Executive pay has been rocketing for decades, exciting the envy of wage slaves. But should investors avoid or opt for stocks helmed by well-rewarded executives, asks Richard Beddard.
First it was the company car, then it was share options – and now it’s the “Long-Term Incentive Plan”. For decades, companies have been finding ways to pay executives more money – they have to, they say, in order to attract the best people for the top jobs.
The headlines usually focus on the obvious outliers – such as WPP’s chief executive, Sir Martin Sorrell, who earned £70m in 2015, up from £43m in 2014. But while Sorrell is an extreme case, pay for CEOs in general has been soaring for decades now. The High Pay Centre think-tank says that the gap between CEOs’ pay and that of the average worker has tripled since the late 1990s. Back then, the average FTSE 100 CEO earned about 50 times the salary of their average employee. Today, as average CEO pay nears £6m, the multiple is about 150.
As a wage earner, you might find this galling. But as an investor, does it matter? After all, if a CEO makes good money for the shareholders, then you could argue that they are worth every penny they get. Yet this is precisely where the argument runs into trouble. The link between high executive pay and corporate performance is in fact extremely tenuous.
Just like employees, shareholders have not shared equally in the bonanza enjoyed by CEOs over the last few decades. The Total Shareholder Return (TSR) – which includes reinvested dividends – on the FTSE 350 index grew by 54% between 2000 and 2013. Total CEO remuneration at FTSE 350 firms more than tripled over the same period.
Some evidence shows that high pay may even hold businesses – and shareholder returns – back. In July, index provider MSCI published a study, looking at executive pay and corporate performance at large US firms between 2006 and 2015. MSCI found that, generally speaking, the more a company paid its CEO, the less well it did. Companies that paid the least (those within the bottom 20%, or quintile, for their industry) delivered a 39% higher TSR over ten years than those in the top quintile for CEO pay.
When a bonus is bad news
So what’s going on? Long-term incentive pay arrangements, ostensibly designed to improve performance over the long run, typically account for more than 70% of total CEO pay. However, while in theory, it might seem to make sense to link CEO pay to corporate performance, in practice it doesn’t seem to be working. It might be that the performance targets are far too easy to achieve, and thus reward relative failure. Or, more insidiously, it may be that performance-related pay is backfiring because the incentives are wrong.
Research shows that bonuses can help to motivate people to work harder in dull, repetitive jobs, where output can be easily measured. But paying for performance is uncommon in high-powered roles. Cabinet ministers, judges and surgeons, for example – whose decisions are rarely made in isolation, and which have consequences years or even decades into the future – are not paid based on performance. Yet a CEO’s pay is tightly linked to the performance of the company they lead, even though there are many factors over which the CEO has little or no control, such as the state of the economy.
The dangers of short-termism
Moreover, when it comes to incentive pay, the “long term” is often a lot shorter than most of us would imagine. A typical so-called Long-Term Incentive Plan (LTIP) links pay to performance over three-year periods. TSR, or a combination of TSR and earnings per share (EPS – a measure of corporate profit), is used as the performance measure. From a shareholder perspective, TSR should be a good benchmark. Shareholders are rewarded in two ways: via dividend income, and in capital gains when they sell.
The TSR embraces both of these, so companies that increase TSR over the long term will make good investments. But TSR is pernicious over short durations (such as three-year periods), because it encourages bosses to boost profitability and thus the share price using short-term measures or financial engineering, at the expense of long-term prosperity.
For example, it might take ten years for a pharmaceutical group to develop a novel drug. While it does so, profitability will be reduced as it bears the cost of research and development. So it makes financial sense for executives on annual bonuses and three-year incentive plans to be less innovative. By reducing investment, and using the funds released to buy back shares, raise the dividend, or buy new businesses, they can inflate TSR quickly.
This short-termism is at its most dangerous when borrowing is used to fund the dividends, buybacks and takeovers, and profits start to fall due to underinvestment in the business. Growing interest payments gobble up more and more of the company’s resources, eventually forcing it to cut dividends, issue more shares, or sell business units to raise funds, reversing earlier short-termism. Making a comeback will be harder if the firm has lost ground to rivals who invested for the long term.
This is not just theory. In 2012, economist John Kay argued in the government-backed Kay Review that short-termist policies, driven partly by this performance-related pay culture, have seen the decline of industrial giants GEC and ICI, the failure of pharmaceutical giants GlaxoSmithKline and AstraZeneca to maintain strong pipelines of new drugs, and the collapse of big banks RBS and HBOS, during the financial crisis.
How did we get here?
If high pay is good for no one but CEOs themselves, then how have we ended up here? It’s partly because CEOs negotiate their own pay and effectively set the level for other board members. But their negotiations are made far easier by the fact that no one involved in setting their pay has any real incentive to exercise restraint.
At most firms, remuneration committees decide what to pay executives – but their members are appointed by the board, and can be highly paid executives at other firms. They employ remuneration consultants who compare the company’s pay with the wage bill of its peers. This creates an imperative to outbid them, resulting in spiralling pay awards.
Fully listed companies must put their remuneration policies to a binding vote every three years, but usually the only shareholders with enough votes to make a difference are fund managers, and they rarely vote them down. Why would they? They are part of the high pay club too, and see little wrong with it. In any case, they frequently outsource voting to proxy voting companies, who may also advise the companies they are voting on.
There is a range of views on how to improve things. The government has this week launched a consultation on corporate governance reform, and how to address concerns around executive pay specifically more effectively.
The High Pay Centre thinks that companies should be forced to publish the pay gap between a CEO and their staff, with the hope that this would shame them into showing restraint. It also proposes an annual binding shareholder vote on pay, and would like to replace the remuneration committee with a shareholder committee made up of the five largest shareholders and a non-voting employee.
