Looking For Incentives
Readers of this blog are well aware that I’m comfortable investing in all sorts of different assets — index funds, bonds, preferred shares, and even common stocks when it makes sense to do so.
Generally speaking, if I’m going to invest in individual assets there must be a significant advantage to putting money into those individual investments versus a good ole index fund. It should make good monetary sense to do so, and it won’t be based upon market speculation or attempts to predict the future. Cold hard number crunching here kids!
(Yes, this is one of those investing posts! It’s going to be the last one for a while, since we’ll be traveling all next month!)
When buying common stocks you see a huge number of different strategies — Some people focus on growth stocks, dividend yields, and others purely on valuation (cheap stocks). Heck, some people even invest based on the new technology introduced by the company (e.g. Tesla).
Those are all cool strategies, but mine is a little different. Over the years I’ve developed what I call a “hybrid approach” to investing that was originally influenced by a Joel Greenblatt’s book The Little Book That Still Beats The Market.
What a stupid title, eh? It might sound stupid, but it’s actually a pretty smart book.
While I don’t follow the Greenblatt “Magic Formula” approach, I did find his ideas innovative — He combined two disparate investing metrics into a hybrid model for making investing decisions. Those metrics (earnings yield and ROIC) produced stunning long term results for Greenblatt.
In other words, he didn’t just espouse buying of cheap companies — he bought cheap AND good companies…and it worked REALLY well. He did so in an easily quantifiable way that didn’t required “smart” decision making. It was a formula!
Today I want to talk about a third leg I’ve added to my own hybrid investing model — Incentives.
Why Incentives Matter
It’s like a law of nature — Incentives drive everything (especially human behavior).
If the right incentives are put in place, humans can and will do incredible things. If bad incentives are put in place, the wrong behavior can appear in attempts to “game” the system for personal advantage.
To quote Charlie Munger (one of my favorite investors), “The iron rule of nature is: you get what you reward for. If you want ants to come, you put sugar on the floor.”
As investors, we want to “put down the sugar” for business executives (and employees) that leads to better rewards for shareholders. In my mind, these kinds of incentives include:
- Reasonable levels of business growth
- Good Customer satisfaction metrics from third party sources
- Excellent operating efficiency
- Careful allocation of capital into projects with good returns
- Good credit quality and debt management (e.g. a good credit score and low debt levels)
- Small or nonexistent rewards for poor performance.
It’s also important to consider that if the wrong incentives are put place it could create absolutely terrible behavior — Bad incentives eventually led to the collapse of Enron or WorldCom (the two largest bankruptcies in history).
These kind of incentives could include:
- Large rewards for simple business feats that require no effort. (You’d be surprised how common this is)
- A focus on a rising stock price.
- Comparison metrics against low quality companies.
- Aggressive growth objectives (usually achieved via frequent acquisitions)
- Earnings growth metrics absent of cost controls.
- Reward metrics that change when the company has a bad year.
- And so on…
There’s a huge number of possible incentives that can be put in place!
By-in-large, I believe incentives are an area of investing that gets largely ignored by investors despite being one of the most powerful controllers of human behavior.
So how can we learn more about how company executive are incented? I’m glad you asked!
Finding Incentive Details – The DEF 14A
If we’re talking about companies in the United States, the king of documents when it comes to incentives is the DEF 14A (sometimes called a Schedule 14A or annual proxy). This document is typically filed by public companies annually with the SEC.
So how does a person find the DEF 14A document? Simply search for the company’s EDGAR filings!
Once you’ve found the company (be careful, sometimes there can be multiple companies with similar names) in EDGAR, you’ll then need to refine the results down to just DEF 14A filings:
In this case, I punched in ‘Southwest Airlines’, a company I happen to like and own shares in. Every year one of these DEF 14A documents should be filed by public companies.
Once you’ve found and opened the DEF 14A document, direct your attention to the section called “Executive Compensation” or “Compensation Of Executive Officers” and start reading. This is usually where you’ll find the meaty bits about executive incentives.
In Southwest’s case, executive compensation is made-up of three components:
- Base Pay (a base salary for the CEO of $675,000)
- Short Term Incentive Compensation (an annual award of up to 150% of base pay for the CEO)
- Long Term Incentive Compensation (RSU equity awards up to 600% of base pay for the CEO).
These three compensation components are pretty standard across most companies The amounts and awards do vary from company to company of course.
Where things get more interesting is when you look at the scorecards for how executive awards are applied. In other words, what hoops are being set for the CEO to jump through?
In Southwest’s case, they use a management incentive scorecard like this:
For the long-term incentive compensation, they also use an additional scorecard for determining executive rewards:
Interesting isn’t it? Ultimately these programs as defined in the DEF 14A will drive executive behavior and stock performance.
As you can see in the tables above, Southwest puts a strong emphasis on ROIC and company profitability by using hard metrics in these two scorecards. (You can read the details in the actual filing)
I really like how Southwest handles their executive compensation programs — not only do they provide “0% Thresholds” (which is very uncommon), but it’s also one of the simplest and cleanest incentive programs I’ve ever seen. Given that, I think this plan is one of the “least likely to be gamed” executive compensation programs around.
This is one of the reasons why I made my Southwest investment — I saw good incentive plans in-place that should drive excellent shareholder rewards in the future.
These healthy incentive plans have also been in place for many years. I saw no evidence of “shifting metrics” or “lowering the bar” when bad years happened — Southwest maintained a focus on ROIC levels even in bad years.
