SIMON BROWN: I’m chatting with Keith MacLachlan, investment officer at Integral Asset Management. Keith, I appreciate the early morning time. We were chatting a few weeks ago, and you were digging into a particular stock out of the US that’s neither here nor there. What you said that struck me is you wanted to know how the executives of that particular company earned their bonuses. That to me was something that was a ‘wow’ idea. Run us through your logic here as to why it matters – how the executives get bonuses.
KEITH McLACHLAN: Morning, Simon. As an investor, I’m often asked how we assess management. One obviously meets management and you chat through the business with them and their strategy, get their understanding, understand where they want to take things – the usual due diligence. But the reality is that at these levels most executive teams are pretty good … but in a stock market context average – because that’s what an average is. You only really know in retrospect which side of the average they lie.
So a key element in looking at this is looking at how these guys earn their bonuses. How are they incentivised? This is part of a broader topic called the ‘alignment of interests’. But how they are incentivised is ultimately how they’re going to act. Everything else becomes noise. These guys are going to move heaven and [earth] just to get paid because that directly impacts them.
So understanding the structure of their bonuses, what their targets are and the like probably will dictate their strategy, and their strategy and the capital allocation alike will dictate outcomes.
If all of these sorts of things are lined up in a good business you’re far more comfortable, because ultimately you get what you pay for, and that’s what incentives are.
SIMON BROWN: And it also helps you understand [E.g.] if the incentive is to grow the number of outlets by 10%, well, then you know what they’re going to be doing – they’re going to be expanding at a rapid pace. If it’s around RoE [return on equity], or something like that, often there’s a bit of a blend in that process; but it does tell you where they are focusing. And if you think growth is not a good idea and that’s their bonus, well, that kind of raises a red flag for you.
KEITH McLACHLAN: Well, I go back to ‘you get what you pay for’. I’ll give you an example of a horrific incentive. A nameless airline a decade or two ago hired a nameless CEO. He was incentivised almost solely based on EBITDA (earnings before interest, tax, depreciation, and amortisation). Sounds like a great structure: you go, ‘oh, there’s profitability, EBITDA is a proxy for cash. That’s fantastic’. Except on day one, he turned up and what he did was he raised a whole lot of debt and bought back most of the [aircraft] they were leasing and any other operating leases the business had. Now, this was pre-IFRS 16 so operating leases were uncapitalised. So what that did was it took an Opex (operating expenses) item, which flowed through and depressed EBITDA, and made it a fixed asset which got depreciated. So it was excluded from EBITDA, and the cost of that was interest on the debt, which obviously is excluded from the EBITDA as well.
So what he did was he changed the structure of the income statement, boosted EBITDA, but ultimately depressed the bottom line because now you have the same assets, but now you have a whole lot of debt as well. He turned around to the board and said, “Pay me my bonus”, and they had to. So you get what you pay for.
In a perfect world the perfectly aligned incentives, in my opinion, should be a combination of growth-oriented, profitability-oriented, and in fact operational-orientated.
Because the business is not a series of numbers. It’s a collection of people and operations and processes pulling towards a common goal, and they’re often quite tangible on the ground.
So we want these sorts of things to balance each other out. If it’s only growth-oriented, you can probably buy it. If it’s only profitability-orientated, then you’ll probably sacrifice growth to boost the various profitability metrics. And if it is only operationally orientated, then you can sacrifice the numbers to make something on the ground look really good. What you want is almost incentives that offset each other, such that the only way you can really achieve them is if you’re running a good, healthy, growing, profitable, successful business. And like I said, you get what you pay for. So make sure you’re comfortable with the incentives because that’s what the guy’s going to move heaven and [earth] to try to get.
SIMON BROWN: I like that – a blend of growth and operational.
A quick last question. We are going to find this in an annual report, right? This is public knowledge. I mean, these aren’t secrets; if we plough through the annual report, we’ll find that data?
KEITH McLACHLAN: Absolutely. It needs to be disclosed and will be either be disclosed in detail in the remuneration side of the annual report … including breaking down how they arrived at it, the different structures and details around [it], [or] sometimes it’s merely referenced there and it’s sometimes included in resolutions and remuneration as well (because often shareholders vote for this). The point is, it has to be disclosed. If you cannot find it, ask the company and they should be able to point it out.
SIMON BROWN: Keith McLachlan, investment officer at Integral Asset Management, I appreciate the early morning.
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