Value Investing using Economic Value Added (EVA)

EVA Dimensions: Any Idiot Can Increase Accounting Profits.

Video: FMN October 2009 - Segment Two: “EVA Momentum: One Ratio That Tells the Real Story”

Bennett Stewart, EVA father, talks about his new measure - EVA Momentum - The only ratio that encourages profitable growth.

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via evadimensions.com

TARP CZAR doesn’t understand why bankers get paid when their banks make money

It's bizarre to watch the collectivist instinct of the people that have come to power in this government.  Most of the people come from Academia - like our President, or from government.  Few come from the real world - I guess by their actions and words.  My friend Marc Hodak nails this with the following post concerning Elizabeth Warren - the TARP Czar.

Elizabeth Warren is discouraged.  Not with regards to her job of overseeing TARP spending, on which the Harvard professor has done a very decent job.  She is “speechless” at the prospects that certain bankers may get record bonuses this year.

“I do not understand how financial institutions could think they could take taxpayer money and turn around and act like it’s business as usual,” Warren says. “I don’t understand how they can’t see that the world has changed in a fundamental way - it’s not business as usual.  All I can say right now is they seem to be winning this argument.”

It’s not an argument, Liz; it’s a business model.  The financial services business model is actually quite simple:  employees get 50 percent of net revenues.  The stable portion of this net revenue is paid out in “salaries” and the uncertain, variable portion of this net revenue is paid out in “bonuses.”  The “bonus” portion gets split in rough proportion to who brought in the revenues.  All this goes on regardless of how “the world has changed.”  Last year, net revenue was lower, and bankers on average got much less.  This year, net revenues are higher, and bankers (the ones who survived the carnage, anyway)  get more.  What’s not to understand?

Read Marc's whole post at the link below.

Elizabeth Warren doesn’t understand » Hodak Value.

6 New ValueAligned Pay Practices at Valeant

Valeant CEO's Pay Package Draws Praise as a Model - WSJ.com.

In the above article in today's WSJ, G Mason Morfit, chairman of Valeant's board compensation committee and a partner at ValueAct, an activist hedge fund whose 22% stake makes it Valeant's largest shareholder, lays out 6 pay practices that mimic a private equity pay plan in a public company. 

While the article does not say what metric - sales, earnings, ROIC or EVA - annual cash incentives are tied to, we can see from the graph below that after the new CEO Pearson arrived in 2/2008 he was motivated to improve economic margin^{tm  _{right away.}}

^{_{Economic Margin or EM on productive capital (calculation details here) explodes in 2009 to over 30 from 5.2 the year before.  How did he do it?  He sold poor performing businesses, slashed research spending and partnered with another firm to introduce a big drug.}}

^{_{The stock market results so far - +105% since the new CEO started with aligned equity incentives:}}

What's the magic formula?

1. Make top managers buy lots of stock with their own money.

2. Tie equity grants to total shareholder return - share in wealth created don't dilute it.

3. Be generous on the upside, but tough on the downside.

4. Don't grant equity automatically every year.

5. Don't backslide - no bonuses if executives miss targets.  Board will not make up reasons to award bonuses.

6. Scrap entitlement perks like car allowances and club dues - let them buy what they want and need with their own money.

These are indeed aligned motivating incentives, but one size does not fit all type of companies.  For instance, retaining technology executives would be difficult without competitive value option grants each year.

It's nice to see how implementing a ValueAligned bonus plan can still motivate executives to take tough, but value creating decisions.

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Big Bonuses and Risk Taking

My friend Marc Hodak writes here about Congress' attempt to eliminate perverse incentives at too big to fail firms.  Of course, Congress does not even know what they are trying to control.

He examines 7 questions that the compensation information firm Equilar finds that companies are asking in their recently filed proxies.  Marc is OK with six of the questions but one stands out as a "teachable moment" to use a recently popular phrase.  He writes:

“Do large maximum bonus opportunities promote risk taking?”

Of course they do.  Is that supposed to be a bad thing?  Entrepreneurs have unlimited bonus opportunities–thank goodness.

