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Tom Hosking
Tom Hosking 09-05-22

Fluffy the dog

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

A phenomenon that crops up again and again in life is the principal-agent problem. Whenever someone acts on behalf of someone else, there is the potential for conflicts of interests to arise and lead to a sub-optimal outcome. The issue is particularly pertinent in the world of investment where the owners of capital, shareholders, delegate decisions about how their capital is best used to the CEOs of the companies they invest in. Agency conflicts can range from frivolous expenses, such as flying around unnecessarily in a corporate jet, to more serious examples such as accounting scandals that end in bankruptcy. The best way of aligning the incentives of the principal and the agent in this context is for management to own shares in the company, thereby increasing the probability that management will act in the best interests of shareholders. However the issue of management shareholdings is not quite as simple as it might seem. Much like how in the first Harry Potter book, readers are introduced to Hagrid's pet, Fluffy, whose name belies his true form: a giant angry three-headed dog, a very different creature from what you would have guessed from its name.

The first head
Of the three ways that management can obtain shares, the most preferable is that they buy them themselves. Investors must make decisions based on limited information about companies. In contrast, management know their companies far more intimately with no disclosure barriers. Investors can take advantage of this information asymmetry by taking note when management buy shares for themselves, suggesting confidence that the company's prospects are more positive than market expectations and that the shares are therefore undervalued. Conversely, when management sell shares, it suggests the opposite: a red flag for investors, although this tends to be a weaker signal because there might be forced selling to meet a tax bill, for example. Such dealings by management are often referred to as insider trades and must be disclosed to the market within two business days. Investing on the basis of management dealing is not foolproof because significant uncertainty exists about an investment's prospects even when you are privy to all internal information – many external factors are beyond management's control, for example. However it is a very helpful signal that a company is worth further research.

The second head
Management may also own shares if they are the founder of the company and have retained shares following an IPO. Founders can often retain significant shareholdings which make them much more aligned than professional managers, not to mention that they also tend to be much more emotionally invested in the long-term success of the business that they built from scratch. Academic research suggests that founder-led companies tend to be very good investments.

However, with management shareholdings it is possible to have too much of a good thing. The stick which shareholders have at their disposal for aligning incentives is the threat of firing company management for poor performance. If a founder CEO owns the majority of the shares, this is not possible. Founder ownership might solve one problem, but it can create another: what we thought was the agent is actually the principal, and what we thought was the principal is actually a minority shareholder with no say in how the business is run. Controlling shareholders can make decisions that benefit themselves disproportionately relative to minorities, such as employing family members rather than the most talented managers. These companies often trade at discounts due to this lack of control. However, the degree to which this disadvantages investors depends very much on the founder in question. The lack of voting rights increases risk but does so in a symmetric way, i.e. it increases the range of possible returns not only to the downside but also to the upside if the company is run well.  For example, it would be hard to argue that having Mark Zuckerberg as the controlling shareholder of Meta (formerly Facebook) has been bad for minority investors: at time of writing, the Facebook share price has risen over five times since its IPO in 2012. The key is to be reasonably confident about the ability and motives of management before investing in a company where you can't fire them if you turn out to be wrong.

Interestingly, management control can be beneficial as it can insulate CEOs from the outside pressures that force them to make myopic decisions. Regular managers may be unwilling to invest in long-term projects because they worry this will damage the company's profit growth in the short-term and lead to them being fired. Maximizing profitability today is not necessarily in the long-run interests of shareholders. For example, in luxury fashion stretching a brand too far in the short-term can jeopardise its longevity. It's no coincidence that the most successful luxury groups, such as LVMH and Kering, tend to be family run.

While limiting voting rights often encourages long-term thinking, it is a second-best solution. Preferable is for the initial base of shareholders to be patient, invest with a long time horizon and use their votes to incentivise management to think the same way. The success of growth companies in recent years, such as Amazon and Netflix, suggests that such a mindset is becoming less rare.

The third head
The final way management can obtain shares is if they are given them as part of their renumeration. Share-based compensation (SBC) aligns incentives and is especially useful for young start-up companies who may be cash poor. A potential red flag for investors is if a mature company rapidly increases SBC because it could be a sign of cash flow problems.

SBC can come in a variety of forms but is typically a mix of share grants and share options. Investors should be wary of excessive use of the latter. The way options work means that their value increases with volatility of the share price and this can create perverse incentives for management to manipulate the release of information around the dates at which they are granted and when they are exercisable. However options do serve a useful purpose if used in moderation. Granting shares can have the effect of making management excessively risk averse as the bulk of their wealth becomes increasingly tied to the fortunes of the company. This can lead them to only invest in very conservative projects and to avoid any project with risk attached even if that would better maximise value for shareholders. In contrast, options have asymmetric payoffs where the owner benefits from share price rises but not from falls. Therefore the inclusion of options as part of the mix can better align incentives.

SBC is also a convenient way of deferring compensation for executives. This is desirable because investors do not want to reward managers for short-term non-sustainable growth. Shares can be granted with restrictions preventing their immediate sale and share options can include a distant exercise date. Ideally SBC should vest as far in the future as possible in order to encourage long-term decision making, but the carrot should not be too far away lest management be incentivised not to exert any effort today. Ideally at least a portion of the shares should not vest until years after the manager has left the company. This is to discourage them from quitting and immediately selling all their shares if they were to discover a problem that has grown under their watch.

As an aside, it is worth mentioning that SBC is usually not fixed but is a component of performance-related pay, another tool for aligning incentives. Investors should look for companies where the majority of executive compensation is tied to corporate long-term goals rather than short-term performance targets. One advantage of being an institutional investor is that we are able to engage with companies on their long-term incentive plans (LTIP) for management. For example, we often request that compensation be tied to ESG metrics such as the reduction of greenhouse-gas emissions. In theory, such considerations should be internalised by management's exposure to the share price anyway but in practice it helps to focus minds by setting explicit targets for certain goals that should boost shareholder value.

The Tail
Investors that have got their heads around all the various ways corporate governance can affect investment returns should not fall at the final hurdle and forget the pitfalls SBC can contain for valuation metrics. It has become fashionable for companies and analysts to add back SBC expenses to calculate adjusted earnings. Their justification for this is that SBC is a non-cash expense and even non-recurring; therefore it should be stripped out. Such reasoning is faulty. Given in lieu of wages, SBC is clearly an in-kind expense that should be recognised when granted, and as employees have to continue to be compensated, it is also an ongoing operating expense. Additionally, any investor's shares in the company are progressively worth less and less as they become diluted by the company issuing new shares. So when calculating the PE ratio, investors should count SBC as an expense and use the fully diluted earnings per share as the denominator. And if valuing a company on free cash flow, investors should use a lower target multiple than for a comparative company that doesn't make such liberal use of SBC.

Harry Potter aficionados will know that Harry and his friends found their way past Fluffy by playing him soothing music. The above is a summary of our hymn sheet for how to think about management shareholdings, and we hope you find it helpful.

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KEY RISKS

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

Investment in funds managed by the Global Fundamental Team may involve investment in smaller companies. These stocks may be less liquid and the price swings greater than those in, for example, larger companies. Some of the funds may hold a concentrated portfolio of stocks, meaning that if the price of one of these stocks should move significantly, this may have a notable effect on the value of that portfolio. Investment in the funds may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. 

Some of the funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

DISCLAIMER

This is a marketing communication. Always research your own investments and if you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.  It should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of securities are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust.  

Tom Hosking
Tom Hosking

Joined Liontrust in April 2022 as part of the acquisition of Majedie Asset Management where he was an Equity Analyst and Co-Fund Manager for eight years.

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