Yes, You Can Predict the Future

It’s election time here in the U.S. and we now know the next president is going to be Barack Obama. I can’t think of any other event in which, people nationwide, engage in predicting the future. Who’s going to win, who’s going to lose? The polls say this, the polls say that. Well, we all know that when it comes to elections, it’s anybody’s guess. But when it comes to investing, let me tell you a way how you can predict the future.

Behind every stock you buy is a management team who collects a paycheck and receives a bonus based on a compensation plan. As publicly traded companies, these pay plans are public for any investor to read and the details are found in an SEC document called Form DEF 14A, short for Definitive Proxy Statement, otherwise known as the “proxy”. Compensation drives behavior. So if you tell me how you’re paid, I’ll tell you how you’ll act.

One of the biggest disconnects between investors and the executives who run the companies you invest in, is something called an “agency problem”. Basically, it refers to the issue of alignment – how do I know the management team is doing what’s best for the company (and me, the investor) and not what’s going to line their pockets? There are various ways to deal with this issue, the most obvious one is vote with your dollars (i.e., don’t buy the stock or sell it). Another way is to invest in teams whose compensation is structured to reward value creating behavior.

For example, what percentage of executive pay is guaranteed cash versus “at risk” in the form of stock options? I bet you those executives who know they’ll receive their million dollar salaries regardless of how the company does act differently than those who are rewarded only when the company does well. And if say, management receives pay in the form of stock awards, how do they vest? Meaning – when can the executive sell them and make a profit? Too often we see executives getting awards that are time-vested, not performance-vested. This means that all the CEO has to do is wait for the passage of time and he receives the awards, even if the company’s financials go down. Also, what metrics are management cash bonuses tied to? For example, do they receive bonuses if they increase sales or profitability? If it’s the former, this may explain (and predict) why a CEO may acquire companies, which immediately boosts the sales line thereby triggering a bonus payout, but may not be profitable and hurt the bottom line.

November 6th, my guess was as good as any as to who’ll be in the Oval Office. But understanding how executives get paid and what motivates them can help you as an investor anticipate what they’ll do next. Just follow the money.