Everything You Need to Know About Incentives

A collaboration with The Compounding Tortoise.

Outcomes are subject to more randomness and luck than we’d care to admit.

When you truly understand the role of randomness, the realisation is paralysing; knowing how fragile outcomes are makes it extremely hard to make a confident decision.

There’s a remedy to this decision paralysis, and it’s of course provided by Charlie Munger, one of the greatest thinkers of all time. It’s all about understanding Incentives.

Incentives are one of the best indicators for long term outcomes, they’re no crystal ball of course, but they’re pretty good. If you have a manager who’s getting paid more than their fair share to act in the best interest of the shareholder, best believe they’ll do it.

Today, in collaboration with the knowledgeable writer - and good friend - The Compounding Tortoise, we’re going to be discussing everything you need to know about incentives.

The discussion ranges from why they’re so powerful, the best way to look at incentive schemes, examples of good (and bad) schemes, and some key nuances to know.

This will be the first of many collaborations with The Compounding Tortoise, we hope you find it valuable.

Why do incentives rule the world?

Every outcome is driven by an incentive. In school we were tested on memory, not understanding, so what did we do in school? We memorised everything the night before and avoided understanding because we weren't incentivised to do so.

You could get graded an A whether you understood it or not, so why bother?

We’re a lazy species. Mostly, we don’t do what is optimal, we do what is acceptable.

An example of incentives that I find fascinating is within the language app Duolingo, they don’t send you a notification reminding you to learn a language; they instead send you a notification to keep up your daily streak.

God forbid you end your daily streak.

They get you to learn by introducing an incentive that isn't even about learning, which is the entire point of the app... It's genius.

When you look at the world through the lens of incentives, you realise that there's an element of predictability to outcomes.

When you know the incentives, the decision paralysis starts to fade away.

Two people that mastered incentives were Warren Buffett & Charlie Munger. At GEICO - one of Berkshire’s insurance businesses - they masterfully created their compensation plans to optimise for long term value creation.

In this video, they explain key nuances like why incentivising profit alone isn’t a good thing… It’s a crucial video to understand what a good incentive scheme is.

These kind of nuances are key to understand when analysing compensation schemes; you’ll start to get a feel for the ones that truly align with the long term goals of the business and the shareholder. More on this later.

To understand how good a compensation scheme is, it’s necessary to understand the business deeply. Different kinds of businesses require different kinds of incentives.

I encourage you to listen to Buffett once more, this video is a masterclass in compensation schemes. I’ve watched it many times over and still find it fascinating.

Side note: The book that Charlie Recommended in this clip is called: “Les Schwab, Pride in Performance, Keep it Going”. Fortunately, one of my favourite podcasts - The Founders Podcast by David Senra - has done an episode on this book.

Here’s the link (available on Spotify too).

The effects of incentives aren’t isolated to individuals in business, it’s everywhere, in everything.

The Quirks of a Capitalist System…

To understand the true power of incentives, it’s necessary to zoom out all the way to Capitalism overall, this is where you can see the true power of incentives and how they’re simultaneously its best and worst feature.

I like to think of Capitalism as a hungry, wealthy man who doesn’t know when he’s full, he likes to eat good food, and when he gets good food he pays up for it.

In the beginning he’s hungry, he eats, pays, and makes all the cooks around him very rich.

One cook notices that as long as the food tastes good, it doesn’t matter how it was made, or what the ingredients are; the man doesn’t care for how it got there, as long as it tastes good.

So this cook makes tasty food with cheaper and worse ingredients, whilst getting handsomely paid along the way. Eventually, the mans body can’t cope with such poorly made ingredients and he throws up all the food eaten - good or bad - onto the floor.

He then punishes all cooks for the mistake of the one. In this moment of pain, the man is careful with what he eats, but after he eats enough good food he begins to forget how bad the experience of poor quality ingredients were.

And so he begins to eat everything that tastes good again, making the cooks very rich along the way.

Then one cook comes along and notices that as long as the food tastes good, it doesn’t matter how it was made, or what the ingredients are…

And so the story repeats.

That’s Capitalism. The system’s boom & bust cycles are driven by incentives. The behaviour of the global economy being dictated by incentives should give you an idea of their power.

So, what makes a good incentive scheme?

Let’s go through some case studies of the greatest (and worst…) to have ever done it.

The result of outstanding compensation schemes:

It’s pretty obvious that companies will put their best foot forward and talk about the right incentives and growth. There are a couple of factors that have defined the best companies’ incentive schemes: prioritizing per share metrics, looking at returns on capital, sales growth, and EBIT(A). The point of not using free cash flow is that to grow your business, you’ll have to make reinvestments. Taking that reinvestment risk is what entrepreneurship is all about. Hence, returns on capital and growth in underlying profits per share will quickly tell you what’s happening.