Have you ever wanted to know how Elon Musk is rewarded at Tesla? Or perhaps you wonder why Netflix is so hell-bent on subscriber growth? Maybe you’re curious why Amazon doesn’t seem to care about profitability?
The answers to these questions and more can be found via reading a company’s annual DEF 14A filing!!
Ultimately, executive compensation is just one small piece of the incentive puzzle to reward behavior. We can infer that executives will drive these incentives downward to the divisions they control and to individual employees they oversee. It’s not a perfect window to incentives by any means.
There are also other incentive plans — Many companies maintain stock option or stock award programs, and even profit sharing plans that drive human behavior. These are also worth looking at closely. (The details on these plans are frequently found in DEF 14A filings.)
When it comes to making investing decisions, I tend to view incentives as an on-or-off switch when making an investing decision — If good incentives are in place the “invest” light switch stays on. If I see evidence of really bad incentives or “gaming”, then my “invest” light switch gets turned off. It’s a no-go.
There is A LOT of variation in incentives from company to company. Clearly can’t cover all the different variations that exist here. A great way to learn more is by simply reading all of the DEF 14A filings from your favorite companies. Yes, it does take a lot of reading!
You’ll definitely learn a ton, and it might just help you become a better investor.
[Image Credit: Flickr]
15 thoughts on “Looking For Incentives”
I didn’t know about DEF 14A. That’s super interesting! I believe altruism exists, but I also strongly believe in the power of incentives no matter it it’s our everyday decisions or stocks. It is important in raising kids as well. When I was little, my mom used to rewards me with some pocket change for good grades. I was SUPER happy to get it and was more motivated to do well in school.
Oh heck yeah … I give my kids incentives all the time.
Interesting, I knew they incentive compensation was published somewhere, I just never bothered to look at it since I mostly do index funds. Still it might be interesting to take a look at what some larger firms do versus my own..
Even if you just invest with index funds you can still learn a lot about how the world works by reading about how major company executives are incented.
Very interesting – I’ve never heard of DEF14A but I can see how it would be useful! So thanks for that.
I do have a question about ROIC and Southwest. Aren’t returns heavily influenced by fuel prices which Southwest executives can’t control? So is there an element of luck involved in the Returns and executive compensation? Or are they hedging fuel prices to minimize volatility?
And what about the impact of events like terrorism, war, or a booming economy? In other words, how much is executive compensation based on luck versus skill?
Mr. Freaky Frugal recently posted…Investing attitude
Mr. Freaky Frugal recently posted…Investing attitude
Absolutely, fuel prices and the economy can have a huge effect on returns. Some years are going to be good years and others will be bad. That’s *supposed to be* the name of the game for skilled executives… which is why I find Southwest’s 0% threshold so refreshing. Often times I see “fishy business” going on when it comes to executive payout plans. In bad years, longstanding metrics get changed, or the bar gets lowered so executives still get a big payout. It’s almost criminal. I think the real skill there is politic-ing the board compensation committee.
Meanwhile, the low-level employees probably won’t get a bonus that year. Disgusting.
I did not know about this, but it definitely makes a lot of sense. I always say that the number one rule of human behavior is that people will do whatever they perceive to be in their best interest, and come up with a justification for it later.
So incentives are very intriguing, as a guide to choosing companies to invest in. The right incentives would, I’d expect, certainly “push” corporate managers to behave in particular ways.
Another common sense approach from Mr Tako that the rest of us never even considered. Brilliant. Thank you for sharing!
Incentives definitely matter. Back when stock options were awarded to management you’d see more focus on retaining earnings than paying out dividends since this effect of holding earnings tends to drive the stock price- even with the drawback of having excess cash to spend on less attractive ROI and potentially some frothy acquisitions.
I bought some KKR a few years ago- it’s a general partnership / limited partnership. I’m disgusted by the incentives there- the GP’s receive annual payouts just shy of 9 figures while the LP’s received a large distribution cut… I’m not seeing the pain being shared to the GP’s. I’m going to exit once I find the right exit price.
Totally agree on the focus on the incentive systems. Sometimes we miss things but over time we will learn to be better investors.
Thanks for sharing and have a great time in Japan.
Thanks Mike! I’m only a little familiar with the KKR situation, but it does seem like the LP’s got the short-end of the stick. Unfortunately I don’t think that’s terribly unusual when it comes to Limited Partnerships.
Cool, didn’t know about DEF 14A, learn something new every day in this blogging world! It’s human nature to respond positively to incentives, otherwise we tend to get lazy! 🙂
GYM recently posted…Things Do Happen for a Reason: Happiness after Heartbreak
I like “the little book that beats the market” too. Haven’t read the new version but I found the original version funny and well written (very rare for investment books).
Interesting way to look at incentives, and how it affects company performance. I’m not sure that monetary incentives is always the best driver for human performance though. I also think a company’s performance won’t always be reflected by how well compensated the executives are. Well paid executives can still suck and drive the company into the ground. But it’s an interesting aspect to consider.
Thanks for the interesting read, Mr. Tako. Incentives are fascinating to look at as it does drive a lot of people’s behavior. Interestingly though, I did find a limit to its effect with my former employees. Certain employees weren’t keen on being able to earn double bonuses, etc. While others would try to max their plans to the last dollar. Anyhow, I’ll definitely be checking out the DEF 14As for my favorite companies. 🙂
Hope you’re enjoying Japan!!
Michael @ Financially Alert recently posted…Unique Ways to Financial Independence #VanLife
This is a great idea! I’m definitely going to start implementing it… http://www.sedar.com/ is the equivalent for Canadian companies!