Standing on Principals

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.

Photo: Lisa Runnels. Source: Morguefile

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

By |2017-07-17T12:22:10+00:00January 25th, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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