The question of a maximum bonus opportunity is simply the wrong question when talking about reward systems.  The question they should be asking is whether steep bonus opportunities are combined with zero bonus opportunities.  All the governance risk faced by a company is in the area where the participant would earn no bonuses unless they can get up into the green zone of bonus payouts with an all-or-nothing, double-down, longshot bet.

So, guess which of those questions most congressmen view as the most critical in determining “excessive compensation risk?”  Yep, the risk that business executives might get paid too much.

Why is any company public? - I often wonder. 

Also, my readers familiar with the incentives at hedge funds will understand that Marc is talking about the free "trader's call option".  When hedge fund managers are in the red zone - where they do not earn performance bonus-there is no penalty, no clawback.  Therefore, like Marc says, the manager has an incentive to take much more risk than "normal" to get a near-term large pay-off. 

There is no free lunch though.  Incentives become drastically misaligned in the red zone as the risk taking incentive is strong for the manager but not necessarily as big for the client.  These asymmetric (mis-aligned) incentives have always been my main criticism of the typical 2% and 20% of profits fee structure. 

It is also why many EVA companies have tried hard to implement bonus reserves where excess near term performance bonuses are held in reserve to make sure performance improvements are sustained in subsequent periods.  This way Boards more easily replicate ownership-like incenitves deep within the organization.  If there is risk of loss then managers can have large bonus opportunities.

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Five commandments for paying the boss

Back in 2006 before the world of finance fell apart, FORTUNE's Shawn Tully wrote an article (here) in which he laid out 5 rules that boards and shareowners should follow when crafting executive compensation.  If only someone listened.  We would not have as many examples of CEO and top executive pay coming so unglued from economic performance.

Of course, there are many exceptions like Harsco (HSC), Herman Miller (MLHR) and Briggs & Stratton (BGG), but they are few and far between.  Tully writes:

Misguided pay is expensive; worse, it is a recipe for decline, because it rewards self- defeating behavior, such as inflating earnings per share to wow Wall Street.

It is up to corporate boards to stand up to the bullying of the compensation consultants and to design plans that work for the best interests of the company. One place to start is to limit severance pay and eliminate bonuses when executives don't perform.

"You don't get paid for failure if things don't work out in a leveraged buyout," notes a prominent hedge fund manager. "Why should you in a public company?" And if performance is not sustained, CEOs should pay back the big bonus.

Such clawback mechanisms make it less likely that CEOs will "pump and dump" - that is, buy earnings through bad management (e.g., cutting R&D), then sell when the stock price begins to drop a few months later.

CEOs that pump and dump?  CEOs that leverage their companies to the hilt? Earning hundreds of million dollars before you get fired and the new guys get hauled in front of Congress while you figure out how to hide your dough off-shore somewhere?

Maybe some of that behavior could have been avoided if boards would follow these five FORTUNE commandments:

I. Thou shalt pay shareholders first.

 

II. Thou shalt base bonuses on economic profit.

 

III. Thou shalt not rely on restricted stock.

 

IV. Thou shalt favor options, cautiously.

 

V. Thou shalt force CEOs to hold, not sell.

 

I'll have something to say about each of these in later posts.  Value-Aligned companies already explicitly follow these rules - that's only 10% or so of the Russell 3000.  Pity the fools that hold forever the rest.

 

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Risk v Executive Reward

All this screaming about excessive incentives for risk taking.  I think it has more to do with asymmetric incentives.  If you give someone the motivation to make a huge amount of money without losing much, then you have done a poor job of incentive design.

The crazy thing about all this talk about pay design for top executives like in this WSJ article today, is that it mostly talks about the pay for the titular heads of these massive companies.  What about the people at the operating levels? And those traders that bet everday with the firms' money?  Those guys that headed the units for mortgage lending? It's the operating guys that we need to restructure pay for.  They take the risks.

Here's my suggestion:  Pay them in variable cash bonuses linked solely to the intrinsic value growth of the unit measured by economic profits in dollars (not ratios). Accrue bonuses earned in a reserve and pay 1/3 (or some fraction above a target for "normal" or "expected performance") of earned bonuses in the reserve each year.  There is then something at risk when future performance is subpar.  If they take another job, they lose their bonus reserves.  If they retire they get it.  Of course, for those of you who know me, I could not have invented something so simple but so beautiful.  No that was the invention of the smart guys like Steve O'byrne, Bennett Stewart and Joel Stern, among many others I am sure. 

