JWI 531 Advanced Financial Management II, week10 notes, 6/12/13
I. Executive Compensation and Public Outrage
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CEO compensation
Cash pay - $1M cap else tax kicks in
Stock options
Bonus
Salary and RSU - preferred way to incentivize execs
Theory
Put a very gifted CEO with a very large firm
Wonderful things happen
Supply and demand for very very talented CEO
CEOs get entrenched with their boards - they are able to extract large amounts of pay
Right BoD gets the right CEO at right pay
- do the fiduciary duty
- understand who the best CEO is
- what is the right pay to attract and retain that person
shareholders and directors should decide the appropriate pay
People get the leaders they deserve
Shareholders get the CEOs they deserve
Shareholders should pay attention
Elect good directors
Monitor management
Go to meetings
Else they might be stuck with CEOs they deserve
Shareholders vote with their feet
Institutional investors can put forth proposals about pay and management
Pay attention to what the Board and management are doing
Shareholders must ensure right people are sitting on board
and CEOs are being monitored very well
Shareholders should ask:
Do we have the right strategy?
Do we have the right leader and is he or she being paid the right amount?
Shareholders shold get involved
- keep an eye on management
- who is on the Board; independent watchdogs ?
- what is the relationship between the board and the management of the firm ?
Better governance, not bigger government
II.Charlie Munger's 10 Rules for Investment Success
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http://www.fool.com/investing/general/2007/12/13/charlie-mungers-10-rules-for-investment-success.aspx
1. Measure risk
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All investment evaluations should begin by measuring risk, especially reputational
Avoid questionable characters, give yourself a large margin of safety
2. Be independent
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Believe that what you're doing is right
Don't follow the heard to mediocrity
Succeed by going against the grain - when others are jubilant, be scared
Do what is ignored by the masses
3. Prepare ahead
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To win, work, work, work and hope to have a few insights
Read thousands of annual reports to cultivate ideas
Be constantly curious about everything in life.
Never stop asking the "whys" in what you do
Stay motivated
4. Have intellectual humility
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Acknowledge what you don't know - this is the dawning of wisdom
Invest in comfort zone - know what the business will look like in the future
5. Analyze rigorously - embrace simplicity not complexity
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Use effective checklists to minimize errors and omissions
Estimate the security's worth first, before you look at the price.
Focus on value of business not market forecasts and timing of business.
6. Allocate assets wisely
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Proper allocation of capital is an investor's No.1 job.
When good ideas come, pour capital into them.
Else, simply enjoy the sun.
When you find a great investment, don't be afraid to bet big on it.
7. Have patience
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Resist the natural human bias to act
Sit on your ass and read
Talk to highly gifted persons you trust and trust you.
Make big commitments in quality companies, then hold on to them.
8. Be decisive
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When proper circumstances present themselves, act with decisiveness and conviction
Don't let others' emotions sway you
9. Be ready for change
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Accept unremovable complexity
Sometimes your best ideas will prove incorrect.
Roll with the changing market
10. Stay focused
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Keep it simple and remember what you set out to do.
In chasing little, unimportant things, don't overlook huge and critical factors.
Keep it simple - fixate on what really matters.
III. Corporate Governance (WK10L1)
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Goal:
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Good governance
Take more responsibility and fewer risks in short term
Help company generate substantial long-term shareholder value
Good Governance is Good business
Good Governance does not guarantee that a business will be successful
Success does not guarantee a cmpany will use good cororate governance practices
Shareholders or employees of a company have their future tied to efficiency and sustainability of the business
Need to consider how organization is run and whether it is built to last for long term
Many investors and general public have lost patience with corporate irresponsibility
Financial decision makers must now be acutely aware of how a business is run from a structural standpoint.
Smart companies understand: Good governance drives a healthy bottomline.
Steady stream of profits, ignoring corporate governance, can lead to unhealthy results eg. financial crisis.
(1) Board of Directors
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- Shareholders own the company and have the right to elect a Board of Directors (but in reality this is an undemocratic process - 99% individuals nominated by the company's exec team run unopposed)
- Finding a shareholder friendly board is important
- Board has a huge amount of power over the company and its shareholders.
- Responsibility of the board is to keep the executive team in check.
- Board determines who runs the company, how much they are paid and overall strategy.
- Board sets pay of top executives
- BoD supposed to act on behalf of shareholders and ensure management is running the business properly
- To test a Board's fitness & suitability, examine the makeup, rules, processes for nominating and electing new board members
(2) Corporate Governance Definition
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- Responsiveness of a company to its owners, the shareholders
- does the company protect shareholder interests?
