Global Equities Research: Spotting Gorillas and Other Primates

Global Equities research: Gorillas and other Primates


Daniel White, Senior Research and Strategy Manager

There is a well-known video on YouTube which asks you to spend one minute paying close attention to a team of people passing a basketball to each other. You are meant to count the number of times they pass the ball. Only the most attentive usually get it right, but being right is not the point of the clip. For the harder you try to count the ball being passed, the more likely you are to completely miss a large furry mammal barrelling through. People are always stunned to find out that they failed to spot the gorilla. That is the problem with targets. It has the advantage of focusing the mind, but as you focus, everything else gets blurred to the point of blindness. So what do company management focus on and what are they consequently missing? What are the differences in what is deemed important on both sides of the Atlantic? We looked at the aggregate data for the largest 30 companies in the UK and the US to find out.

Source: Canada Life Investments' research, company annual reports 

The major difference between US and UK CEOs – beyond the scale of the pay shown in the graph above – is the reliance which US remuneration committees place on the share price to motivate the CEO. Two-thirds of American CEOs pay package comes in shares either given to them for just turning up to work every morning, or linked to some performance metric which must be achieved in order to claim the share award. In the UK, variable pay is almost always about cash. A British CEO will typically have to hit some target to get a variable pay award. This might be Return-on-Capital, EPS, Cash-flow, Profits, or Sales. It can often be the share price, but if that target is hit, unlike in the US, the pay-out will be in cash rather than shares.

Source: Canada Life Investments' research, company annual reports 

        

Source: Canada Life Investments' research, company annual reports 

Both the UK cash-based and US shares-based pay packages have their strengths and weaknesses. The trouble with the share price as the be-all and end-all of investment life is that, in the words of Warren Buffet “in the short run, the market is like a voting machine, but in the long run, the market is like a weighing machine”. As the share price flickers up and down every second of a trading day, the temptation to be overly concerned by this single metric of a company’s health can warp one’s judgement. It’s like saddling your emotions to an unbroken bucking horse at a rodeo. The short-term health of the share price can mean that you miss the gorilla doing its best to wreck the long-term future of the company. For what is the simplest way to increase EPS (useful if your incentives are based on earnings) and provide support for a flagging share price? Buy back shares. In our previous newsletter we looked at trends in excessive cash-return in the US market and a worrying rise in corporate debt levels. The combination of low rates and heavy shares based incentives is the most obvious cause of these record share buy-backs and rising debt. It’s great for the short-term, but, in aggregate, corporate America is boosting share prices by borrowing from the future.

What of the UK’s preference for setting cash incentives linked to operating measures such as Sales, EBIT etc.? Given that gorillas have been happily stomping around this newsletter, let me bring in another more colourful primate.

In 2018 a short-lived Iceland supermarket advert pictured a cartoon orangutan whose habitat was being decimated by loggers keen on planting palm oil plantations. This clever advert had quite an impact in highlighting how the use of palm oil in endless series of products that we buy is having a serious ecological impact on tropical forests. Now if you look at the ever-growing number of pages in annual reports, which highlight companies’ concerns to be seen as a sustainable, environmentally friendly company, it is a surprise that this concern does not feed through into the targets set for management. There are exceptions. The Dutch multinational company DSM has a full 19% of management incentives linked to sustainability. However, in the 30 largest companies we surveyed in the UK, the sustainability targets are typically absent and in aggregate make up less than 1% of management’s total remuneration. In the US it is even lower than that.

If it is not a target, you don’t see it. And if you don’t see it, eventually it won’t exist. If we make Iceland’s cartoon Orangutan stand in for all those pages in annual reports on “sustainability” we need this orangutan to climb one level higher in the foliage and make it into the incentive packages of management. Then we will spot it. By spotting it, we may save it.

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CLI01433 Expiry 30/06/2019

Daniel White

Daniel White

Senior Research and Strategy Manager

LF Canlife Global Equity Fund

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