“Managers of other people’s money rarely watch over it with the same anxious vigilance with which they watch over their own”   - Adam Smith
 
After my last article appeared, a reader asked me about how I look at executive compensation in each of the Nintai Charitable Trust’s investments. I am pleased to say none of them are on the top 200 list of best compensated executives. In general my view on compensation in publicly traded US companies is quite poor. To me this isn’t just a matter of conscience but a fiduciary issue that all shareholders should care about. Management – and their respective Boards of Directors – who conceive of some of these enormous pay packages (more about this later) are providing little value to shareholders. Whether as cash, stock options, or deferred compensation, executive compensation is no different than any other labor cost. I want to be clear up front that I’m not bringing up the issue of executive compensation as a partisan or public policy issue. Rather I look at it as all investors should – a cost that ultimately can reduce your return in cases of poor performance or egregious payments,
 
There are several reasons why I think investment managers and shareholders should be concerned by some of these pay packages– the growth of compensation, how compensation is designed, and the measures used to compensate.
 
Growth of Compensation: A Great Anomaly of the Age
 
In 2015, CEO’s made more money than any year before. Average compensation for top 200 CEOs was $17.6M up about 2% from 2015[1]. The median compensation for the top 100 CEOs was roughly $15.1M. This compares to roughly 47% of all Americans who earned less $25K per year or 75% who make less than $50K per year. The average (not the median) American worker makes roughly $46,300 per year or roughly 1/326th of the median CEO.
 
I have absolutely no problem paying a CEO for great performance. Sadly, most don’t come up to scratch. Jack Bogle, in his wonderful book “The Clash of Cultures”[2], shows that most senior executives performed quite badly during this steady run of annual increases. For instance CEO pay has risen roughly 6.5% annually since 1980. During this same time frame, management predicted 11.5% annual earnings growth but produced barely 6% growth. This is less than the average 6.2% nominal GDP growth for the same period. As Bogle says, “how that somewhat dispiriting lag can drive average CEO compensation to a cool $9.8M in 2004 and then to $11.4M in 2010 is one of the great anomalies of the age”. I couldn't agree more.
 
When you are looking to invest in a company peruse the annual reports for CEO pay, projected growth rates over the past 10 years, and the actual growth rate over that period. Any management that sees itself as either far more important than their average worker or worthy of steady pay increases for mediocre performance doesn't belong in your portfolio.
 
Compensation Methods: Not How Much, But How
 
When investors hear about CEOs taking a $1 salary and being “all in” with his/her shareholders, hold your nose and get out the latest SEC compensation numbers. Total compensation can be more than a salary. Much more. It might include bonuses, stock awards, options awards, non-equity incentive plan compensation, changes in pension value/deferred compensation earnings, and a more general “other” compensation (such body guards or personal use of the corporate jet).
 
You would think all these options and stock awards would make CEOs large shareholders in their companies. There you would be wrong. Per the Harvard Business Review, CEO stock ownership for large public companies (measured as a percentage of total shares outstanding) was ten times greater in the 1930s than in the 1980s. That number has dropped even further in the past 30 years (it’s now roughly 12 times greater).
 
A recent Conference Board/Arthur J. Gallagher & Co report showed that CEO David Zaslav was paid by Discovery Communications (DISCA) $156 million in compensation last year of which $145 million was in stock and stock options. CEO Satya Nadella was paid by Microsoft (MSFT) $84 million of which $80 million was in stock awards. And finally CEO Larry Ellison was paid by Oracle (ORCL) $67 million, $65 million of which was in stock options.
 
This focus on stock grants (while boosting ownership – which is good) unfortunately is not hinged to any long-term value performance measures. All too often we see the mix of compensation driving the CEO to fudge earnings reports, misrepresent financials, and sometimes to resort to outright fraud.
 
When you look to invest in a company the question that should be asked is how is management compensated not how much. Does the compensation reward for building long term corporate value? Does the CEO truly have skin in the game (not just warrants and options)? In the Nintai Charitable Trust we look for compounding machines to grow our investment. To get this type of performance, it all starts with how the CEO is compensated.
 
Compensation Measures: Where’s the Beef?
 
If CEO’s are being rewarded for underperforming their estimated growth by 50% as seen in the last section, what incentive is there to grow the long-term intrinsic value of their company? When CEOs are awarded $220M for nearly running their company into the ground (Bob Nardelli received $223M for being fired from Home Depot) it really isn’t an incentive to worry too much about underperformance.  
 
Investors should look for companies that drive compensation through long-term value creation. For instance, Nintai Charitable Trust holding Fastenal (FAST) uses measures of return on capital to drive some of CEO compensation. Another holding – Expeditors International (EXPD) – faced a shareholder revolt in 2014 when investors felt the bonus package for outgoing CEO Peter Rose was not long-term focused (I should note we were a shareholder that voted against the package). The company got the message and changed its compensation calculations. 
 
Golden parachutes for failed management and non-performance based compensation are two clear red flags for any potential investment. You don’t reward organizations that perform poorly in your personal life, so why should you in your investments?