- structure of BoD
- independence of BoD
- board's oversight of executive compensatio
- ability of shareholders to call special meetings
- include local communities, employees, environment
- values: integrity, honesty, transparency
(3a) Good corporate governance procedures can
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- help leaders evaluate the strength of a business partner
- decipher the inner workings of a Merger or Acquisition target
- fend off a hostile takeover
- find a reputable employer and increase its profits
(3b) Companies with good corporate governance
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- select the right Directors for the Board (the heart and soul of good corporate governance procedures)
(3c) When investing in such a company as an employee, customer or owner, you
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- entrust your reputation, money to the organization's management team
- trust this team to act as competent, vigilant stewards of these valuable assets
- ask they demonstrate transparency in their actions
- ask they invest themselves and their money alongside the average stakeholder
- ask that they don't pay themselves huge bonuses when their individual performance does not warrant it
- ask they seek out independent viewpoints to allow for superior decision making
- expect the business to be run as honestly and efficiently as possible
(3d) Good corporate governance procedures are designed to protect against bad behavior
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Strong practices and controls
ensure rules are followed
right people benefit from the success of the business
good corporate governance leads to robust financial performance
market rewards good corporate governance, punishes shady behavior
Effective governance protects from impact of bad decisions
Bad decisions can be made in all corporate governance environments, weak or strong
(4a) Companies with poor corporate governance
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- make decisions that adversely affect the interest of shareholders
eg. excessive bonuses for underperforming executives
- weak corporate governance structures allow bad decision making
- By definition, Management and Board are not supposed to get too cozy.
But too often though they form close relationships after working together over the years
In reality, too often, management teams abuse their positions
- they treat shareholder money like it is theirs
- become secretive
- greedy
- dictatorial
(4b) BoD Conflict of Interest
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- Board sets their own pay: potential for conflict of interest exists (shenanigans)
- If CEO is also Chairman of Board, then fox is guarding the henhouse: potential sign of a weak board
- A company nominating questionable people to the board
individuals who have ongoing business interests with the company: employees, friends and family of the management team, resulting in related-party transactions
people with little industry experience who can be manipulated by management
- Related Party Transactions
A business deal between two parties that have a relationship aside from the business transaction itself
eg. a corporation may deal with relatives of executives or with companies owned by its executives or major shareholders
(4c) BoD voting process
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plurality voting - get elected with margin of a single vote: weak corporate governance allows this; board members can get a seat even without receiving 50% votes shareholders cast
majority voiting - need to earn a majority of votes to gain a seat
(4d) Dual Share-Class Structures: Self dealing management
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Designed to redistribute decision-making at the board level: insiders like managers and directors typically own a minority stake in the company but control majority of voting rights
Violate one share one vote concept
Class A preferred stock = boost employee power to 10 votes per share; outside sharehlders get a single vote per common share.
Sophisticated investors move away from buying shared with lesser rights - they know their interests will be overlooked since their votes carry less weight
Dual share companies tend to have higher cost of capital
It begs the questions:
Does management treat shareholders as partners?
Is management capable ?
If answer is No
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Managers can insulate the company from proxy contests, hostile takeovers
Protect themselves from being removed for incompetence
If answer is Yes
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Multiple classes of shares can allow management to focus on creating shareholder wealth for the long term
eg. Berkshire Hathaway
Techniques to defend firm against invaders
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Any of these techniques when used inappropriately can do damage to shareholders.
From anti-takeover provisions they can become dangerous management weapons quickly.
Poison pill can seriously dilute ownership levels of legitimate stockholders.
Redesign of corporate capital structure of a company may suit management interests but not necessarily interests of common shareholder
5a. Anti-Takeover Provisions to repel corporate invaders
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Significant ramifications for employees and investors
Financial weapons a company can deploy to dissuade another company from taking it over
companies use these defenses to fight off unwelcome competitors
these provisions can be highly destructive to the common shareholder
5b. Poison Pill Deterrent to take-over
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The company's BoD passes a resolution that grants existing shareholders the right to receive additional shares of stock.
if an entity purchases more than a small fraction (eg. 10%) of the company's outstanding shares.
If someone acquires enough shares to cross the hurdle, rights of other shareholders to obtain new shares immediately take effect.
Dilutes potential acquirer's percentage ownership in the company.
Company could issue so many additional stocks that an acquirer could never gain a controlling interest.
