.
If the Board is convinced that they have to pay the CEO far more than what is offered elsewhere, it says the Board places inordinate importance on keeping this CEO.
Any Board that is that enraptured with its CEO is unlikely to effectively oversee his performance or provide the vital check to the power invested in that role.
This can be a particularly dangerous situation for investors when the company is considering questions of capital allocation.
#2 What’s more important to this Board: substance or form?
Long term incentive plans (LTIPs) are a ubiquitous feature of remuneration reports. Since the advent of the ‘two strikes’ policy, the form of LTIPs has narrowed to those most likely to be approved by the governance advisory industry. Typically this means using relative TSR, cliff vesting (ie nothing for performance below the 50th percentile of the peer group), and a testing period of three or more years.
But, as many directors will quietly admit, they are also a colossal waste of money. This is because the vast majority of executives who participate in this type of LTIP see any rewards that it offers as so beyond their control that the LTIP is really little more than a lottery.
In fact a 2013 study by PwC and London School of Economics professor Alexander Pepper showed that only 38% of Australian executives rated their firm’s LTIP as an effective incentive.
The capriciousness of the typical LTIP and its consequential ineffectiveness as an incentive is not new. So, a Board that chooses not to employ the typical LTIP may well care more about effectively applying shareholders’ money than following the listed company herd. A focus on substance over form augurs well for the treatment of shareholder funds in other matters.
#3 What does the Board think really drives the value of the company?
It is fair to assume that most public company directors are genuine in their desire to see the value of the company grow over time. But what do they think really drives the value of the company? Is it earnings growth? Asset growth? Free cash flow? A higher return on equity?
This is important, because ultimately the Board is responsible for the big capital allocation decisions that can make such a difference to shareholder returns. On what basis do they judge those opportunities?
Few companies set out what they think drives the value of the company (unfortunately), but the remuneration report can provide useful insight into this question because in structuring a reward program, the Board must answer a basic question, ‘What are we prepared to pay for more of?’
Assuming the Board will reward more of what they think drives the value of the company, the metrics used in the company’s reward programs are telling.
For example, Boards that reward EPS or EBITDA growth trumpet to the world that they recognise the importance of profit growth. But they also make it clear that they don’t value what rate of return the business generates on investors’ capital. After all, money invested at as little as 2 or 3% will grow EPS and EBITDA, even as it destroys the wealth of investors.
What does this mean when the company is faced with a major capital allocation question? Any Board that is prepared to reward managers for EBITDA or EPS growth is likely to view favourably investment proposals that grow EBITDA or EPS, even if that means a return on investment as low as 1%.
A Board that pays for EPS growth or EBITDA growth either doesn’t understand the importance of generating a return above the cost of capital, or doesn’t care.
Return based measures, such as Return on Capital Employed (ROCE) and Economic Profit signal instead that the Board is awake to the importance of getting a decent return on investors’ money and of encouraging managers to recognise this as well.
What’s more, a remuneration report that includes transparent return measures signals the company’s confidence that it will be able to invest funds at attractive rates of return. EBITDA and EPS based reward structures are silent on this point.
#4 How aspirational are management?
Most investors accept that the growth prospects of a firm are vital in assessing its value. But the actual growth achieved by a firm is dependent on the aspirations of management and in particular the targets that they set for themselves.
How can an investor get a sense of how aspirational a business is likely to be in its target setting? For any business priced for strong growth, investors need to watch for two flags, found in the remuneration report that may threaten how aspirational the business is in its target setting and hence how fast it grows.
First, where financial metrics are used, watch for Short Term Incentive plan targets set off budget. In this situation, managers can improve their rewards by either improving performance or lowering the budget. The latter is most likely easier than the former, especially given management are closer to the business than the Board and so better able to negotiate a target to their advantage.
For investors, tying incentive targets to budget can be very damaging. Not only does it waste resources by dragging out the budget setting process, but budgets that have been ‘sandbagged’ lead to missed sales and profits due to under-resourcing. Worst of all, it creates of culture mediocrity, where setting aspirational targets is actually in direct conflict with the interests of managers. And it has a corrosive effect on the organisation as managers down the line see that it pays to lie to their superiors.
These problems are also found where rewards are made at the discretion of the Board. Here what is likely to matter most to the executive is managing perceptions; perceptions of how well management has performed in the circumstances.
It pays then for the CEO to bring down Board expectations by putting up plans that are as conservative as he can get away with. Again this is the opposite of what is needed in most companies but especially in one priced for growth.
#5 Are management being paid to grow the value of the company?
From an investor’s perspective the ultimate question on remuneration must be, ‘Are management being paid to grow the value of the company?’
Most investors would look to equity based remuneration to address this question. But as we have seen, most managers ignore the typical equity reward program, treating them as little more than lottery tickets.
As the PwC/LSE study found, managers actually put far greater emphasis on salary and short term incentive payments.
Salaries are largely a function of size – the bigger the business that I run, the bigger the salary I take home. But revenue levels, assets or headcount – all the size measures used to determine salaries – are poorly correlated with growing shareholder wealth.
That leaves the humble Short Term Incentive Program (STIP) to do all the heavy lifting with respect to directing management attention toward growing the value of investors’ capital.
Unfortunately, most STIPs are designed to create management wealth, rather than shareholder wealth. They function more as deferred compensation than truly ‘at-risk’ compensation.
Here again, there are clues to how well the STIP will align management’s interests with those of shareholders.
Firstly, how many measures are used? The more measures are used, the greater the ‘portfolio effect’ that will apply, allowing managers to get some reward even in a very poor year.
Second, are incentive targets set off budget, allowing managers to increase their rewards by ‘sandbagging’ their plans?
Finally and most telling: is the STIP capped? If the STIP encourages managers to sustainably grow the value of the firm, why would the Board ever cap it? Why would they ever say to managers, ‘This much shareholder wealth is enough: we won’t reward any more’?
No, a cap on an STIP is a vote of no-confidence in it, by the designers of it. It says loud and clear, ‘This incentive plan does not pay managers to grow the value of the business.’
The purpose of equities research is to glean an informational advantage over other investors. If you know where to look and what questions to ask, the remuneration report can provide fascinating and often overlooked insights into the way decisions are made, capital is allocated and wealth is created (or destroyed) within a listed company.