Weekend thoughts: incentives and bad corporate governance

Roughly twice a year, I try to do a piece in my “Trite Buffett” or “Trite Munger” series (the most recent one was at the start of this year). The premise behind the series is simple; Munger and Buffett have said so many things that I’ll initially think are hokey (and they probably are)…. but five or ten years later I’ll stumble on a situation or my understanding will evolve and I’ll realize how much wisdom was packed into their hokey phrase.

This year, I’ve been thinking a lot about Munger’s quote on incentives (which I used for my H1’23 trite Munger piece and which I believe is from Poor Charlie’s Alamanac?):

Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.).

Why have I been thinking about that quote?

I think if you had asked me ten years ago, I would have told you my investing style was extraordinarily focused on incentives. I very rarely buy a stock without a serious incentive angle. At minimum, most stocks I look at / buy have either high insider ownership (so insiders benefit when shareholders make money) or a significant share buyback (signaling management thinks the stock is undervalued)…. and I’d prefer them to have both high insider ownership and share buybacks! Of course, there are plenty of other incentive driven plays; these days, I’m finding myself more and more focused on event driven investing, and a lot of event driven investing comes down to trying to understand the incentives of different key players (the management team, board, etc.). A simple example: I love to look at companies that have recently updated their change of control agreements for management since it signals that management / the board are at least thinking about a change of control!

But, over the past year, I’ve come to believe I wasn’t focused on incentives nearly enough. In particular, while I was always skeptical of the incentive structure for boards that didn’t own a lot of stock, over the past year I’ve come to think I was woefully underappreciating how poor the corporate governance and incentive structures are at many companies. There’s an old study that says just a handful of stocks drive the majority of the market’s return, with more than half of stocks generating negative returns and >95% of stocks underperforming 1 month T-Bills. Obviously there are a hundred different factors that go into that history, but I’ve increasingly come to believe that a big reason so many firms underperform is so few boards and management teams have any incentive to actually drive shareholder value.

What’s lead me to that belief? Well, part of it has been my recent experience with busted biotechs; I’ve written about these ad nauseum (including my open letter to SAGE¹ last week), but it’s hard to be an optimist on corporate governance after you’ve watched a parade of biotechs decide to play roulette and YOLO shareholders’ money on clearly NPV negative projects instead of doing the shareholder friendly thing and returning cash after their key drugs fail.

But part of it has been my direct experience with boards and management. Over time, I’ve stepped up my engagement with management teams and board members, and I’ve generally found the results to be downright appalling…. and appalling in not just the ways you’d expect (i.e. given the lack of share ownership at these companies, it’s not surprising that the boards and management teams weren’t hugely motivated to do difficult things like layoffs or cost cuts or return capital even if the actions were desperately needed (the “not now” problem I’ve discussed before)), but they were appalling in lots of little ways too.

Let me start with an experience I had a few months back that I think nicely highlights the type of mindset I’m discussing. I was talking to the CEO and Chairman (to clarify, these are two separate people; the roles were split at this company) of a small cap company (at the time of the conversation, the market cap of the company was ~$300m; it’s much smaller now!) about a few different things, and towards the end of the conversation the CEO started ranting about a smaller shareholder who had used the SEC’s new proxy access rules to file a proposal the management team and board didn’t like. The CEO went an absolute tear; he used some very colorful language but I remember a specific quote being “and this eff’ing guy barely owns $1m worth of stock; who is he to tell us what to do?”

Now I was pretty familiar with this company and their (lack of) insider ownership, so I was pretty quickly able to respond, “that’s more stock than all of your board owns combined; why should your board get more say in the matter than he does?” That took the fire out of the CEO’s rant; he (and the Chair) didn’t really have a response to that, and the call ended awkwardly a few minutes later. Since that call, the company’s stock is down >50%, in large part due to a series of blunders by the board / management that the shareholder proposal was specifically designed to prevent.

That’s just a little anecdata / an N = 1, but I think it nicely highlights the attitudes that I’ve seen in dealing with a lot of these companies. I’ve found management teams and particularly board members think of stockholders as almost a bother who they need to deal with, not the true owners of companies who should at least be able to lob in some thoughts on the company’s direction. For example, I’d find many board members were just completely aghast that a shareholder, even a significant one, would dare to reach out to them (even if it was through very regimented channels, like asking the CEO to speak to the head of a specific committee for a certain reason); the responses I’d received would range anywhere from “why are our shareholders bothering us?” to “you’re just a stockholder, you wouldn’t understand real business.” And I’d often find the boards had insane time restrictions that suggested they weren’t really devoting any time to the company; most management teams I’d talk to would tell me how engaged and insightful their boards were…. but when I’d try to talk to any individual board member I’d often find that they allocated basically no time to the company aside from the required board meetings².