Forces acquirers to spend more than they expected in order to biyout a company's shares
Poison pill is Rarely triggered because
BoD can cancel the poison pill
Potential acquirer' seek the agreement of a company's board as an initial step in a takeover bid
5c. Interlocking director terms
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Makes it impossible to change BoDs at a single annual meeting
5d. Golden parachutes
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Requires Large payments to executives if management changes
5e. Warrants
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when attacked, warrants are issued, allowing shareholders to greatly increase the number of outstanding shares
5f. Macaroni defense
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Issuing bonds that require large cash payments to redeem
5e. Pac-Man Defense
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Retaliating with a hostile takeover bid against an acquirer
5f. Greenmail
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Pay the corporate raider to go away
5f. Scorched earth defense
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Destroy or liquidate a company's crown jewels, the most valuable assets
Assume new large debt liabilitis
Take measures to make the company unattractive to a hostile bidder
6a. Related Party Transactions
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A business deal between two parties that have a relationship aside from the business transaction itself
eg. a corporation may deal with relatives of executives or with companies owned by its executives or major shareholders
6b. Change-in-control payments
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Special bonuses offered to executives should their company be acquired
6c. Classified board
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Less friendly to shareholders
Directors in board elected at different times and serve differing lengths
Makes takeovers or drastic company changes more difficult
6d. Transparent disclosure
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A company is up front about forthcoming problems
Good for shareholders
6e. Poison Pill
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Provision that immediately dilutes company ownership
Offers more shares to existing shareholders - makes a hostile takevoer expensive
6f. Dead-hand provision
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Provision allows poison pill to be removed only by the person who set it in place.
Goal is to make it more difficult for hostile acquirer to remove the poison pill
6g. Say-on-Pay vote
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Provision gives shareholders a right to vote on executive pay.
Can be binding or nonbinding
6h. Clawback policy
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Rule enables company to recoup prior incentive based pay from executives in the event that corporate earnings are negatively restated or when execs are later accused
of misconduct
7. Organizations researching corporate governance
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Corporate Governance Quotient CGQ data from Institutional Shareholder Services
theCorporateLibrary.com provides in-depth discussions of corporate governance levels at various firms
IV. The Financial Consequences of Executive Compensation (WK10L2)
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Executive compensation - core focus of HR professionals in past; now also financial analysts
Incentives are key
Pay attention to incentives execs receive via their compensation packages
"Never, ever think about something else when you should be thinking about the power of incentives", Charlie Munger
Understand which compensation package enables positive outcomes and which ones can court disaster
1. Poorly designed compensation schemes for execs
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- When a leader's financial incentives are poorly constructed, the organizational outcomes tend to fare poorly as well
- Execs being lavished with bonuses while companies underperform or even fail; just not right
- negative financial consequences for shareholders, employees, customers
2. CEO Responsibilities (ECC)
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(1) Empower: the right people to run day-to-day operations of the business
(2) Capital allocation: Make the best possible capital-allocation decisions
(3) Culture: Foster and implement long-term strategic and cultural change
3. For handling these crucial roles, CEOs are handsomely rewarded.
This is not a bad thing.
It takes rare talent to run an organization properly.
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People should be paid well if they deliver the goods
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Talent and performance need to be rewarded
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4. What is going wrong today?
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- CEOs are given incentives to hit wrong targets
- Many execs receive large sums of money regardless of whether they are ultimately successful in hitting these targets
- high executive compensation is one of the clearest indications that a company will underperform over the long term
- higher the "CEO pay slice" (avg 35%), the CEOs portion of the company's total compensation, less likely a company will earn in future.
- many well paid CEOs cannot justify their gaudy compensation packages
- CEO to average worker pay differential higher than 20:1 endagers morale and productivity
Avg US CEO makes 263x more than average worker (Anderson et al, 2010) vs 525x (2000s) vs 107x (1990), vs 42x (1980).
- higher CEO pay does not produce higher results (higher pay correlates with but does not cause bad performance)
5. With right incentives, a good CEO will steer his company in the right direction
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5a. The wrong way to craft incentives (Enron story: Conspiracy of Fools, 2005)
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Failures of the worst compensation systems
- execs and CEOs receive large sums of money even when they missed targets by a mile and did unethical things
Jeffrey Skilling cashed $60M in shares before the company declared bankruptcy
- execs handsomely rewarded for achieving objectives which were harmful to their organizations eg Enron
Booked inflated earnings, shifted huge debt and losses off the balance sheet through special purpose entities
Rewarded executives for creating spikes in price of electricity; this led to 38 rolling blackouts across California
- Impact: Destroyed the company, brought down Arthur Andersen accounting firm, investors lost billions,
damaged lives of 10s of thousands of employees, millions of innocent victims in process
Compensation scheme can ultimately make the business worse-off eg. sales growth metric
Higher sales does not mean the org is built for long term
A self-interested CEO can push short-term sales growth, reap financial reward and damage long term fortunes of the business
5b. Solution: Keep incentives in line with what you want the CEO to be doing
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Key Metrics & Questions to align performance with incentives & create effective executive-compensation structure
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Long Term Bias - Does it minimize short-term thinking ?
