Bad managers can wreck your investments – here’s how to avoid them

It looks like we’re set for another round of hand-wringing over executive pay. Some in the EU plan to control the ratio of a board’s pay to that of the average worker in the firm. It’s also a highly controversial topic in the US.

In 1965 the typical American CEO earned around 20 times the average worker; today, it’s well over 200 times.

Concern over income inequality is the latest incarnation of the desire to control pay. A few years ago we worried about ‘golden parachutes’ – the provision of big pay-offs for CEOs who had failed. More recently there’s been a desire for vengeance against bankers. Their bonuses have been regulated, specially taxed and in several high-profile cases, voluntarily waived.

If they’re too embarrassed to draw their pay, you know something really isn’t right.

But I don’t think these governance issues get solved by legislation. Running companies well, which includes setting executive pay and incentives, is largely a cultural issue. In fact, passing laws can do more harm than good. How then do we get the culture right and find those companies that really run themselves well?

They don’t make it easy for us

I don’t think we find them just by looking at how well a company complies with all the rules and codes of practice that have sprung up over the years. Open Barclays’ latest annual report and you’ll find a staggering 78 pages on ‘governance’. I started my working life as a banks analyst and I doubt whether the first annual reports I reviewed were this long in their entirety. The Barclays remuneration committee report alone runs to 41 pages.

Compiling these reports and dreaming up convoluted pay schemes has become an industry in itself. As investors, we’re deluged with information. We’re distracted by it and can’t see the wood for the trees. As a result the whole thing can degenerate into a box-ticking exercise; checking that there’s the requisite number of independent non-execs, or that option schemes have appropriate performance criteria.

It all leaves little time for thinking about qualitative issues, and about what sort of pay is appropriate and sensible.

The truth about bankers: they’re replaceable

But when you try legislating around the problem, some pretty silly things can happen.

For example, restricting the size of a banker’s bonus to 100% of basic pay resulted in salaries being increased to compensate. So more of the pay package is guaranteed and less is variable. Which means the banker will be better off during those tough times when shareholders and the broader economy are suffering. Whatever rules are introduced, you can bet there will be plenty of effort and imagination put into getting around them.

However, none of this addresses the central issue of what’s the right amount to pay people. In the words of Barclays CEO Anthony Jenkins, huge pay packets are necessary to “prevent a death spiral” of staff leaving.

But are those footloose employees really irreplaceable? Why not try calling their bluff? I just don’t believe that there’s such a tiny pool of specialists uniquely capable of running a bank.

For the man at the top of most very large companies, the job’s mainly about administrative skills and the ability to allocate capital sensibly. Those genuinely rare qualities of creativity, entrepreneurial flair and risk-taking, aren’t really that desirable in a big company CEO.

And those star traders and deal makers that Mr Jenkins is frightened of losing aren’t all that rare either. They look good largely because they’re benefiting from the decades of goodwill and capital accumulated by Barclays. The corporate brand name, all those contacts, business flow and huge financial backing are what really delivers the goods. Often those top traders struggle when they move to the unforgiving glare of a hedge fund. Or the great deal maker will find he’s a lot less productive in a boutique bank.

Don’t invest in a toxic culture

What’s needed is a change in the culture. I just wish I knew how to initiate it. Institutional investors must play a bigger role in this. Somehow a broad consensus has to emerge in the business world. Otherwise we can look forward to more half-baked legislation.

In the small company arena that I focus on, these issues are less acute. The resources usually aren’t there to pay outlandish salaries in the way they are in big corporates. On the other hand it can be easier for smaller companies out of the spotlight to coast along without their leaders being put under pressure to perform.

Governments don’t have a good record on this problem, and neither do shareholders as a group. So what can you do as an individual investor to avoid getting fleeced by management?

I look for:

  • Bosses’ salaries that are on the same planet as those paid to the workforce.
  • Incentive plans or share option awards that are simple to understand and linked to the long-term performance of the company.
  • Directors with a meaningful personal shareholding.
  • Most importantly, one or two strong non-executive directors are a great comfort. As well as providing guidance on strategy, I look to them to ensure the business is properly run and to ask the right questions of the CEO.

Ultimately I doubt there’s a single set of rules or formula for governing companies. It’s about paying directors and workers sensibly; having clear, simple incentives; and looking after your customers really well. It’s about getting the culture right, starting at the top. And if the CEO thinks like an owner who’s in it for the long haul… then you’re well on the way.