Thursday, 19 July 2018

US bonus culture limits equity returns

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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.

James Saft, Reuters Columnist

U.S. corporations are holding a record US$1.74 trillion in liquid assets, according to the Federal Reserve’s quarterly “flow of funds” report released on Thursday.

That’s up 16% 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 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.

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% 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 companies.

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.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at )

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