Although Andvari’s evaluation process is exhaustive, it is possible for any investor to misjudge the character and quality of management. We find one of the best protections against bad management is a thoughtful, well-constructed, executive incentive compensation plan. A good plan can stymy or preempt bad behavior.
Evaluating the Compensation Plan
The exact details of good compensation plans might vary from company to company, but there are a few universal themes shared among well-conceived structures. To suss them out, these are some of the questions we ask ourselves when reviewing a company’s proxy statement, alongside examples of what we believe to be in the best interest of long-term shareholders.
Do executives and board members have sufficient “skin in the game”? Are executives required to own a minimum number of shares?
Andvari’s Ideal: An owner-operator who forgoes a pay package by virtue of significant equity ownership and a lack of ego. For example, Constellation Software’s founder and CEO, Mark Leonard, owns ~2% of the company. With his ownership stake now worth over $500 million, he has waived his pay package in each of the last three years.
In previous letters, we’ve communicated the importance of investing in companies with strong, owner-oriented cultures. Mark’s willingness to forego pay sets a cultural standard for other Constellation employees: that not even the founder and CEO is above exercising frugality and focusing on the team rather than the individual.
What proportion of total pay does incentive compensation represent?
Andvari’s Ideal: We prefer those companies that significantly overweight incentive compensation relative to base comp. For instance, executives’ incentive comp at HEICO — which has fostered one of the best cultures of ownership we have encountered — runs anywhere from 4x to 9x higher than their base salaries.
How is incentive compensation paid out? What proportion is in (1) cash; (2) options / RSUs; (3) equity?
Andvari’s Ideal: We prefer payments in equity rather than in options. In our experience, equity awards more strongly confer a culture of ownership and entrepreneurialism, whereas option grants tend to attract the more mercenary-minded executives.
What metrics are used to calculate incentive compensation? What measurement periods are used?
Andvari’s Ideal: We believe metrics focused on returns on capital and growth in FCF or owners’ earnings per share most closely correlate with more favorable long-term total shareholder returns. On the latter, we reiterate the importance of a “per share” metric. We prefer management teams that lack the incentive to dilute shareholders to reach their bonus targets.
In this respect, we admire American Tower’s compensation plan: equity awards are based on achievement of an “Adjusted Funds from Operations per Share” target (~70% of potential compensation) and an average ROIC target (~30% of comp), as measured over rolling three-year periods.
Assessing management’s skill and integrity is a process that defies quantification. Many capable investors can and do get it wrong (we are guilty as charged). Our experience tells us the best protection from a poor management team is to ensure their compensation incentives are aligned to produce good results for shareholders.
Andvari fully appreciates Charlie Munger’s frequent quip, “Show me the incentive and I’ll show you the outcome.” We have invested hundreds of hours reviewing proxy statements over the years. Incentive compensation is just one of many factors we assess in our qualitative-focused investment process.
IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari may re-evaluate its holdings in such positions and sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
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