CEO Compensation: What Motivates Senior Managers? by Andrew Iu, Burgundy Asset Management
When we study a company, an important step in our research process is to evaluate the CEO as a leader and fiduciary. Is this person going to protect and grow our investment? Will this person treat us like an equal partner in his or her enterprise?
To help us answer these questions, we consider how the CEO is compensated. Ultimately, we look for a compensation package that aligns the CEO’s interests with those of long-term investors, like us. At our 2014 Client Day, Stephen Mitchell, Portfolio Manager of U.S. Large-Cap Equities and Global Equities, discussed how a major part of modern compensation packages – stock options – can cause a CEO’s interests to diverge from those of shareholders with long time horizons.
The latest issue of The View from Burgundy, entitled “Top Quartile,” builds on Stephen’s presentation. “Top Quartile” surveys the CEO compensation programs of Canada’s largest companies in an attempt to understand how the average Canadian CEO is paid, how widely Canadian companies differ in their compensation strategies and, most importantly, how compensation affects business stewardship.
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To convey the survey results, “Top Quartile” uses a parable about two business executives (originally introduced in the August 1998 issue of The View entitled “Stealing a Fortune“) navigating the complexities of CEO compensation with the guidance of a clever advisor. Throughout the narrative, it addresses questions like: Why do stock options encourage managers to buy back shares and does this harm shareholders? What role do taxes play in compensation programs? How do share awards compare to stock options?
The lessons of “Top Quartile” are useful for investors aiming to understand how a CEO might affect their investment thesis, for board members contemplating how to incentivize their CEO, and for readers curious to learn how Canada’s business leaders get paid.
A Survey of Canadian CEO Compensation Programs
In 1998, we wrote about the unintended consequences that options have on manager behaviours in an issue of The View from Burgundy entitled “Stealing a Fortune.” We illustrated our thoughts with a story about two companies: Excellent Corporation and Subpar Corporation. Excellent Corp. motivated its CEO (Mr. Topnotch) with a bonus tied directly to share ownership, while Subpar Corp. offered options to its CEO (Mr. Hohum). Excellent Corp. went on to outperform Subpar Corp. through a combination of better capital allocation and better business decision-making.
In the years that followed “Stealing a Fortune,” we supported stricter accounting rules, arguing that rational accounting treatment for stock options might temper reliance on stock options and improve alignment between managers and shareholders. In 2004, we were thrilled to witness new accounting rules take effect in Canada, which required public companies to expense stock option compensation through the income statement; however, we have been unimpressed by companies’ subsequent abuse of non-GAAP (generally accepted accounting principles) metrics like earnings before interest, taxes, depreciation and amortization (EBITDA) to conceal stock option compensation with the tacit concurrence of some research analysts. In this edition of The View from Burgundy, we revisit stock options, surveying Canada’s 60 largest companies to understand how stock options are being used a decade after the changes in accounting rules.
CEO compensation: A Tale of Two Board Members (and One Advisor)
Topnotch and Hohum are now retired from their corporate manager jobs, and have recently taken up posts on the board of New Corp. to occupy their spare time. At the first board meeting, the duo is charged with the daunting task of designing a compensation package for New Corp.’s CEO, Mr. Newguy.
The compensation committee is meeting in two days, so the panicked duo hires a consultancy, Good Governance Advisors, to help them. Topnotch and Hohum ask the lead partner at Good Governance, Mr. Fairpay, to make a presentation to them the next day.
See full A Survey of Canadian CEO Compensation Programs in PDF format here.