Missed Opportunity Earning a Real Return on Real Investment

Johari: ‘I am a turnaround specialist
Datuk Johari Abdul Ghani anak jati Kuala Lumpur dilahirkan dan dibesarkan di kawasan setinggan Kampung Pandan pada 6hb Mac 1964. Mendapat pendidikan awal di Sekolah Rendah Kampung Pandan dan seterusnya melanjutkan pelajaran di peringkat menengah di Sekolah Aminuddin Baki, Kampung Pandan. Meneruskan pengajian peringkat Diploma dalam jurusan Perakaunan di Institut Teknologi MARA, Shah Alam dan kemudian melanjutkan pelajaran dalam jurusan yang sama di United Kingdom dan berjaya memperoleh “Fellow Chartered Association of Certified Accountants”.

Boards, executives and compensation consultants hold an almost fanatical attachment to the expectations market because they believe that the job of management should be to maximize the long-term value of the firm and the current stock price is considered the best proxy for that long-term value. Hence, boards and executives assume that if they increase the stock price of the firm today, they have contributed to the maximization of long-term value. That thinking has led to the tying of compensation to stock price through grants of stock options and restricted stock, which in turn has led to the shift in focus of executives away from building real companies and toward the manipulation of investor expectations.

KUALA LUMPUR: CI Holdings Bhd group managing director Datuk Johari Abdul Ghani said CI Holdings Bhd’s next acquisition target is one where management is weak and has limited abilities to raise funds. Size does not matter, and the acquisition target could even be a small company.

