The primary role of management in a company is simple: Provide shareholders with the best rate of return.
This requires operational excellence, profitability, and most importantly, the prudent allocation of capital.
Reaching the helm of a listed company is the pinnacle of professional ambition for many people, and therefore only the very smartest people in the world are selected to be leaders of listed companies.
Yet despite the undeniable talent that leaders must exhibit to get into the role, some leaders still tend to do things that are not optimal for shareholders.
In my years of investing, I’ve identified two areas where even the “smartest” consistently fail shareholders.
Buybacks
One of the most common value-destroying “habits” of management is to buy back shares at bad prices.
Although buybacks are not inherently bad for shareholders, it is extremely price-sensitive.
When a company buys back shares, it reduces the share count, increasing the ownership of remaining shareholders.
The goal of buybacks is to be able to provide remaining shareholders with higher future dividends per share, eventually. Sounds great, but there’s a catch.
If buybacks are done at a very high valuation, the number of shares that the company can retire from buybacks drop. This reduces its impact.
And buybacks have a cost- it is paid for by the company’s cash coffers. That war chest can be used for many things such as acquiring another business, paying a dividend or simply being stored on the balance sheet to be used during opportune times. All of these could be better uses of cash than buying back shares at high prices.
Too often I notice companies guide toward a certain amount of buybacks for the year. This means that the company plans to use its cash to buy back shares during the year no matter the price of the shares at that time. This is lazy and can be detrimental to shareholders if share prices rise to an unsustainably high price.
A better way to do it would be to only buy back shares when shares are cheap or trading close to “intrinsic value”.
A rare example of a leader that bucks this trend is August Troendle of Medpace (NASDAQ: MEDP). Under his guidance, Medpace has only repurchased shares at prices that August deems cheap. He has even directed Medpace to take on debt to buy back shares when prices are cheap. He has let cash pile up on the balance sheet when share prices rose too high.
Stock-based compensation
Stock-based compensation is the practice of paying employees in stock.
I’ve written in depth about some of the drawbacks of stock-based compensation here. While often marketed as aligning incentives, stock-based compensation can be very dilutive.
This is especially true when stock prices are depressed.
When stock prices are low, the number of shares that a company needs to grant is higher in order to satisfy an employee’s wage demands.
Yet, management teams seem indifferent to this, actively using stock-based compensation despite these nuances.
I believe stock-based compensation has a role, especially as a way to incentivise top leaders of a company.
But using stock-based compensation across the entire company and through different cycles of the company is lazy management.
Leaders need to rethink their total rewards framework. If they must give employees stock-based compensation even when shares are cheap, it is important that leaders find a way to manage dilution, perhaps through opportunistic buybacks.
Constellation Software (TSE: CSU) has a great compensation structure for executives that avoids this conflict. It does not provide traditional stock-based compensation. But to align leaders with shareholders, executives need to invest 75% of their bonus into Constellation Software’s common shares. These shares are held in escrow for four years so that executives’ wealth is also inextricably tied to shareholders.
Bottom line
Top executives are paid top dollar to run a company to maximise shareholder value. Yet elite leaders continue to do things that erode investor wealth. As shareholders, we can’t control what managers do but we can choose where we deploy our capital.
When we see a management team unwittingly destroying shareholder value, either through “lazy” buybacks or broad-based stock-based compensation, take it for what it is – a massive red flag.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Medpace. Holdings are subject to change at any time.