"Never, ever think about something else when you should be thinking about the power of incentives." -- Charlie Munger
What brings the crowds to the ballpark? For years, many general managers thought it was the star players who jacked home runs left, right, and center. Such "big sticks" earn the headline-grabbing payouts, sure, but as Oakland A's general manager Billy Beane showed, the key metric to attracting fans is wins.
So what's this have to do with investing?
"Aloha" means "good buy"
Beane carefully examined what really drove profit-producing fans to the ballpark. Muscle men "swing for the fences" because they are paid handsomely for their success, even though they often strike out. Beane discovered that a less expensive player with a higher on-base percentage could help the team win more cost-effectively. Because he understood the power of incentives, Beane changed how his players were compensated, paying them to get on base, draw walks, and avoid outs. In short, he managed to revolutionize the way players were incentivized. And following Beane's system, the Oakland A's suddenly became one of the winningest teams around the turn of the 21st century.
Similarly, the way your companies incentivize executives is absolutely central to how they perform for you. It can determine whether the managers are in it for themselves, or whether they are working to turn your shares into not just a four-bagger, but perhaps an eight-bagger, a ten-bagger, or more.
A case study in incentives
Nell Minow, corporate governance expert and founder of research firm The Corporate Library, advises that compensation is the first thing you should consider when examining a potential investment because "it's less susceptible to manipulation." She also notes that incentive compensation should have both an upside and a downside. After all, it's hardly an incentive if the CEO doesn't have to work hard to earn it.
Tech companies such as Microsoft (Nasdaq: MSFT ) , Cisco (Nasdaq: CSCO ) , and eBay (Nasdaq: EBAY ) were all huge proponents of options back in the go-go stock days some 10 years ago. But as we learned, giving options to managers doesn't always align their incentives with ours. Among other reasons, options don't usually force executives to put their own money at risk. Managers reap a bonus if the stock goes up, but aren't penalized if the stock declines. Like the ESPN highlight-reel muscle men, options often encourage execs to take risks and swing for the fences over a short time horizon, at the expense of long-term profitability.
A board of directors that is too friendly with the CEO also likely spells trouble for shareholders, since they're inclined to play loose with the purse strings. As Minow states, "It is a very rare CEO who wants to surround himself with people who criticize him. When they surround themselves with people who don't know anything about business, or who are basically in their pocket, that's a bad sign."
Minow favorably mentions the shareholder-friendliness of CEOs such as Costco's (Nasdaq: COST ) Jim Sinegal, JPMorgan's (NYSE: JPM ) Jamie Dimon, and Fool favorite Berkshire Hathaway's (NYSE: BRK-B ) Warren Buffett.
One ugly example
If there are a few good ways to incentivize managers effectively, there are a million bad ways. The latter is the case with three-time Motley Fool Hidden Gems selection Middleby (Nasdaq: MIDD ) . The company was a notable star as it came out of an operational turnaround, and the newsletter's three separate recommendations of the stock rose nearly 400%, 100%, and 40%. The Hidden Gems team even added the stock to its real-money portfolio in early 2009, and scored a 42% gain in less than a year.
But the power of executive incentives was not lost on Hidden Gems co-advisor Seth Jayson, who noted in early January that "Middleby management and board members don't regard incentive pay as incentive pay." The board had cancelled a large grant of restricted shares to executives, mostly to CEO Selim Bassoul, which would have vested only if the stock traded between $60 and $80 over the next two years. The stock had traded between $45 and $55 or so over the previous six months.
Then the board changed the yardstick for success, replacing the cancelled shares with new ones that would vest if the company managed to earn a meager return on equity (ROE) of just 10% to 12% over the next couple years. That range is not a particularly high return, and if you combine it with Middleby's high debt financing, a tactic that boosts ROE, the hurdle is ridiculously low.
How low? Amazingly, that range implies that earnings would have to shrink 40% to 45% over the next couple years. Anyone could roll over that hurdle without getting out of bed. In fact, Seth calculated that the managers could actually destroy shareholder value and still walk away with their incentives. After you finish picking up your jaw, you'll learn that the board of directors even gave management a mulligan. "Finally," explains Seth, "the fine print ... gave executives a built-in do-over clause should they miss the metrics, as well as allowing the board to exclude pretty much anything it wants from the relevant calculations."
Because of these nagging incentive issues, Seth made the tough decision to sell the company in January, despite the stock's stellar performance over the years. The incentives simply weren't in place to create strong returns for Hidden Gems subscribers.
An invitation to a journey
As Charlie Munger, Billy Beane, and these other experts understand, you get the performance that you incentivize for, and that is one of the key criteria that Motley Fool Hidden Gems examines in its search for the market's overlooked small-cap stocks. When managers' incentives are truly aligned with our own, we have the best chance of getting those managers to increase our returns. Combine that with small companies that are underfollowed by Wall Street, and you have a potent combination for explosive gains.
If you'd like our experts to help you find superior small-cap ideas, you can check out all of our Hidden Gems stock research, as well as our 13 "Buy First" small caps for new money now, free for the next 30 days.
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Fool contributor Jim Royal, Ph.D. owns shares of Microsoft and Middleby. Berkshire Hathaway, Costco, and Microsoft are Inside Value selections. Berkshire, eBay, and Costco are Stock Advisor picks. Motley Fool Options has recommended a diagonal call position on Microsoft and a bull call spread on eBay. The Fool owns shares of Berkshire and Costco, and has a disclosure policy.