It's not how much, but HOW management is paid. What does compensation tell you about a firm's performance?
Every Wednesday, we publish articles about these kinds of topics with hopes to help you strategically think about your financial decisions and achieve true wealth in the long run. Ready to know more about today’s feature? Keep reading to understand how pay can—and can’t—tell you a company’s performance.
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It's not how much, but HOW management is paid. What does compensation tell you about a firm's performance? When choosing a company to work at, the rate of pay matters. After all, in today’s economy where inflation is high, lots of applicants and employees can’t help but look for “greener pastures.” However, is money all that there is when job seekers choose their potential employers? NO. Time and again, various studies show that money matters… but only to a certain point when working at a company. Let’s take a look at this example…
Goldman Sachs (GS) is known as one of the best-paying companies in the financial world. In fact, its first-year analysts often start at six-figure salaries. In 2021, data showed that an average Goldman employee made upwards of USD 400,000. That’s indeed a great pay rate! No wonder finance graduates spend their first 2 years working at high-paying investment banks like GS. What could be surprising, though, is it’s just as common for these workers to leave the company as soon as their analyst contracts are up. WHY? The reason seems odd at first—such salaries are some of the best a recent graduate could ask for! Despite that, studies show that banks have incredibly high turnover rates. For instance: GS has a 15% turnover rate for all its positions. That’s much higher than the national average, which is closer to 9%. The reason for that is quite simple. Good pay alone isn’t enough to motivate employees. When firms put too much emphasis on money and not on engaging their workforce, it can cause lots of problems to the business. This scenario doesn’t only apply to recent college graduates but also to management teams and investors. Allow us to explain why… It’s Not All About Money: What to Look For When Planning to Invest in a Certain Stock In a past “The Independent Investor” article, we talked about the theory called “incentives dictate behavior (IDB).” Here, Professor Joel Litman and his team at Altimetry Financial Research say people will do what they’re motivated to do based on promised rewards. IDB applies to everyone. It doesn’t matter whether you’re a first-year analyst or a CEO with decades of experience. That’s why according to Professor Litman, whenever he and his team analyze possible recommendations in their monthly advisories, they don’t focus on how much executives are paid. Instead, they focus on how these people are paid. This is because Professor Litman and his team believe the metrics behind executive compensation will drive the decisions they make for the company. So, how do Professor Litman and his team do this? They look at 2 main factors: First, they analyze what management has to do to get paid. They ask, “Is the CEO guaranteed his full salary no matter what, or does his company have to hit certain metrics first for him or her to earn the bonus?” Second, they analyze how long-term-oriented the management team is. They ask, “Does the team get paid cash bonuses every year or does it take stock that accumulates over time?” By asking these questions, Professor Litman and his team ensure management has the company’s and shareholders’ best interests in mind. For example: If a company plans to expand, Professor Litman would prefer a management team that gets paid stock based on a 3-year average revenue growth rather than an annual cash bonus for maximizing earnings per share (EPS). Why? It’s because the team focused on revenue growth will be motivated to invest for 3 years to keep growing. On the other hand, the team focused on one year of EPS might use cash to buy back shares or conduct harmful layoffs to minimize costs and get the most out of short-term earnings. Management Compensation is a Tell-Tale Sign for Investors It’s easy to see when management isn’t paid the right way. Sooner or later, those problems will become apparent in a company’s performance. Every quarter, Professor Litman and his team put together a Do Not Buy list for their Microcap Confidential subscribers. This list consists of companies that investors should avoid AT ALL COSTS. One of the companies in this list is LifeMD, a telehealth business.
In June 2021, Professor Litman and his team warned that LifeMD’s executives seemed to be getting paid without having to focus on the business. Prior to that, two company executives had an agreement that could net each of them USD 37 million. The condition? They should be able to keep the stock price above USD 3.75 for 90 days straight! Unsurprisingly, the stock easily cleared USD 3.75 for 90 days straight. After all, that’s what management was being motivated to do. However, after that time span, the management team had no more reason to keep shares high. That’s why Professor Litman and his team warned investors to stay far away from LifeMD’s stock. It has been in freefall ever since. LifeMD’s stock traded for USD 14.32 per share when Professor Litman and his team gave the warning… and in March 2023, the stock price closed at USD 1.50. That’s an incredible 90% drop! See? That’s the power of motivation at work. Based on the IDB theory, management will do what it’s paid to do—nothing more, nothing less. You can also do this type of analysis for any public company you plan to invest in. Start with its DEF 14A, a proxy filing that lays out how management earns its keep. Take note of this powerful investing insight and apply it to your next investment strategy! Be wary when compensation isn’t indicated clearly. After all, there’s no reason management needs to play games or hide how it’s getting paid. If you don’t see a reason for company leaders to act in your best interest, they probably won’t—not now, not ever. Hope you’ve found this week’s insights interesting and helpful. There’s not a lot to be excited about in today’s market. Learn more about some of the best investment practices in a bull market in next week’s article! |