The textbook example for incentivisation is the Canadian vertical market software serial acquirer Constellation Software, which is a highly meritocratic organization that rewards dedicated employees. In 2015, over 100 employees had more than $1 million in company stock. The company's employee bonus plan requires all employees who reach a compensation threshold to invest a portion of that compensation in Constellation shares, which vest over four years.

Between 25% and 75% of an employee's after-tax bonus must be invested in Constellation shares. In this way, remuneration is linked to the performance of the individual and the operating group, while wealth is largely tied to the success of the organization. Today, insiders hold almost 1.5 million of Constellation's 21 million shares. This pay-for-performance culture is attractive to many of Constellation's potential targets.

Constellation is one of very few companies that so far hasn’t implemented the widely accepted (quite dangerous development when few are questioning the consequences) share-based compensation tactic and for good reason: transparent accounting.

“We designed our plan so that the full expense of any compensation flows through the P&L. We don't like stock options as the P&L impact is not reflective of what the true expenses are. We also want people focused long term. We don't want employees focused on driving up the price of the stock so that options can be in the money.

We pay bonuses based on growth and return on invested capital, but there's a large component that gets withheld. We take that cash and we buy shares in the open market in an employee’s name and he or she is restricted from selling the shares for an average of 4 years. We have 6,000 - 7,000 employee shareholders now so we still have the benefit of employees being actual shareholders.”

The thing that stands out to us is the breadth of the incentivisation and many individuals’ low starting wealth. It’s obvious that growing your cumulative bonuses of say 100,000 USD via stock price appreciation makes a more meaningful difference versus starting out with a net worth of 1 billion USD. What difference does it make to grow your 1 billion USD to 1.2 billion USD? For incentives to be effective, they’ve got to have a meaningful financial impact on many individuals and they should be based on a healthy dose of ambition combined with prudence. If you’re incentivising rapid growth, it becomes easy to lose sight of the use of financial leverage.

Other interesting examples that stand out to us are Brown & Brown, Watsco, and Harvia where many employees are shareholders in the company. Ideally, you look for companies with one or two reference shareholders (could be the management team, or the founding family) who put the organization above their personal interests. Significant but still minority shareholders. Another example could be the Finnish Puuilo, where the CEO has a base gross salary of 195,000 EUR and 3 million EUR in stock ownership. Additionally, their headquarters are very modest and they keep a close eye on administrative cost overhangs. Compensation is all in the details: you’d better look for humble managers and employees who strive for the same goal. One of their competitors, Tokmanni, pays the CEO a base numeration of close to 500,000 EUR (with several bonuses on top, despite losing market share), all while generating far worse returns on capital and EBITA that’s set to fall behind Puuilo’s quite quickly.

And the not so great compensation schemes…

Companies that aren’t focused on real intrinsic value creation metrics such as ROIC, revenue growth, growth in EBITA per share should be analysed carefully.

For instance, Unilever’s bonus scheme is based on sales growth, while we’d care more about incremental profit growth, volume growth, and the returns on capital. You’ve got to question the ambition side and relevance of certain KPIs that management’s compensation is tied to. If there’s a significant imperative on EPS and EBIT margin, you should analyze the impact of buybacks, share-based compensation (which is oftentimes excluded from adjusted EPS as it’s “non-cash”, it’s being paid for by shareholders - believe you me…), and short-term management actions. It’s what we’ve talked about in a previous blog. Perfecting the next quarter by cutting back on investments that can’t be capitalized but are immediately expensed (like R&D, marketing and sales) may support near-term profitability, but the long-term impact of missing out incremental sales is a lot more devastating to that final compounding.

The Art of (Not) Selling - Makings of a Multibagger

Looking at one of the world’s best retailers, O’Reilly Automotive, it’s remarkable that share-based compensation for all managers was about 29 million USD in fiscal 2024. Their struggling competitor, Advance Auto Parts, has been paying executives around 40-45 million USD in stock-based compensation. Logically, it should be the other way around: when you deliver excellent financial performance, you deserve to get paid for it.

Perhaps three other anecdotes that come from one of our fellow premium members David, who joined The CT community late January 2024. We were very fortunate to meet him in real life two weeks ago, and are truly grateful for learning more about his decade-long experience in analyzing companies and reading management teams’ minds. Here are three real-life examples he shared with us.

“The most egregious case we fought with was UST known as the US Tobacco Co. producer of Skoal and Copenhagen moist dipping tobacco. UST had a solid history of being able to raise prices and allow those $ flow through to the bottom line. We noticed along the way that UST Inc began to inflate their stock option program. They began to grant 4% of the outstanding share in options to the management of the business. Management argued that they deserved such as the business was difficult to manage. We thought that reasoning was dubious at best. At the same time UST was buying back about 4% of outstanding shares back each year in the open market. All of this activity served to greatly inflate compensation to management and take a great deal of current value each year away from us - The Owners. I wrote and proffered to UST Inc. a shareholder resolution to reduce the stock option program and focus more on the owners of the business. UST's legal counsel dismissed our resolution as not being of interest to the shareholders overall-It was a spurious result but we decided not to engage with legal counsel to fight the battle.

