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Inspiring Leadership

While there are many quantitative aspects to analysing a company, it is often the qualitative ones that can be the most difficult. Assessing the quality of management, with all its nuances, is a good example of this. Generally, we look for businesses where the fundamentals drive the bulk of its value. Be that as it may, it would be overly simplistic to ignore the importance that management can play. After all, even the best built ship needs a good captain.

One of the reasons judging the competency of management can be so difficult, is because not all companies require the same skills from their CEO. Furthermore, the same company may require one type of CEO in one situation and an entirely different type in another. There are many responsibilities that a CEO must manage; for example, setting or maintaining the right company culture, devising a strategy, executing that strategy, and deploying the cash generated by those operations to continue to grow the business and enhance its competitive position. Their most important job, however, can be summarised as creating long term value for shareholders.

Ultimately, the board needs to make sure the interests of shareholders are clearly aligned with the CEO. It is their job to lay out a framework that is conducive to long term value creation. Though, curiously enough, most compensation schemes tend to focus on the near term. This leads CEOs to make decisions based on how today´s stock price will react rather than taking decisions that will create true long-term value. Often, these short-term decisions are harmful for the future of the company. A clear example of this took place a few years ago when several companies in the consumer staples industry started to reduce advertising and promotion spend to meet their profitability guidance. This allowed companies to announced success in reaching their guidance, causing stocks to react positively; CEOs would then get their compensation as they had achieved profitability targets.  The problem was that these measures had negative side effects; they were subsequently followed by a deceleration in sales. Revenues for consumer staple companies are highly linked to the brand, their advertising and the promotion spend related to that brand.

Instead of this short-sighted approach, boards need to design pay packages with incentives and contract structures tied to long term fundamentals and with substantial risk of forfeiture. Ideally, all relevant staff should have skin in the game with a material portion of their personal wealth in equity. This discourages excess risk taking, which is more prone to happen if the CEO is betting someone else’s capital.

Simplifying things, as many of you already know, the value of a business is derived from its future cash flows and, therefore, maximising these is at the heart of long-term value creation. There are three main drivers of cash flows: sales growth, profitability, and asset efficiency – how many resources the business needs to produce that level of cash flow. As a result, remuneration of top management should be closely tied towards enhancing those three cash flow drivers; human decision making is influenced by personal interests, of which wealth usually comes near the top. Importantly, it should also be structured so that management achieves these goals in the right way.

Let’s illustrate what happens if the remuneration package is structured in the wrong way with a simple example. Take the case of a CEO who is approaching retirement and whose remuneration is highly based on net profits. He comes up with two easy routes to boost net profit before he retires: he could sell some of the most attractive company assets to boost net profit; or he could acquire a large competitor, taking on more debt and levering up the balance sheet of the company significantly in the process. The latter example may be particularly tempting given the current level of interest rates. In the short term, both measures are highly likely to achieve his goal of increasing net profits. However, the first measure would compromise future earnings growth and the second would increase earnings by using significantly more resources; it would also increase both execution risk and bankruptcy risk. Nonetheless, net profits, and the CEOs total pay, would increase in both instances. The CEO retires, and, for him, it is the end of the story, happy retirement. The long-term shareholder, however, is left with a fundamentally worse business in both instances.

Coming up with the right structure is a complicated affair, and each company may require slightly different compensation arrangements. But there are some core principles that can be followed to encourage the right sort of strategy and behaviour. A good remuneration package should consist of a balance of fixed and variable compensation, and short, medium, and long dated pay. There should be cash for the base salary and STIPS (short term incentive performance units), so that the team do not entirely lose sight of any shorter-term considerations. By far the largest potential component, however, should come in the form of LTIPS (long term incentive performance units). This part should vary depending on the company’s long-term performance; it should have long dated (three-five years) vesting and lock in periods. This means that, even after the CEO leaves, there is still sufficient time for the market and the incoming management team to determine whether there was true value creation or whether there was an attempt to drive the share price up in an unsustainable manner.