Conclusions
 
Management compensation can tell you a lot about corporate culture and how the Board and executives see their shareholders. As value investors we should be seeking management that provide – and are compensated for – steady long-term value creation. There are many companies in the investment world that seriously address this and act accordingly. Unfortunately there are all too many who do not. Management that compensate themselves like the divine kings of old are a disgrace to their industry and do not belong in your portfolio. If investors are going to outperform the markets, then they need to invest in companies and management that look to do the same. 
 
As always I look forward to your thoughts and comments.
 

[1] CEO compensation data was obtained from proxy statements filed with the U.S. Securities and Exchange Commission (SEC) for the CY2015 and CY2016

[2] “The Clash of Cultures”, Jack Bogle, Wiley & Sons, 2012

“Good questions are often far more powerful than answers,” they argue. “Good questions challenge your thinking. They reframe and redefine the problem. They throw cold water on our most dearly held assumptions, and force us out of our traditional thinking. They motivate us to learn and discover more. They remind us of what is most important in our lives.”
                                                                        - Andrew Sobol and Jerald Panas[1]
 
In 2013 during a strategy session reviewing decision-making in the Second Iraq War, an officer heard a case study and whistled. “How the hell could we have missed something like that?” he asked. After a long pause, the facilitator said, “Simple. You never asked the question”. Since then the Army War College has spent time developing a course on how to ask the right questions – obtaining information that will affect your decision-making and produce better outcomes.  
 
I bring this up because in our article last month (May 25th, 2016, “Asking the Right Questions”), we discussed the importance of asking the right questions about a possible investment opportunity. In the ensuing discussion, Zejia asked me about what questions I might ask management of an investment opportunity. Much like the army officer training, I look for questions to management that can increase the possibility of a successful investment. In today’s article, I wanted to briefly discuss the topics I discuss with management as well as specific questions I might ask in the course of our conversation.
 
Before I get into greater detail, I should make it clear we generally talk to roughly one-half of our investment holdings’ management. Our ability to get on the calendar of Bob Deuster (CEO of Collectors Universe CLCT) is far greater than with Intuitive Surgical’s (ISRG) Gary Guthard. When we can’t actually speak to management we will occasionally send in a questionnaire asking our questions. How (or if) management replies can make or break our decision to invest.
 
There are four (4) major areas I want to explore with management – capital deployment, compensation, forecasting, and corporate responsibility. I look to map management’s responses with the historical record from SEC filings such as the annual 10-K or quarterly 10-Qs.
 
Capital Deployment and Returns
Perhaps that greatest role played by senior management is to wisely deploy the company’s capital so that it earns a good return.  Wise allocation of capital is harder to find than you might think. Why is that? First is the truly abysmal record of management itself. Of the S&P 2000 roughly one-half of the companies’ weighted average cost of capital (WACC) exceed their return on invested capital (ROIC). It is also estimated that roughly 80% of all mergers and acquisitions destroy value. Second, there is no real training to become CEO or on allocating capital. You either learn it on the way up or through on-the-job training. It is no wonder managements have such a poor record. Some of the questions I ask are:
 

1. What are your key drivers for return on capital?
2. What are your key measures in capital deployment decision-making?
3. Does success/failure in allocation of capital impact compensation?
4. What do you define as long-term thinking?
5. Do you integrate long-term thinking with allocation of capital?

 
Compensation and Incentives
There really isn’t any best way to align management’s compensation with long -term value creation. We know with some certainty what doesn’t work: free stock options, measuring value by stock price, easily obtainable goals that can be manipulated. The list goes on. I look for management that openly grapples with this issue and isn’t afraid to tinker with the system to improve it. It’s better to try to align goals with some uncertainty than not align goals with a fixed certainty. Some questions I might ask are:
 

1. How do you align management and shareholder goals?
2. Do you try to incentivize management and employees equally?
3. How often do you measure the impact of incentives?
4. What changes have you made over the past 12-24 months?

 
Forecasts, Mistakes, and Reviews
Over the course of their tenure, CEO’s will make a fair amount of predictions, estimates, and assessments of their strategy. They do this through investor documents (such as their Annual Reports), quarterly earnings conference calls, and presentations made at industry conferences. I look for managements that openly acknowledge failures and address what went wrong and what they’ve learned. Most of all they must measure and adjust as time passes. A management team that fails to learn and adapt is a prescription for underperformance. Some questions I might ask are:
 

1. What predictions have proven correct? Incorrect?
2. What have you learned from getting predictions wrong?
3. How often do you review your predictions and assumptions? Quarterly? Annually?
4. How do mistakes impact your role as CEO? How does it impact the company?

 
Corporate Responsibility
I look for management that realizes it doesn’t work in a bubble. Companies can have an impact on public policy, their community, and their workers’ family life. This doesn’t mean I’m looking for a not-for-profit socialist haven. Rather I look for a blend of shareholder value with an enlightened approach to corporate responsibility. Treating your employees – and the community you work in – with respect and fairness simply makes business sense. Some questions I might ask are:
 

1. How do you help your employees assist their community?
2. Are any of your employees on public assistance?
3. How does the company give back to the community?
4. What is the payroll ratio between the CEO and the lowest paid employee? The median average employee?

