Mr. Yacktman criticized the awarding of stock options as an incentive for management. Specifically, having all upside and no downside does not align the manager with the stockholder. As an alternative, he offered the discounting of outright share purchases, but, more importantly, he advocated the supremacy of cash bonuses, not stock awards, for the senior agents of the corporation.
Here, his reasoning was simple – the stock price will not necessarily (in fact, rarely does) reflect accurately the performance of the individual divisions of a company. A division may do great while the company flounders and the stock tanks. A division may be a drag on a flourishing enterprise whose stock marches higher in spite of it. And, perhaps worst and most common of all, a division may do great or poor, and the company may do great or poor, while the stock will do whatever the manic vicissitudes of the stock market dictate over the short run. Mr. Yacktman’s insights prompted these two four-squares:
Business Unit Performance Is Good
Stock does poorly
Not fair to manager
Stock does well
“Lucky” for manager but fair
Business Unit Performance Is Poor
Stock does poorly
“Lucky” for shareholders but fair
Stock does well
Not fair to shareholders
Stock awards create an inherent gamble between management and shareholders. If a stock does poorly – for whatever “reason” – the good manager will not have received his just rewards, while the shareholders will have at least avoided having to come up with any real dough to compensate his efforts – shareholders win, in other words.
On the flip side, if a stock does well, the shareholders will have over-compensated the incompetent manager with windfall stock award profits – management gets away with a “fast one” win. In those events, when the stars align and the stock performs in line with the performance of the business unit (either good or bad), justice is served, but I qualify this as a “lucky” event for, as most value investors would agree, stocks – in anything but the long-run (much more than one year) – are not marked rationally while incentive systems generally reflect annual results (the better ones do have some element of “rolling years” to them).
The four-squares above do, however, show that an intelligently constructed (an assumption) cash-based incentive system will be fair regardless of what the stock price does, and this is Mr. Yacktman’s wise contention. My only addition to the matter would be the advocacy of the shareholder vote for top management pay. And this is to head off the major issue with the cash-based system – the assumption that the system is in fact intelligently constructed and not easily manipulated for the gain of management. I figure that if the top management pay is visible, scrutinized, and controlled by watchful, skeptical shareholders (well, at least, value investors tend to be), top management will, in turn, be quite interested in just how (or how much) their senior lieutenants are being compensated. In essence, shareholders, in controlling top management pay, can harness the power of envy to ensure a more rational and more shareholder-friendly distribution of profits throughout the organization.
Eric Houssels is the co-founder and managing member of Houssels Capital Management, LLC, a money management firm based in Las Vegas, NV. The firm focuses on investments in the stocks of publicly-traded companies of all capitalizations that possess, preferably, significant earnings power or, alternatively, assets that can be (re)deployed to achieve significant earnings power and are trading at reasonable valuations. Houssels Capital Management was founded in 2000.