Posted: December 10, 2015 | by: Thomas F. McKeon, CFA
Two stories in the financial press today illustrate the perverse incentives lining the pockets of C-suite executives while simultaneously stifling investment, innovation and long-term growth.
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We try not to let the endless stream of financial media noise distract us here at Clothier Springs. We do try to tease out the occasional meaningful item or two, not to trigger an immediate portfolio action, but rather to inform our long term perspective. Two items caught our attention today—one from CNBC and the other from Reuters. The two items dovetail like a perfectly cut woodworking joint and go a long way towards explaining why market appreciation may be limited for some time. Here they are:
From CNBC: Massive Insider Selling Spurs Stock Market Concerns
From Reuters: The Cannibalized Company—Stock buybacks enrich the bosses even when business sags.
The CNBC article details how corporate insiders have been selling their shares at near record levels—thought to be a sign that insiders don’t see much near-term return potential for their company’s shares and are getting out while the getting is good.
The Reuters Special Report details how corporate insiders use share re-purchases to increase earnings per share even as operating results lag or shrink. Juicing the EPS helps the shares reach valuation levels that trigger lavish executive compensation payouts. These re-purchases come at the expense of investing in organic growth.
In short—insiders are increasingly using financial engineering to prop up their shares and trigger bonus payouts while selling shares at near record levels. What would a rational investor make of that?
Compensation theorists and academics like to point out that the current system aligns shareholder interest with insider interests, and that is true in a very limited way. Propping up a stock with financial engineering may deliver a few percents of short-term return to shareholders. But the insiders reap millions when their arbitrary share-price hurdles are met. There is no group of stakeholders on the planet with as much to gain from gaming the stock price as corporate insiders. This “cult of shareholder value” has created incentives for corporate insiders to focus on short-term gains for themselves at the expense of long-term value creation for shareholders, employees and customers alike.
Our research leads us to believe that returns for US equities will be constrained for quite some time, owing to extended valuations and meager economic growth. These two items today only buttress our argument.