Shareholder interest - Does it match up CEO and shareholder interests?
Fraud-Proof - Does it reduce opportunities for fraud?
Wholesome Decison Making - Does it generally encourage good decision making ?
When evaluating a company's compensation scheme, know
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(1) the benchmarks on which the board is basing executive pay: right plan in place, and right metrics within the control of the CEO
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(2) how much the CEO is getting paid to attain those benchmarks: Scale of pay; how much guaranteed vs pay for performance? how much is tied to metrics that CEO can control?
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Compare total pay vs net income: 2-4% of a company's net income typically turn into CEO compensation
Look at comparable companies to determine appropriate pay levels in the industry
Look at company's proxy statement (notice of annual general meeting of shareholders): board's compensation, audit committees, important details of executive pay
(3) trustworthiness of directors who set the compensation: Quality of the board - a strong board will find a workable compensation system
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- Upstanding
- Conservative
- real independence
- realistic incentives
6. Ideal CEO pay package
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Good corporate governance comes down to good executive incentives.
Well-constructed pay package should have 3 elements (Nell Minow, Corporate Library):
(1) Meaningful Clawbacks - if numbers were misstated, bonus given must be recouped or "clawed back"
(2) Low up-front payments with a payday when things work out
Incentive compensation should be attached to specific performance goals or to outperforming a company's peer group
(3) Long term restrictions on stock sales: Execs should never be allowed to sell stock from Restricted stock grangs or
realized options right away, and at least until 3 years after leaving the company.
Decisions CEO makes should not only guarantee corporate success when he is there, but also long after he is gone.
7. Get executive compensation right
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With Effective package of incentives, the company will be built to last from top down for all:
Employee looking to work for the right leader
Investor struggling to identify a safe investment
Board member looking to structure a CEOs compensation package
V. Ten Rules to Live by in Finance (WK10L3)
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"It is not about the tool, it is about the carpenter !"
It takes years of practice to use strategies effectively
Guidelines for financial decision making and saving financial headaches
(1) Debt Kills
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Stay conservative with debt of all kinds and avoid it outright, if possible
You can make a lot of money without borrowing
Excessive debt has destroyed many financial decisions
(2) Expand your time horizon
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Dont give in to short term performance pressure
Ignore short term volatility, avoid reckless and reactive decision making
Position a business to succeed for decades
Rome was not built in a day, and neither are great businesses
(3)Stay conservative
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Consider a range of outcomes, not just the most optimistic ones
Results you achieve matter more than what you want to happen
Dont promise more than you believe is possible
Be cautious and honestly capture the downside
(4) Dont let the tail wag the dog
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Confirmation bias - deciding before analyzing the data
Data should inform decisions. Not the other way around.
(5) Dont put all your eggs in one basket
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Diversify to protect against something going wrong
Prevent total failure
Be able to walk away from mistakes or uncontrollable events and get back in the ring for another round
Dont take more risk than you feel comfortable losing
(6) Trust but Verify
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Verify accuracy of data used to build complex models that fuel critical decisions
Go to the source of the data - the originial documents; owners who speak to facts on a first hand basis
(7) Check your emotions at the Door
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Emotions cloud judgment in the middle of a dramatic event but dissipate over long term
Intense emotion is the enemy of effective financial decision making
Emotions follow Big money
When stressed, take a break - few breaths, minutes, days - to revisit the issue
" control urges"
(8) There is a right & a wrong price for everything
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Do not overpay for acquisitions
Things that were written off for a song are actually hugely valuable.
(9) " Risk Adjusted" Return is what matters
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Assess risk in a particular action
how much will the payoff be once you calculate the likelihood of happening * factor in how bad it could get if things didn't turn out as you expect.
(10) Never Stop Learning
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Improve financial decision making through life long learning
Expand and ruminate over the lessons learned.
Become comfortable with complex ideas and put your knowledge to practical use.
If price were to knock down 20%, 50%, 90%, people could get interested
No matter how attractive, there's a price at which you need to say "no thanks" and move on
Reference
http://blogs.hbr.org/cs/2013/04/when_best_practices_dont_travel.html
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