As you know, finding a management team that is aligned with the shareholders (owners) of a company can be tricky. Despite attempts to bring increased alignment, it's clear that the incentives have never, and probably will never, be perfectly aligned. Most CEOs and corporate boards say one thing publicly yet do something altogether different privately. The consequences when this happens can be staggering for the shareholders.
You're probably thinking that the CEO of your favorite company is a shareholder and he receives numerous stock options every year. You have no doubt been informed, via management communications, how these options better align the CEO with you the individual shareholder. While stock options certainly allow management to profit from rises in the stock, they don’t allow management to suffer proportionally if the business it self is not performing.
For most management teams, it's a clear case of heads you win, tails you win more.
I concede, I am not a big fan of stock options for high-level executives. I feel management should participate in the future of the company by making a substantial investment in much the same way other shareholders have. Compensation should be reasonable, within the control of the executive, and clearly aligned with the underlying performance of the business. When setting compensation for top management, there is no substitute for a management team that thinks like owners. Unfortunately, the rest of the world hasn't caught on yet, but I still hope that they will.
Although there is no foolproof way of finding a management team that wil l be properly aligned with the shareholders, finding a respectable board of directors with a substantial percentage of their net worth invested in the company is a great starting place, and the advantages to investing alongside management-owners can be numerous.
For example, if management has significant downside risk, this should help ensure discipline around expenses. It will also foster an environment where all employees treat the company's money as if it was their own. Significant ownership will also force the company to use higher hurdle rates for their internal investments in the business. (For example, investing $1 million in an existing business that results in increased sales by $10 thousand is not a good investment.) A company should only invest capital where the returns are adequate.
Another advantage of having management-owners is that it will reduce the natural tendency to pursue empire building. This disease infects far too many executives, and typically results in companies seeking out acquisitions that either increase revenue or allow them to acquire some hot new technology that will change the world in five years. These acquisitions are followed by media conferences where both companies promise increased profits, numerous synergies, etc. as they walk down the yellow brick road together. Unfortunately for the shareholders, these acquisitions are typically done with little regard for return on investment, and often fail to deliver on the promises. This type of situation happens more often than I can count, after all these executives are usually not spending their own money. Generally speaking, it would be better for shareholders to see a certain return to an uncertain acquisition.
At Sears Holdings (NASDAQ:SHLD), the board of directors holds a very significant ownership stake in the company representing over 45% of the outstanding shares. This means, for every dollar spent the board accounts for over 45 cents of it. Communications from the company are clear and candid with problems openly discussed. Compensation for executives is clearly aligned in a manner that ties pay to operating performance of the company (not stock performance).
Referring to the large ownership stake the directors of the company have, Eddie Lampert, the chairman of Sears Holdings, said it best:
Now that my friends, sounds like an owner with a lot of skin in the game.
...we will be able to manage the business strategically and for the long term without having to worry about figuring out how to make monthly same-store sales targets, hit a specific target, and without giving any type of quarterly earnings guidance and then trying to manage the business to that guidance.
Is it a coincidence that one of the greatest modern business turnarounds came after the company required executives to take positions in the company stock alongside the shareholders? IBM was in a lot of trouble in the early 1990s when Louis Gerstner took over. One of his significant early changes was to the compensation structure. Executives were not to receive stock options unless they had a pre-determined multiple of their salary (as high as 4x) in company stock that was bought on the open market. He wanted the top executives to know they wouldn't be benefiting unless shareholders did as well. Looking back, IBM turned itself around in a hurry with a lot of hard work from some brilliant people, but I have a suspicion that requiring executives to have meaningful portions of their wealth in company stock certainly didn't hurt the turnaround.
At this point you're probably wondering if there are many companies publicly available with owner operators. The answer is yes, off the top of my head I can think of the following (and a few of them are even selling for attractive prices):
If you want a real eye-opener, the next time you get a proxy statement in the mail look at how much of the company the board owns. If you want a real shock, remove the stock options, and make the same calculation (you'll want to put your coffee down first).
I should end by saying that investing your capital with management-owners is no substitute for thinking before you invest and waiting for attractive opportunities to invest at prices well below the intrinsic value of the business. After all, you should deploy your capital in a similar way to the one you expect the companies you own to deploy it - that is with a high hurdle rate of expected return while paying great attention to downside risk.
Disclosure: At the time of writing, the author or his immediate family owned positions in one or more of the companies mentioned.