As for the sorts of compensation packages we should want to see – ShareSoc, the UK Individual Shareholders Society, publishes guidelines for companies and shareholders. It reckons that average pay at larger firms needs to be cut by more than half from current levels. ShareSoc would also – in most cases – cap annual bonuses at a maximum of 100% of salary, while annual awards under LTIPs would also be restricted to 100% of salary.
For smaller companies, ShareSoc recommends salaries be no more than the median of companies earning similar revenues. That currently equates to between £150,000 and £350,000 for companies with sales of £250m. In smaller companies, bonuses should once again be no more than 100% of salary. Complex LTIPs should be avoided in favour of share option schemes that require a “meaningful portion” of the shares to be held until the CEO leaves the firm. The Kay Review recommended all executive bonuses be paid in shares held significantly beyond the executive’s tenure. The point is to simplify pay packets and to encourage top executives to act more like owners, by giving them a stake in the company that they must hold through thick and thin.
Saying how executives should be rewarded is one thing – measuring performance is another. Growing pay complexity has resulted in inscrutable remuneration reports, running into dozens of pages for companies on the main market. Those on Aim don’t even have to reveal performance conditions attached to share options or LTIPs, and often bury terse statements on pay in the notes to the accounts.
Avoiding the pay pitfalls
So if badly structured CEO pay packets are a burden for businesses, how do you avoid investing in such companies? There are three sensible rules of thumb. Firstly, be sceptical if remuneration is too complex to understand, let alone value. Secondly, compare a CEO’s pay to the value of the shareholdings he or she owns – you want the company to be run by someone with plenty of “skin in the game”. Finally, favour companies that show restraint, through below-average salaries and bonuses.
The poster child for pay restraint is Aim-listed Quartix, which makes tracking devices for vans. These allow businesses to send the closest available vehicle to a job, and fleet owners to check that drivers are driving safely. It’s a highly profitable, fast-growing business with a focused direct sales operation, yet managing director and founder Andrew Walters took a salary of just £81,961 in 2015, and Quartix pays him no bonus, benefits or options.
Instead, Walters retains nearly 18 million shares, worth nearly £64m – 780 times his annual pay. As a CEO, he receives modest remuneration, but as Quartix’s biggest shareholder, he earned almost £1m in dividends in 2015. Clearly, he’s much more likely to be interested in the health of the business, than in milking it for a higher salary. Such probity rarely comes cheap, and Quartix trades at 33-times debt-adjusted earnings. Below we look at four stocks helmed by CEOs with large shareholdings relative to their salary, which are more reasonably valued.
Four good firms with sensible pay structures
Science (Aim: SAG)
Market cap: £57m
Debt-adjusted price/earnings ratio: 14
Martyn Ratcliffe’s £275,000 salary is slightly above the median for a company earning annual revenues of £31m, but it rewards two roles – he’s both CEO and executive chairman of Science. Science’s annual report reveals only one other remuneration item in 2015. It paid him £50,000, 18% of basic pay, for extra time spent integrating the company’s recent acquisitions. Ratcliffe was appointed in 2010 when he bought a substantial stake in Science and while it was developing a sharper commercial focus that has transformed profitability.
Today, he owns 33% of the company, a stake worth nearly 70 times his pay. Acquisitions can be a sign of short-termism, but Science is probably motivated by long-term value – buying other consultancies is a cheap way of recruiting scientists from less commercially adept consultancies.
Next (LSE: NXT)
Market cap: £7.5bn
Debt-adjusted price/earnings ratio: 12
High-street fashion chain Next sits in the middle of the FTSE 100. CEO Lord Wolfson earned £4.7m in the year to January 2016, including bonuses and incentives. That’s more than the £4m median for FTSE 100 firms. However, he received his maximum bonus and more than 75% of his LTIP maximum. While a maximum bonus of 150% may seem high, it isn’t by FTSE 100 standards, and Wolfson receives any amount paid out over 100% in shares.
Although 2016 may not match 2015, Next’s profitability has been high and stable for over a decade. And unlike many of its FTSE 100 peers, shareholders have enjoyed the benefits too – Next’s TSR has grown substantially faster than its CEO’s pay. Lord Wolfson’s 1% stake in the company is worth about £74m, almost 15 times what he earned.
XP Power (LSE: XPP)
Market cap: £330m
Debt-adjusted price/earnings ratio: 17
XP Power makes power converters that are typically installed in medical and industrial equipment. It was a profitable distributor before it started designing and then manufacturing its converters about a decade ago. Now, with more control over the product it sells and sales offices around the world, it’s a highly profitable manufacturer.
The firm is still chaired by its founder, a substantial shareholder, while CEO Duncan Penny joined in 2000. His stake of nearly 2% is worth almost £6m, compared with his basic salary of £260,000, below the median for a firm with revenues of £110m. He receives a bonus and share options, capped at 100% of salary.
Castings (LSE: CGS)
Market cap: £182m
Debt-adjusted price/earnings ratio: 9
Castings makes van and truck parts, and is working through one of its periodic contractions. Recent half-year results show that profit fell by 25% compared with the same period last year, due to the ending of a major contract, the cost of tooling up for new work that has yet to start and reduced demand. But while it operates in capricious markets, Castings has a history of prudent investment and long-term growth, so it should bounce back.
CEO David Gawthorpe is leaving in January, but his successor Adam Vicary, an internal promotion, is unlikely to deviate far from the company’s remuneration policy. Gawthorpe’s salary in the year to March 2016 was £250,000, below the median for similar companies. He received a bonus of 40% of salary in the year to March 2016.