Do we have too many principals?
Principal-Agent Illustration. Source: Wikipedia.
40 years ago we didn’t. That’s when several researchers described the “agency problem,” where principals own the assets, but agents make the decisions. This can lead to conflicts, like when executives decide commercial air travel is too inconvenient, so they buy a corporate jet instead. Who decides whether the jet is a productivity tool or a luxury?
When executives use corporate resources for cushy perks, it’s bad for shareholders and bad for the economy. So firms designed compensation structures that aligned the interests of shareholders and managers—the principals and the agents: options, restricted stock, and other benchmarks. Under this theory, executives would do well when the shareholders did well.
But it hasn’t worked out that way. Companies perform in the real market, but equities go up and down in an expectations market. The market expects so many earnings, so much revenue, such-and-such cash flow. If these expectations aren’t met, share prices fall. This can create perverse incentives. For example, when new CEOs are hired, it’s in their interest to lower expectations, diminishing the firm’s prospects. That way, when options are struck, the bar is set a lot lower. It’s easier to outperform and make more money. Conversely, when executives are about to retire, it’s in their interest to talk up the shares—improving their payout—irrespective of the underlying reality.
And company managers may engage in more than just talk. Channel-stuffing—where sales are inflated by forcing inventory through a distribution channel—is common when sales don’t meet expectations. Software firms, drug companies, even doughnut shops have been known to inflate their sales numbers in this way. An investor was once at the loading dock of a consumer products company on September 30th, and asked the dock foreman during his lunch break how the quarter had gone. The foreman responded that he didn’t know, the day was only half over.
Regulators have tried to prohibit accounting tricks that allow executives to manipulate earnings, but this is a whack-a-mole exercise. As fast as one loopholes is closed, another is created. Eventually the accounting rules become so Byzantine that they distort financial reporting by their very complexity. By several measures, stock-based compensation has had little or no net benefit to shareholders over the long run.
The solution is to provide incentives based on real-world performance. These don’t have to be complex: just earnings, sales, and market share. Let the investors invest. And encourage managers to manage.
Douglas R. Tengdin, CFA
Chief Investment Officer