Alright. So you’ve found a potential investment. The numbers seem fine, but did you remember to look at management incentives? In American companies, you can find this information in the proxy statement. The proxy statement is filed along with the 10K (annual report), and can usually be found in the “Investor Relations” area of a company’s website.
What Motivates Us?
People are motivated by incentives. Why else bother doing anything at all? You pursue higher education, where supposedly the incentive is a higher paying job and/or quality of life. You look for a bargain on something, the incentive is to keep more money in your own pocket. Even in volunteer work there is an incentive: The joy of helping others. There are different levels to incentives, some more attractive than others.
If the goal is to be an intelligent investor, you need to know what management gets paid for. After all, you’re their boss – the owner. This is the mindset you need to have, whether you buy 10 shares or 10,000. You want management incentives to be aligned with your interest. So how do we know if this is the case? Granted, the proxy statement may sometimes be hard to decipher with confusing corporate law jargon. Here’s some keys to help you out.
Profitability, Yes. But The Right Way
Management incentives should have a clear statement on their focus on the long-term. An easy red flag to discard an investment idea from the get go is if a company rewards executives through “increase in market capitalization”. What this means is that they are incentivized to increase their stock price. This is not what you want. There are many ways to artificially raise the stock price in the short-term. Remember: Price and value are two different things.
Muddying the Waters With “Profitability”
Obviously we want companies to be profitable. But I advice people to be careful if management is incentivized by EBIT (earnings before interest & tax), profit-before-tax or some other related uttering. The reason being that income statement numbers are much more prone to “creative” accounting than say the cash flow statement. Here’s an example scenario:
Company X management incentives have a focus on increasing earnings before tax. The CEO is hired for a few years to see how he/she performs. Since the timeframe to deliver is short, what is an executive to do? The easy path is to do an acquisition of company Y. Now the firm is bigger, EBIT has increased, and bonuses get paid. If a company wants to make an acquisition, it will rarely be objected by the board or shareholders. The problem is that in most cases, the acquirer overpays and synergies are not realized. In the short-term, the company has been “dressed up”:
- Acquisition announcement gives the share price a boost. “Look! We ARE creating shareholder value”
- EBIT may rise, but how much must the acquired company produce in order to justify the acquisition price?
- The “assets” on the balance sheet have now gone up through the added line item “Goodwill”. But since most companies overpay in acquisitions, this is more like a bag of chips: half content, half air.
In the long-run the company is not necessarily better off. Forces of capitalism’s creative destruction are constantly at the gates. If the acquisition is made through debt, risk increases. If you’re looking at a business growing through acquisitions, beware the glutton!
ROIC To The Rescue! … And it’s sidekick: Cash!
So how do we know if management truly has a long-term orientation? There are two main incentives that will put a smile on an intelligent investor’s face: ROIC and Free Cash Flow.
If the phrase “Return on Invested Capital”, “ROIC” or something similar to this is emphasized, it’s usually a good sign. The reason ROIC is a good management incentive, is that it forces management to think harder on their capital allocation decisions. If there is a threshold of return to meet in relation to the funds that the company invests, you have the odds on your side for a wiser decision. Incentives may vary between industries, but you want to see incentives promoting organic growth. For example in retail, you want to see an incentive to increase “Same Store Sales”. This keeps management from expanding foolishly (and for the wrong reasons).
One of the most important figures of all is free cash flow (FCF). It is the cash flow available to all the creditors and investors in a company, including common stockholders, preferred shareholders, and lenders (AKA. The real amount of cash your business is producing). As a business owner, this number is your baby. Companies are not obliged to report this number separately, and sometimes you need to figure it out yourself.
If management stresses the need to over time increase its FCF, this is usually a great sign. But remember to check how they’ve delivered on this in the past!
Skin In The Game
Finally as a management incentive, you want to make sure that management owns stock in the company. The reason is obvious: They have skin in the game. Even better if management is buying stock during a price drop. It is almost guaranteed that they know the business better than you, and most likely they would not be buying into a doomed operation. This information is also filed to the public. In American companies, look for “Form 4”, under “SEC Filings” in the Investor Relations page.
Finally, a quick tip to find management incentives keywords in proxy statements. Once you’ve opened the document press ctrl+f (or cmd+f on Mac) on your keyboard, and type the words you are looking for to be sent to the relevant part of the document. For more on evaluating management, check out my post on shareholder letters here.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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