Benji Dawes
Co-manager of the Premier Miton UK Growth Fund
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Times are a-changing
At the recent capital markets day event of a UK Plc with a phenomenal track record of shareholder returns, I sat down with the non-executive directors and they asked me what investors might like from them in terms of engagement and disclosure going forwards. The company in question will remain anonymous, however it was one of a relatively small group of incredibly successful companies that have historically maintained a (rather long) arm’s length relationship with “the City”.
Early on in my career I used to marvel at the number of Plc executives I’d pass recurrently, criss-crossing Threadneedle Street and Old Broad Street, far from their own headquarters in the Black Country or wherever else they might hail from, presumably heading for (more) investor meetings. Surely, they should be visiting their divisional leadership team in Derby or Darlington, eking out efficiencies and driving sales targets? Who is running the business while they’re here meeting bankers and investors?
Times have changed, and many companies use technology to help them run more efficient investor engagement programmes, so they free up time to get on and run their companies. However, this clutch of companies that have driven outsized investor returns for long periods, while eschewing investors, remains, and continues to intrigue me. One interesting characteristic of these companies is their alternative approach to executive compensation.
Judged by the madness of crowds?
In an ideal world, company non-executive Boards and investors would be able to isolate the impact of management actions to influence company performance, and reward them with a commensurate discretionary bonus each year.
However, capital allocation decisions made today cannot accurately be judged for years to come, in some cases, this means that compensation schemes rely heavily upon shorter term gauges such as earnings per share (EPS) which is often heavily adjusted for “one offs” and the prescience of stock markets, given the heavy dependence in pay-outs on share price performance.
Our personal preference, for what it’s worth, is return on invested capital, as a metric for measuring medium term management actions. All these tools are imprecise instruments. They do their best to reflect what is by nature an elusive beast, that being the future.
Panning for gold; sifting out market forces
A company’s fortunes and those of the executive pay cheques, will inevitably be skewed by “events,” such as market forces beyond management control. While the industry standard is to allow these external forces to influence pay, there is another group of companies that take an uncommon approach. These outliers challenge non-executive Boards to apply their discretion and take on the challenge of sifting cyclical or market forces from management actions to reward management teams more reasonably for their input.
While an imprecise art, this reduces the chance of huge payouts to executives that have benefitted from a “windfall” that should not rightly be theirs to claim. Recent examples include the CEOs of housebuilding firms like Persimmon, who arguably benefitted from uncapped long term incentive plans that were rewarded by higher prices and volumes largely resulting from government support schemes such as Help to Buy.
Which companies seek fairness over formulas when it comes to executive pay?
Are they really the same companies that are less inclined to court investors in the City than their peers? And does this link help point to a cadre of UK Plcs that generate, and might continue to generate, outsized returns for their shareholders?
The answers to these questions are equally difficult to be precise about. Nevertheless, these companies are of particular interest to us, not least because of the preponderance amongst them of other characteristics we prefer, such as longstanding founder involvement, market leadership, continuous investment and high management share ownership. Let us cut to the chase and mention a few such companies.
Outsiders
One is JD Sports. A fashion retailer from Manchester, this company is easily overlooked, yet it has been built by long term founder manager Peter Cowgill into a global behemoth that dominates distribution for premium sporting leisurewear, like Nike and Adidas. While it doesn’t have the prestige of a brand like Nike, it has grown its business faster, and it also has the luxury of diversification, such that it is not over-reliant on a single brand. The fortunes of adidas and their soured relationship with Kanye West have highlighted recently how important that balance might be.
Another is Nottingham based Games Workshop; one man’s nerdy board game, another’s world leading media franchise. The company has gained stardom with its once-niche fantasy content, given its prominence on social media, its high-profile fanboys including Ed Sheeran and Henry Cavill, who will star in its upcoming series being produced and published by Amazon studios.
Human behaviour at work
The challenging state of the economies globally has put pressure on pay budgets, but the requirement for incentives to support organisational success is as pressing as ever. At the same time, there is a growing body of research from the behavioural sciences – behavioural economics, cognitive neuroscience, and psychology – that provides insights into human behaviour at work. As investors, this can give us a fuller, more nuanced understanding of what incentivises CEOs today.
This has led to questioning around levels of executive compensation and the link between executive compensation packages and company performance.
This presents a challenge to commonly held investment market wisdom that higher executive pay leads to higher returns for shareholders over the long run. While studies have found this to be the case, there are some interesting examples of smaller companies in the UK where the inverse is true.
A study by Chung and Keasey in 2006 found a significant positive correlation between CEO compensation and firm performance, specifically for larger firms. This size effect is key. Another study by Vecchio and Brazil in 2007 found a similar positive relationship but noted that it was moderated by several factors, such as industry and firm size.
This interests us
This has caught our attention as investors, particularly since we believe smaller companies have a wider range of potential outcomes when it comes to investing for the future and by putting specific criteria in place linked to financial incentives it can be limiting.
In an ideal world, which of course we do not live in, company boards would be discerning and fair when allocating discretionary bonus awards based on their assessment of skill versus luck. Management should, in our view, show clear alignment with shareholders through stock ownership that is not granted to them freely, but hard earned or purchased at market prices.
Without the “blinkers” of a particular financial hurdle to be overcome to achieve an award, executives are liberated to think more broadly about what is best for stakeholders in the long run. Long term incentive programmes are typically short term, for instance three years, hardly living up to their name!
Companies without this short-term financial focus might take the decision to invest today, depressing near term profits, for the long term good of the company. We look out for such behaviours and find them a key differentiator when assessing both executive skill and likely success of a business.
Zooming in on the long term
It is a focus on company’s long-term competitiveness and value that excites us, we are long term investors after all. There are a handful of UK companies, some of which I have mentioned, that have demonstrated the advantage of such a strategy. These include a few of the best performing UK Plcs of the past two decades. We believe their strategy of bucking the “City norms” is the right one for the long run.