Here's what Professor Murphy, the guy that wrote the paper with Michael Jensen that got much of the "structure of pay design" discussion started. 

Kevin Murphy, a finance professor at the University of Southern California's Marshall School of Business, says it is possible to control how much risk is built into pay packages. He said compensation fell sharply for CEOs of banks receiving federal bailout money last year, compared with those of other banks and non-financial companies.

Mr. Murphy says paying executives with cash bonuses, restricted stock and stock options creates strong penalties for failure. He says companies also can control risk by paying executives for longer-term, rather than shorter-term results, and "clawing back" pay when big losses wipe out prior profits.

I argue with Professor Murphy that equity in the whole company which is not bought and paid for by the individual does much good - there really is nothing at risk especially if they get paid a lot of money.  But if they earn or pay for their equity I am all for it.  How do they earn their equity?  By giving them the option to purchase it with a multiple of that cash bonus reserve we just talked about.  Or for top executives make them take loans out and buy stock.

But it is a minor argument and probably differs only with the level of executive or employee we are talking about - I am talking about the guys that take the risks - the traders, division heads, etc.  Not the CEO only.  Murphy'sbig contribution in this article though is that clawback thing - we called it a "bonus bank" at Stern Stewart.  And it is designed to mimic ownership like incentives for operating people with a much better line of sight.  They will be less likely to tank the whole company like at AIG if the risks they are taking are borne mostly by them.

Look for more on this topic and please join or email list by putting your email in the box above - we will keep private and only use it to send you information.

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The Radical Experiment in Pay Regulation under TARP

Mark Hodak, my friend and colleague, who worked on the original Shareowner Alignment Index that sparked our idea of measuring and investing in companies whose management team was most closely alignedwith shareowners.

This is an excerpt from the second in a two-part series on executive compensation and financial service regulation. Marc's part one article examines the short history of executive compensation and how it is influencing today’s policy debate over regulation reform.

Most people in and out of the financial industry believe that perverse incentives were at least partly responsible for the crisis prompting the TARP program, initiated in the Emergency Economic Stabilization Act (EESA). Stronger alignment of managers and shareholders would likely have prevented much of the damage we are now facing, and it’s sensible that financial services reforms address those incentives. (my emphasis; this stronger alignment also eliminates shenanigans and poor performance at non-financial companies as well) EESA includes a provision that calls on the elimination of compensation that creates “unnecessary and excessive risks,” a provision reiterated in the American Recovery and Reinvestment Act (ARRA).

Unfortunately, EESA and AARA depend on the Treasury Secretary to make distinctions about what incentives do or do not contribute to excessive and unnecessary risk. This is not an easy call. Even the most seasoned corporate boards, with considerable experience in managing or overseeing financial services firms, have a very difficult time distinguishing compensation-induced risk, even without the political considerations that might drive directors to conflate governance risk and business risk.

For instance, most people equate compensation plans with steep pay-for-performance lines as “riskier” than plans with weaker incentives. Critics argue that stronger incentives induce reckless behavior. In fact, shareholders have been placed in far more danger when the incentive leverage is zero than when it’s steep. The area below targets or goals where there is no longer any more pay-for-performance is where the trader finds his or her greatest temptation to double down in the hope of getting back into the green. This phenomenon is well known in banking circles as the “trader’s option.” The fundamental problem is not the steepness of the plan when the participants are on the incentive line, but the discontinuous incentive leverage across the spectrum of performance. This problem is reinforced by discontinuities across time, characteristic of bonus plans with specific end dates, like the November 30 fiscal year-end for many banks, which means to a manager that anything that happens after that date is of no consequence to my bonus this year. These discontinuities create asymmetry between the risk preferences of the employee versus the shareholders.

Marc Hodak is Managing Director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance. Marc teaches corporate governance at New York University’s Leonard N. Stern School of Business. He can be reached at mhodak@hodakvalue.com.