“I am a turnaround specialist. I turn companies around and bring them to the next level. It is not about the sector.
“I like companies with weak management, meaning that the existing management cannot convince bankers that they can grow.
“Secondly, these companies have a limited capacity to raise cash because of the background of the shareholder of whatever reason. And thirdly, this company finds it hard to attract talent,” Johari toldStarBiz after the company’s EGM.
Johari said he had a few proposals on his table and was in the process of evaluating them.
He was, however, adamant that the only two sectors he would not be touching were the oil and gas and property sectors.
When CI Holdings first bought Permanis in 2004, it only had 15,000 outlets nationwide and was a fledgling bottling company. At the point of its sale to Asahi Group Holdings last year, Permanis had a reach of 40,000 outlets and was Malaysia’s second largest soft-drink maker by sales volume. CI acquired Permanis in 2004 for RM72mil, and sold it to Asahi Group Holdings for RM820mil.
“When we first bought into Permanis, it was already a saturated market with many competitors.
“I revamped the business model and increased the number of outlets carrying our products.
“We did lots of promotional activites and strengthened our research and development to introduce more drinks.
“We put in the right people at every level. You need to pay people very well if you want the right results,” said Johari.
During the EGM, shareholders approved the proposed capital repayment of 50 sen per share or RM71mil. This dividend is part of the RM5.10 cash distribution that was first proposed in July last year.
Thus, 88% or RM724.2mil of the RM820mil paid by Asahi for Permanis will be distributed back to all of its shareholders, which translates into a cash distribution of RM5.10 per share. This was raised from its initial proposed cash distribution of RM4 previously.
Critics of eliminating the focus on stock price and stock-based compensation fear that doing so would leave companies without ‘an objective function’ — something to guide their performance toward creating the value they are supposed to generate. They argue that focusing on measuring value on the basis of stock price and providing incentives that are stock-based may not be a perfect system, but it is the only one that can guide proper company behavior. And they argue that investors deserve a return on their investment in the company so it is the role of management to work assiduously at maximizing the stock price.
These arguments play fast and loose with logic. Let’s say I start a company and take it public at $20/share. Ben, who helps me post these columns, buys a share for $20/share is part of the IPO. Let’s imagine that Ben needs to earn 10% on his investment to account for its riskiness — so I have to produce $2/share of net earnings for him, which would enable me to dividend it out to him and enable him to earn his targeted 10%. However, let’s imagine that there is a LinkedIn-like frenzy after the IPO, the stock skyrockets to $100/share, and Arianna buys the share from Ben for $100. The prevailing theory says that I owe Arianna (who has the same desired return for her risk) $10/share of return.
But do I? Did Arianna give me $100 like Ben gave me $20? Did Ben turn around and return his $80 profit to the firm? No. Arianna gave an $80 profit to Ben who pocketed it. Did I promote or authorize or even know of the sale by Ben to Arianna? No. They decided on that transaction themselves — my firm was not a party to it and the capital I have for investment is still $20.
So to satisfy Arianna’s return requirement, I need to make $10/share based on an investment of $20 or 50% return on investment — a very hard thing to do. All because she decided it was worth it to buy the share from Ben for $100.
She didn’t give me a single dollar of investment capital — and I don’t owe her anything more than a return on the $20, which is the total capital I have ever received for the share that she now owns. That should be the only obligation to shareholders that companies ever accept: to earn them a return above their cost of capital for the capital actually provided by shareholders (plus any earnings on those shares retained by the company rather than paid out in a dividend) — i.e., the book value of the shares. If shareholders want to trade those shares between themselves based on their expectations of the future, they should knock themselves out and do it. But those trades and the value they are made at should have no bearing on the obligations of executive management.
But because this is not the case and executives routinely accept the obligation to earn a return on the market price of the shares rather than the book value of the shares — and have their incentives tied to the former, they engage in extremely risky actions when their share price rises. Michael Jensen wrote a very good article on the subject entitled “The Agency Costs of Overvalued Equity and the Current State of Corporate Finance“, which argues that spectacular crashes including Enron, WorldCom and Nortel could be traced to this problem. Management feels the obligation to earn a spectacularly high return on the investment resources they were actually given in order to earn a minimally acceptable return on value based on the expectations of investors. That article was written in 2004, well before the 2008 crash, but the actions of the big American banks bore a great similarity. The stock price of Citibank went up by 15X during the 1990s and headed another 50% higher in the time before the crash. What did Chuck Prince think he needed to do when he took over as CEO in 2003? I suspect that it was to earn an acceptable return on the wildly inflated stock price of Citibank — however risky that was to accomplish. And it was riskier than anyone could have imagined for Prince and the other “too big to fail banks”.
At the very heart of the problem are two deeply flawed theories — first, that the obligation of management is to earn a return on the expectations of shareholders, however insanely high those expectations happen to be: and second, that stock-based compensation provides a useful motivation for management to take care of their company. They both sound good on the surface, but shareholders would be better off in the long-run if management felt the obligation to earn a fair, risk-adjusted return on the investment capital they were given and if their performance incentives were based on their company’s performance in the real game.
Executive compensation in the United States has risen dramatically in the last 30 years. The difference between the lowest-paid employees in major corporations and top executives has gone from approximately 100 to 1 to over 500 to 1. As a result, executive compensation has gone from having no noticeable effect on corporate profits to having a significant impact. More significant is the social and economic distance it has created in our society. Simply stated, the rich have gotten much richer.
The arguments justifying high levels of executive compensation usually cite pay for performance and scarcity of talent. The credibility of the pay for performance argument actually increased when the recession began in 2008. As it should, executive pay, particularly CEO pay, dropped dramatically when the stock market and economy collapsed in 2008.
In addition to providing a credibility boost, the 2008 drop in executive compensation provided an opportunity for corporate boards to orchestrate a long-term reduction in executive compensation. It is very difficult to reduce someone’s compensation when there is no performance decrease to justify it. Simply saying that because executives are paid too much they will receive a reduction in pay is a hard thing for boards to do.
In 2008, the recession reduced pay, so “all” corporations had to do to reduce executive compensation was to have plans that did not provide the lavish pay and benefits that their past ones did. Of course doing this required that they do something they have been willing to do for decades — not be driven by their CEO’s demands for higher and higher compensation.
In the case of many corporations, not changing their pre-2008 executive compensation programs was an option that “at best” was likely to lead to a slow return of executive compensation amounts to the prerecession level. Only by creating new plans with lower performance goals could they quickly return executive pay to its pre-2008 levels.
Rather than taking advantage of a rare opportunity to reduce executive pay, most boards decided to create new plans with less demanding performance targets. It is now clear that because of these new plans, executive compensation has returned to its pre-recession levels and is headed higher. However, the economy and the market value of most U.S. corporations has not recovered from the 2008 recession, nor has the compensation of the American worker.
Household income in the United States has dropped almost 10% since the beginning of the recession and shows no sign of trending upward. This is creating the worst possible social dynamic. Most members of society are seeing lower income levels, while executives are enjoying record levels of compensation. It is bad enough for executives to have a compensation level that is growing faster than that of a typical worker; it is much worse to have the compensation amounts of workers and executives going in opposite directions.
To add insult to injury, there are a number of CEOs who have been fired recently and have gotten extremely large severance packages. For example, Carol Bartz at Yahoo! got an estimated $10 million package, and Leo Apotheker at Hewlett Packard got a $13 million package after working for HP for less than a year. It is hardly surprising that there is rising social discontent with how wealth is acquired in the U.S. — witness the widespread “occupy” demonstrations.
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