Share Sleuth: Why 'skin in the game' is important

Criterion number four of the five rules I use to select shares for the Share Sleuth portfolio does not measure the quality of the business, nor my understanding of it, as the previous three do. It tests the executives, and their incentives in particular.

Long-term investors must trust executives will invest the company's resources so they achieve good profits for many years, an activity we call "capital allocation". One of the capital allocation decisions that executives make is how much to allocate to themselves.

The growing prevalence of performance-related incentive schemes, potentially many times more valuable than basic salaries, means that generally executives are allocating far more than they used to.

This is an industrial scale misallocation of capital. Research from academia and data providers indicates the correlation between executive pay and corporate performance is negligible.

Some studies show it's negative, which means companies that pay chief executives the most may perform least well over the long term. So how should investors measure executives' worth?

The most common performance measures are growth in earnings per share (EPS), a measure of profit, and total shareholder return (TSR). Over the long term, a company that earns a lot of profit is likely to have been a very good investment.

TSR adds the dividends paid to the change in the share price over a period of time. A share that has paid handsome dividends and increased substantially in price over the long term will most certainly have been a good investment.

However, over one year or even three years - the typical performance period for so-called Long-Term Incentives Plans - these are terrible measures.

Share prices and profits can be volatile and influenced by events beyond executive control, so they're not really measures of executive performance at all.

Worse, there are things executives can do - such as reducing investment - to boost profit in the short term, but they often reduce long-term prosperity.

In his government-sponsored report on the UK stockmarket published in 2012, the economist John Kay identified the misaligned incentives that contributed to the failure of BP to invest in safety and protecting the environment, and the failure of GSK to invest in its drug pipeline.

He proposed a simple idealistic solution: that bonuses should be paid in shares, and executives should be required to hold them until after they step down. This would ensure executives are exposed to the risks and ultimately the rewards of long-term investment.

I've married Kay's requirement for share ownership to another idealistic requirement, that executive salaries be benchmarked against those of other employees.

Usually companies benchmark executive pay against their peers at similar firms, but when everyone wants to be paid more than their peers, salaries can only go in one direction.

My criterion for management incentives is therefore: management should profit through the ownership of shares held for the long term. They should be paid fairly, according to the demands of the job and relative to employees.

I can only think of a handful of companies that satisfy these stipulations entirely. Perhaps Quartix meets them best.

Quartix makes vehicle-tracking devices. The company is still run by its founder, who retains a large shareholding.

He doesn't pay himself a bonus or a six-, seven- or eight-figure salary, which means most of his income comes from dividends and his wealth will also grow if the company grows in value.

Perhaps not surprisingly the company is very profitable, and it has done very well since it listed on the stockmarket a few years ago.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.