UK investor Neil Woodford scraps bonuses as it leads to ‘wrong behaviours’

Colin Kruger, CBD:

One of Britain’s most respected investors, Neil Woodford, has scrapped staff bonuses at his investment group, saying it has proved to be “largely ineffective” which can lead to “wrong behaviours” by staff.

“There is little correlation between bonus and performance, and this is backed by widespread academic evidence,” said the firm’s chief executive Craig Newman.

The academic evidence directly cited by the group was even more damning. “Financial incentives are often counterproductive as they encourage gaming, fraud and other dysfunctional behaviours that damage the reputation and culture of the organisation,” said an extract from The Journal of Corporation Law. “They produce the misleading assumption that most people are selfish and self-interested, which in turn erodes trust.”

I hope we see more of this. Large corporations need to wake up to the fact that bonuses are counter-productive. Not only do they encourage “wrong behaviors” among company executives, they also destroy trust within the organization and with shareholders and the public. Share options are simply a variation on the same theme.

Rather encourage staff to become shareholders, with low-interest loans linked to a clause that prevents sale of the shares for a minimum of 5 to 10 years. That gives employees some skin in the game and aligns their interests with shareholders.

Source: UK investor Neil Woodford scraps bonuses as it leads to ‘wrong behaviours’

Beware of recency bias

Every the year the 2016 Russell Investments/ASX Long-term Investing Report provides an invaluable summary of before and after-tax returns on various asset classes for Australian investors, over 10 and 20 years.

Naive investors are likely to automatically pursue the asset classes that offer the highest yields. Recent performance is more likely to attract our attention than more stable longer-term performance. Josh Brown highlighted last year that mutual funds that attracted the most new investment tended to underperform funds that attracted the least new inflows. I suspect that the same applies to asset classes.

If we consider each of the asset classes highlighted, it is clear that performance over the next 10 years is likely to be substantially different from the last decade.

Australian Asset Classes 10-year Performance to 31 December 2015

Source: 2016 Russell Investments/ASX Long-term Investing Report

Australian Shares

Australian Shares endured a (hopefully) once-in-a-lifetime financial crisis in 2008. 10-Year performance is going to look a lot different in two years time (20-years is 8.7% p.a.). Prices of Defensive stocks, on the other hand, have since been inflated by record low interest rates.

Residential Property

Residential property prices boomed on the back of low interest rates and an influx of offshore investors. But growth is now slowing.

RBA: Australian Housing Growth

Listed Property

REITS were smashed in 2008 (20-years is 7.7% p.a.). But before contrarians leap into this sector they should consider the impact of low interest rates, with many trading at substantial premiums to net asset value.

Bonds & Cash

Low interest rates again are likely to impact future returns.

Global Shares

Global Shares also weathered the 2008 financial crisis (20-year performance (unhedged) is 6.4% p.a.). Subsequent low interest rates had the greatest impact on Defensives, while Growth & Cyclicals trade at more conservative PEs.

I won’t go through the rest of the classes, but there doesn’t seem to be many attractive alternatives. It may be a case of settling for the cleanest dirty shirt, and the least smelly pair of socks, in the laundry basket.

Defensive PE at a dangerous high

Low interest rates and the accompanying search for yield have driven the forward Price-Earnings ratio for Defensives to a 20-year high. This is likely to reverse when (not if) rates eventually rise. Cyclicals and Growth, however, still look reasonable.

Economists Turn a Blind Eye to Historical Data | Bloomberg View

Barry Ritholz explains where many economists are going wrong when comparing the current recovery to previous recessions:

Why are so many economists, journalists and asset managers using the wrong history for their analysis? In a word: context. As I have been pointing out for nearly a decade (see here, here and here), most are looking at the wrong data set to analyze and compare this recovery to prior ones, using post-World War II recession recoveries as their frame of reference. The proper frame of reference, as Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University explained in 2008, are debt-induced financial crises…..

Why is there such a difference between economic recoveries? The defining characteristic of any recovery from a credit crisis is ongoing debt deleveraging, meaning that households, companies and governments are primarily using any economic gains in income or borrowing costs to reduce their debt. Low rates are not being used to buy homes, but rather to refinance existing obligations. Hence, the entire current post-crisis period has seen only mediocre retail sales gains and slow GDP growth. Reinhart and Rogoff observed that, while rarer, post-credit-crisis recoveries are weaker, more protracted and much more painful.