 
Conclusions
Understanding how management thinks about allocation of capital, compensation, decision-making, and corporate responsibility can shed light on some of the most important jobs a CEO must master for success. From this give and take an investor should feel comfortable that management is honest in their communication, skilled in the strategic decisions, and acutely aware of the power of incentives. By not asking the right questions, investors might focus on topics that will play no role in the long-term success of their investment. To do so – in the parlance of our War College students – would be to win the fight but lose the war.


[1] “Power Questions”, Sobol and Panas, Wiley; February, 2012

In 1956, John Kelly of AT&T’s Bell Labs published “A New Interpretation of Information Rate ”. This publication discusses the criteria and formula that assisted AT&T with its long distance telephone signal noise. After its publication, Individuals who engaged in betting realized the potential of his work. Talk about intellectual cross-pollination! The Kelly Formula allowed gamblers to optimize the size of their bets in the long term. Since then the formula has found a strong group of proponents in the investment world. 

The Criteria
The Kelly Criteria are actually relatively simple in their design. There are two components that make up the basis of the formula. The first is the probability that your transaction will produce a profitable return. This is called the win probability. The second is the total dollar amount of transactions with positive returns divided by total amount of transactions with negative returns. This is called the win/loss ratio.   

The Formula
The actual Kelly Formula utilizes both of these criteria in its calculations. The formula gives the investor the Kelly Percentage – or what percentage the transaction should take up in your portfolio. Let’s start with formula itself.

                                                   Kelly % = W - [(1 - W)/R]

W represents the win probability and R represents the win/loss ratio. To get the numbers required to populate the equation, the following steps are required. 

1.    Collect data on your previous 50 trades.
2.    Calculate the winning probability by dividing positive return transactions by negative return transactions. 
3.    Calculate the win/loss ratio by dividing the total gains from your positive return transactions by the total losses of your negative return transactions. 
4.    Plug these numbers into the formula and the Kelly percentage represents the percentage that this transaction should amount to in your portfolio. 

Some Thoughts on the Formula

It’s far beyond the purview of this article to comprehensively address the pros and cons of the formula. However, at the Nintai Charitable Trust we employ the Kelly Formula as a piece in an integrated capital deployment strategy. Simply put, it plays a very diminished role in our capital allocation decisions. Over the course of our investment management career we’ve had many individuals ask why we don’t use the formula to a greater degree in our portfolio selection. 

The short answer is I believe the formula gives an investor a partial – and wholly incomplete – picture of the capital allocation process. The idea of your largest position being dictated by a formulaic approach is compelling. In games of chance it is even more so. Allowing your allocation of capital to be decided by such an approach alone gives away the great advantage one has as an investment manager. 

Whist versus Bridge
Anybody who plays whist and bridge knows there is a vast difference in the role of luck between them. In bridge, partners communicate with each other through a detailed bidding process that discusses both strength of their hands and their preferred suit. In whist, players communicate about points but cannot disclose anything about their preferred suit. I bring this up because the Kelly Formula is similar to whist. One can get a pretty good sense of how much to invest but the context of what to invest in – industry, strength of management, balance sheet strength – is not part of the investment decision process. 

“The Odds” versus Compounding
One of the real dangers in the investing world is Wall Street’s penchant for creating formulas that back-test amazingly. The Street also loves to use formulas to make it appear their recommendations are based on sophisticated data-driven models. We see a little bit of this in Wall Street’s approach to the Kelly Formula. At the Nintai Charitable Trust we are happy to rely less on mathematical formulas to calculate capital allocation and more on managers who are extraordinary allocators of capital. Put more simply, we rely less on short-term bets on portfolio position size and more on long term compounding.

A Working Example

In February 2015 two stocks reached Nintai’s buy price and I began the standard process of double checking our numbers and deciding on capital allocation. The two stocks were Paychex (PAYX) and SEI Investments (SEIC). While the Kelly Formula gave a recommendation based solely on win probability and win/loss ratio, looking at our forecasts (such as free cash flow growth, future return on capital, margin expansion/contraction, etc.) I came to a diametrically opposing view on how much to allocate to each position. For instance the Kelly Formula took no account of the impact of interest rates on Paychex “float” and their long-term impact on gross and net margins. In addition, the formula failed to reflect the growing disparity between active and index based investing (indexing creates larger margins for SEI based on trading volumes). In the end, each position was allocated capital on a blend of valuation, market trends, financial strength, and yes, the Kelly Formula.  

Conclusions

Much like the whist versus bridge comparison, the ability to layer on additional data can provide investors with a vastly different view on capital allocation. While the Kelly Formula can certainly play a role in your investment decisions, I generally like to include multiple sources of data when making decisions on position sizing. The ability to understand major market drivers (such as competition, technology innovation, etc.) is a critical component to getting a broader view on capital allocation.  The Kelly Formula is a useful tool to have in your investment toolbox. Used by itself, it’s a formula for short-term volatility and potentially long-term underperformance. 

 1 For those real junkies the original work can be found here: https://www.princeton.edu/~wbialek/rome/refs/kelly_56.pdf