As I remember a major turning point for us was when on a company visit the IR representative told us that the Board of Directors had just issued a special grant of a significant number of shares to the CEO who had to testify to Congress about moist tobacco and the regulation thereof.

We were incensed that the CEO was receiving I believe hundreds of thousands of options for simply doing their job. It was laughable that the CEO received value potentially worth multi millions of dollars simply for testifying to Congress. Clearly we were not partners in the business and we decided to exit after that treatment of shareholders. We had pointed out that with the ability of UST to raise prices each year without substantial impacts on volume would result in a stock price that would go up just like a savings account-and that people did not give options on predictable savings accounts.”

“Another example was a business named CUC International. It was a business model that was built a great deal on customer relationships. The company sold membership programs that allowed purchasers a discount on various items. The company was purchased by Hospitality Franchise Services. During the integration phase post merger the long time fraud was discovered, The losses fell on the acquirer which had been renamed Cendant. CUC would publish earnings numbers and always had adjustments to obtain a much higher number. During our visits we would focus on the adjusted number and attempt to get to the same higher numbers management used. After a number of meetings without ever successfully verifying the number we finally decided to sell the position. That discomfort with how management answered our questions served to allow us to avoid the ongoing fraud by corporate leaders.”

Finally, David mentioned a case where growth was being prioritized without management mentioning whether it was realistic and how much capital it required.

We met with a company named Safecard Services and we would discuss the simplicity of the business model. The company was in the business of for a yearly fee monitoring the credit cards of a consumer while protecting the member against loss. We discussed with management how small incremental changes should yield solid results over time. The CEO would never look us in the eye and proceeded to tell us he wanted to swing for the fences. His goal was to achieve 30% plus growth in revenues and income without ever telling us how he thought his business assets would allow them to deliver such results. Needless to say we departed what we believed was a decent business model because we were scared the CEO would chase poor business decisions. Over time the poor management delivered the results we feared.

What to look for in compensation schemes:

We’d say that incentives and skin in the game are closely related. Looking at the ratio between a CEO’s fixed base salary and his equity ownership (like 20-30x or more) tells quite a bit about where his/her priority truly lies. If you’re getting a sizable short-term bonus while not holding any shares, it’s questionable whether you’ll stay focused on the long-term objectives all other intrinsic shareholders care about. The same’s true about using adjusted numbers. You can adjust for several variables just to make it look a lot better. It’s almost like counting the number of adjustments versus management referring to the actual financials.

Compensation should be based on long-term shareholder value creation, especially as stock prices are inherently unpredictable. You want the managers, employees and shareholders to be in the same boat, and with past years’ volatility or periods of exuberance, the list of truly phenomenal businesses gets shorter with every crisis that’s passed.

As with everything in the investment world, there are a few nuances easy to trip up on. You’ll want to see schemes that enforce open market purchases, this gives a strong incentive to actually improve the business since shares are bought at going market prices, many schemes offer shares at nil-cost – where the recipient of the option pays nothing for the shares – which means the stock could fall 80% and they’d still be in the money. Not much skin in the game there…

Another idea – covered in a recent blog on share repurchases – is the dangers of EPS incentives in compensation schemes, research showed that managers with EPS as a main of component of compensation would engage in value destroying share repurchases, this would be to sacrifice high return investments to repurchase shares and reach an EPS target. This is short term thinking that can – on face value – seem like prudent cash management. EPS paired with a metric that focuses on returns on investment will reduce this misalignment of incentives.

Compensation plans have a predictive power regarding long term outcomes, they’re the clearest signal we have in understanding the underlying behaviour of an organisation and the direction they’re driving the business. Good compensation plans can be one of the most fundamental cogs in driving long term returns, like those mentioned previously with Constellation Software.

Never underestimate the power of the executives long term incentive plan, if it encourages short term thinking, you’ll see short term behaviour soon enough. It’s also a huge tell regarding how management views the business; long term value creating plans not only tell you where management is focused, but they’re a sign for many other positives regarding that business.

Incentives really do rule the world, to underestimate this fact would be a major mistake.

Good businesses will make what’s best for employees the same as what’s best for shareholders.

Thank you for reading.

We hope you found this article valuable.

As stated earlier, this will be the first of many collaborations between us.

Sincerely,

The Intellectual Edge & The Compounding Tortoise

The information provided in this article is for educational and informational purposes only and does not constitute financial, investment, legal, or professional advice. While every effort has been made to ensure the accuracy of the information, no guarantee is given that it is free from errors or omissions. The authors accept no responsibility or liability for any loss, damage, or harm arising from reliance on this content. Readers should conduct their own research and seek advice from qualified professionals before making any decisions based on the information provided.

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