US bonus culture limits equity returns
June 7 (Reuters) – Quarter-by-quarter management and a
compensation-driven obsession with company share prices may be
impairing the long-term prospects of U.S. stocks as executives
live off of their companies’ seed corn rather than disappoint a
market obsessed with short-term results.
U.S. corporations are holding a record $1.74 trillion in
liquid assets, according to the Federal Reserve’s quarterly
“flow of funds” report released on Th ursday.
That’s up 16 percent since the end of the last recession in
June 2009. A variety of explanations has been posited for this -
ranging from fear of regulation to a reluctance to repatriate
gains and pay taxes.
The tax argument may play a role, but to judge by foreign
companies’ headlong drive to invest in the United States and by
the healthy return on net worth earned by non-financial
corporations in recent years, it is tough to blame Washington or
even the economy for this one.
Economist Andrew Smithers, of asset allocation adviser
Smithers & Co in London, says changes in corporate behavior are
part of a secular change over two decades, driven by executive
compensation practices and the bonus culture.
As he notes, most executives get bonus payments, often in
shares, based on metrics such as earnings per share, return on
equity and return to shareholders. All of which can be gamed and
all of which might encourage short-termism.
“A decision to allow profit margins to fall will almost
certainly hit profits in the short term, but a decision to raise
prices or cut costs in order to limit or prevent such a fall
will increase the longer-term risks of losing market share,”
Smithers writes in a note to clients.
Similarly, buying new equipment can cut profits short-term,
but provide long-term benefits, he argues.
“As the calculations on which bonus payments are based
depend on short-term changes, the growth of the business culture
has naturally increased resistance to cuts in profit margins and
has inhibited investment,” Smithers writes.
In other words, it seems likely that U.S. firms are hoarding
cash and choosing not to invest – not because of economic and
policy uncertainty, but because the managers are not paid to
invest for the longer-term.
INVESTMENT AND THE CEO REVOLVING DOOR
Whereas CEO turnover at U.S. firms was at 12.5 percent
annually in 1992, it increased by half to 18.5 by 2005 and was,
at least anecdotally, much higher than in the 1950s and 60s. It
is perhaps no coincidence that the bonus culture and high
turnover developed alongside a much more gimlet-eyed view of
long-term research and development.
The issue for equity holders is that, while this approach
flatters profit margins in the short term, it reduces the scope
for a firm’s long-term growth and health.
If you don’t maintain a car and run it into the ground it is
indeed cheaper, and might be a viable strategy if you don’t own
the car and only want to drive it so far.
That may well describe the strategy of a generation of chief
executives, who quite naturally want to maximize the benefit
they can extract during their time on the playing field. A
manager who is sticking around for only 6 or 8 years has an
incentive to cuts costs, goose profits and cash out her options.
Further evidence for this behavior is found in the fact that
U.S. publicly traded firms hold more cash, and have been
stockpiling it more quickly, than both their international and
privately held peers over the past decade, according to a recent
study by academics at Georgetown and Ohio State universities.
This may be because the bonus culture is less embedded
outside of the English-speaking world and among privately owned
For U.S. industry generally this is troubling because it
implies that, 20 years or so into this experiment, many
companies and industries have been living off the investments
made by previous generations, while not replenishing the stock.
While U.S. industry has produced wonders in recent decades,
the innovation has been concentrated in technology start-ups and
healthcare, which benefits from a parallel universe of publicly
and charitably funded research.
A possible partial remedy would be to force CEOs to become
long-term holders of the majority of the shares they are granted
in their companies, perhaps by mandating a 30-year tapering
schedule of allowable ex-CEO share sales.
To judge by the returns to shareholders in the past 15
years, the current system does investors no favors.
In theory, this problem will be self-limiting, as U.S.
companies lose market share to foreign and private competitor.
But the damage to pension funds and investors in the meantime
will be huge.