Active investment commentary & analysis

Don't derail the corporate gravytrain, reroute it

February means results season, with key updates for investors. But companies will be struggling to find positives for 2018 - for many it was a year to forget. And an uncertain economic background means outlook statements may be vague and unhelpful. That information vacuum may direct interest toward executive pay and other – usually overlooked – disclosures. Will boards and executives share investors’ pain?

Surprisingly, some big pay packets are to be found in mid-cap companies. While major FTSE 100 businesses focus incentives and pay on profits, a wide range of metrics and adjustments can drive mid-cap rewards. Paying bonuses on Ebitda or adjusted earnings will typically deliver just that, rather than cash profits. Indeed, any particular target that does not have a cost against it or longer-term linkage to shareholder returns will inevitably be gamed. Executives know how to maximise reward if there is little regard to risk or limit to share issuance. Incentives are a less well-researched aspect of behavioural economics, not least because it delivers such cynical conclusions about human psychology. 

The surprising thing about incentives is that the total amount of pay – the numbers that hit the headlines – may matter less than the reward structure. And what incentives can change is not just a company’s total performance, but its structure and direction. If earnings growth matters over a CEO’s tenure, divestment of duller cash-generative divisions may be delayed. This impacts not only roll-outs of new units but acquisitions and demergers. GlaxoSmithKline (GSK), for example, is only now splitting off consumer healthcare to focus on the long-term growth of pharmaceutical development. Despite decades of poor performance by GSK, previous CEOs did not appear to question a complex group structure. Over time, a reward package is likely to see a company moving in the direction it encourages – at least until worried lenders or exhausted shareholders put a stop to it. In the tougher credit environment of 2019 that may happen more often.

This month, the Investment Association is consulting on sustainability, recognising the importance of environmental and social goals. But governance is the part of environmental, social and governance (ESG) factors that should need no encouragement, as it leads directly to culture, incentives and rewards. Academic research has pointed to the increasing use of earnings adjustments to drive bonuses. In good times, this may matter little, but in 2019, financing could be more difficult. The danger is that these businesses have not developed cash management skills.

More analytical effort on the governance part of accounts, such as audit and remuneration reports, can quickly spot bad culture and an unsustainable business model. It may go against the grain to focus on negatives, particularly in ‘growth businesses’, but it could be key to avoiding pitfalls in 2019. And the risks are not just with small and mid cap or even in the obvious metrics and bonuses. 

The auditors’ language in many large companies makes for interesting reading and can highlight the extent to which earnings and the balance sheet rely on management judgement. Projections of growth and profit are typically needed to justify valuations of inventory, new units or cash-consuming subsidiaries. Year-on-year changes in wording can be clues to rising risks. Goodwill, in particular, can be very dependent on reassurance about prospects given by management to an auditor. Yet executive judgement may be conflicted by incentives, realising that impairment of goodwill could unravel the business model and breach borrowing limits. The potential impact of incentives cuts to the core of the numbers that investors rely on. 

In the short term at least, governance may be the most useful element of ESG analysis, and incentives the clearest part of behavioural finance. In a framework of incentives, people do usually behave in quite predictable ways – there is little room for altruism. Investors should spend more time on this year’s annual reports. 

A version of this article was published on Citywire Wealth Manager on 19/02/2019.