As well as being balanced, companies need to ensure that the level of pay is fair. Again, determining this is far from straight forward but it is extremely important. Too low a level of pay will not attract the right calibre of individuals. If the pay level is too high, the company will be reducing cash flows unnecessarily while potentially causing disgruntlement among employees and even incentivising high risk strategies. Companies can use a variety of tools to benchmark pay. Frequently, pay will be compared with average employee compensation or against similar sized peers that operate in the same industry or region. This is a good first step but it doesn’t consider the management team’s performance; it is hardly fair to pay a CEO the average if he has performed significantly better than his peers.

We believe companies should also incorporate value creation to decide final CEO compensation. Of course, this works both ways. If an average employee does not perform his duties, his contract will be terminated. Yet CEOs rarely lose portions of their compensation, even when shareholders suffer big losses.  There needs to be a mechanism to avoid this. Using absolute total shareholder return (TSR) , rather than relative TSR, can help to achieve this. With absolute TSR, a pronounced drop in the share price will lead to a fall in remuneration, thereby aligning the fortunes of the CEO with their shareholders.

The final challenge is trying to ensure that the level of value creation is captured correctly. Therefore, objectives should be clearly defined, measurable, and should also match the maturity and type of the business. Companies in the early stages of their lifecycle might do well to focus metrics and KPIs (key performance indicators) on growth maximisation. As companies start to scale up and move into the later stages of their lifecycle, they should progressively shift their focus onto profitability and operational efficiency. Therefore, in our minds, it makes the most sense to remunerate management partly on absolute TSR, and partly on ROIC1; if growth objectives are included, these should be focussed on organic sales growth. To us, it makes no sense to compensate CEOs on net profit or earnings per share alone – these measures include no operational efficiency metric, are more easily manipulated and massaged, and often encourage excessive risk taking or over investment, which can lead to significant value destruction.

We are not against large pay packages – if they go hand to hand with value creation and metrics that are clearly defined and measurable. The cornerstone of our philosophy is that, over the long term, earnings drive share prices. With this premise in mind, if a CEO can consistently deliver earnings growth during their tenure, it should be reflected in a similar magnitude in the company’s share price. If this is the case, ´profit sharing´ between the company and the person in charge of devising and executing strategy is more than welcomed because, at the end of the day, this will benefit both shareholders and the CEO.

Sometimes, it may be difficult to assess the quality of management. But through the right framework and the alignment of interests, shareholders can increase the probability that their ultimate goal, long term value creation, is actually met. It’s about making sure that your boat is equipped with the latest technology and the right navigation tools to help the captain get to their destination efficiently and safely.

F, Leon.

30 November 2021

1ROIC is calculated as NOPAT (net operating profit after tax) divided by Invested Capital. It tells us how much profit a company produces for the level of resources or assets that they have invested in and, therefore, how efficient the company has been at deploying cash.

Any forecasts, opinions, goals, strategies, outlooks and or estimates and expectations or other non-historical commentary contained herein or expressed in this document are based on current forecasts, opinions and or estimates and expectations only, and are considered “forward looking statements”. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to be different from expectations.  Nothing in this newsletter is a recommendation for a particular stock.  The views, forecasts, opinions and or estimates and expectations expressed in this document are a reflection of Seilern Investment Management Ltd’s best judgment as of the date of this communication’s publication, and are subject to change. No responsibility or liability shall be accepted for amending, correcting, or updating any information or forecasts, opinions and or estimates and expectations contained herein.

Please be aware that past performance should not be seen as an indication of future performance. Any financial instrument included in this website could be considered high risk and investors may not get back all of their original investment. The value of any investments and or financial instruments included in this website and the income derived from them may fluctuate and you may not receive back the amount originally invested. In addition stock market fluctuations and currency movements may also affect the value of investments.

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