If I was able to lock a director down for any period of time, I’d often find they weren’t really plugged into the company. Every investor has a bunch of companies that they follow out of the corner of their eye; they look at the stock price and maybe read the top of every earnings release. If you asked the investor about one of those companies, they could probably have a conversation for a few minutes about it, but eventually they’d tell you that they’re not following it super closely so they can’t comment to intelligently on it without spending some time re-brushing up on it. I find a lot of board members interact with their companies in the same way; they look at the stock price every now and then and read the quarterly reports management gives them, but they do basically no other work. So you’ll have board members that think the company is doing great because revenue is growing and the stock is up…. while completely ignoring all industry context. Maybe the stock is up 10% over four years and revenues are growing, so the board thinks the company is crushing it…. but because they only read the reports that management gives them, they don’t realize every peer has better margins, faster growth, and stock prices that crush the board member’s stock.

I could go on and on with crazy stories of disinterested boards, but you probably see where I’m going. Is there any takeaway?

For me personally, the answer is yes. My evolution on incentives and corporate governance has had three key impacts on how I invest / operate.

1. Perhaps the most obvious one, but I’m much more interested in companies with clear indicators of engaged board members (high insider ownership, a history of shareholder friendly decisions, etc.). I realize this is much of what the “side car” investors have been saying all along (find a great management team / company / board, buy the stock, and just hang on for the ride), but if only a handful of companies are going to outperform over time, and the reason they’re going to outperform is in large part due to engaged / aligned management and boards, it can’t hurt to try to fish in that pond!

2. Along the same lines, when researching investments, I’m spending a lot more time on historical proxies than I used to. When I’ve gotten hit by bad behavior at a company, I’ve often found a prelude to that bad behavior in past proxy decisions (weird bonus agreements, awarding raises when the company was doing poorly, switching peer groups to justify bigger salaries, etc.). So I now spend a lot more time looking at the past few years of proxy statements and how the board / compensation has evolved over time. The hope is doing so might help me dodge a few train wrecks that I otherwise would have gotten hit by!

   1. The particular one that gets me: I read a lot of proxies, and it’s almost impossible for a management team to not hit their bonus targets in at least some way every year. I know of multiple companies where their stock price has been cut in half multiple years in a row and way underperformed peers, but the management teams are qualifying for 80%+ of their target bonuses year after year. I’m not saying stock price is the end all / be all of corporate performance, but I can guarantee that things at these companies are not going well and somehow they’re still triggering their bonuses every year because the bar is getting set so damn low. On it’s own, this one isn’t the end of the world (even if it’s infuriating), but I suspect that this type of “given them a one inch bar year after year” incentive setting is indicative of a weak board that doesn’t care, and I’ve generally found these types of boards associated with some of the worst decision making I’ve seen.

3. I increasingly want to use my (small) platform to call out and improve examples of bad board membership. Perhaps it’s me doing the calling out (like with SAGE), or perhaps it’s hosting a shareholder who feels a company and its board are letting them down / need improvement….. but it honestly angers me how bad the governance at a lot of these companies are, and I can think of no better use for my platform than trying to slightly improve these.

Why do I mention all of this? Well, it’s all been floating around my head, and I like to write / spill out whatever is floating around my head. But I also like to throw stuff out into the world because when I do so my readers often point out interesting situations or ideas related to what I’m thinking about that I should be looking at, or things that I might not be thinking about fully enough when I’m developing a thesis.

So I figured I’d throw it all out there and see what came back my way. Comments / email / DMs open.

PS- I told my friends at AlphaSense about my focus on corporate governance, and they sourced a fantastic expert who had served on dozens of board / teaches corporate governance and suggested I do a (free) webinar with an expert to explore the topic. If you’re interested, you can find the (free) webinar here. It was a really interesting discussion; Dennis had a completely different view point on a lot of topics than I do!

1. Disclosure: I am long SAGE

2. A fair pushback here is “maybe the board members just didn’t want to talk to you.” Completely fair…. but having done this multiple times and seen a lot of curious behavior I think it’s much more likely they just weren’t plugged into the company.