There is normally only one credit crisis per generation. They take a long time to fade from memory. And recoveries are slow and protracted. Which is why we should insist that steps are taken to prevent rapid debt growth and a long-term repeat of the 2008 disaster. Increasing bank capital requirements and targeting nominal GDP growth (as suggested by market monetarists) are two important bulwarks against future credit crises.

Source: Economists Turn a Blind Eye to Historical Data – Bloomberg View

Lies Politicians Tell Us | Hoover Institution

Great insights from Allan H. Meltzer at the Hoover Institution:

Most of us learn at some point that politicians tell lies. We expect them to stop once they hold office or to face the consequences. In the past, politicians that violated the public trust resigned, most notably President Richard Nixon. Other lesser officials have also been punished for abusing public trust. No longer. In campaigns, and in office, politicians and their aides or supporters deliberately lie about matters of importance.

….The Obama administration lied to change a major foreign policy issue. Other lies are about less important but not unimportant issues. The French economist Thomas Piketty claimed that capitalism squeezes the middle and lower classes to favor the rich. Piketty’s book Capital in the Twenty-First Century and other studies that followed supported that argument by relying on deceptive data—specifically, income before taxes and transfers. Critics pointed out that the case is much weaker if income after taxes and transfers is used, as it should be. That’s much closer to the receipts that people have. And the differences are large. Transfers that are not part of income before taxes amount to more than $1 billion annually. The top 20 percent of taxpayers paid 84 percent of all income taxes in recent years. And the derided top 1 percent paid 23.5 percent of the income tax.The failure to use income after taxes and transfers cannot be accidental. It seems to be a deliberate attempt to mislead the public. And it is not the only misuse of data. Much of the recent large rise in the income received by the top 1 or 10 percent results from the Federal Reserve’s policy of lowering interest rates and raising housing and stock prices.

…..Hillary Clinton proclaims almost daily that women receive only 78 percent of the income that men receive. Her message is so misleading as to be dishonest. The 78 percent number is the ratio of women’s to men’s median pay. It does not adjust for occupational and other differences in the work that men and women do. For example, skilled neurosurgeons and football, baseball, and basketball stars are men. Domestic workers and hospital cleaning crews are mainly women. A recent paper by Diana Furchtgott-Roth summarized studies at Cornell and other quality economic departments. When adjustment for occupational differences are considered, the ratio is 92 or 94 percent, not the advertised 78 percent. And the remaining difference may not be due to discrimination. Differences in time in the work force, hours worked, and other factors may play a role.

….These are just a few examples of lies and misleading statements that we encounter every day. Clinton lies frequently and Trump shouts a falsehood a day—and probably more—as a major part of his campaign. This is not what citizens of a free country should expect and demand.

….Free societies require truth and honesty.

Worth reading the entire article at: Lies Politicians Tell Us | Hoover Institution

Hat tip to David Kotok.

ASIC review of investment banks shows poor practice

From Sarah Danckert:

The ASIC review of investments banks found that not only do the heavyweights of Australia’s financial system have difficulty in managing their conflicts of interest they also financially reward staff for potentially conflicted behaviour.

…..So ugly is the result the Australian Securities and Investments Commission has warned the people often known as the smartest men and women in the room it will take action against the culprits if the poor behaviour continues.

……Managing conflicts of interest are crucial for investment banks because often one part of the bank is advising on an asset sale or an initial public offering while the bank’s research arm is producing research for the investment banks’ investor clients about the quality of the assets or the IPO.

….ASIC said it had also found “instances of remuneration structures where research remuneration decisions, including discretionary bonuses, took into account research analyst involvement in marketing corporate transactions”.

The review also found “instances with mid-sized firms where research reports on a company were authored by the corporate advisory team that advised the company on a capital-raising transaction or had an ongoing corporate advisory mandate”.

Results of the review come as no surprise. When there is a conflict between profits with multi-million dollar bonuses and independence the outcome should be obvious.

Having worked in the industry, I believe that the only way to achieve independence is to separate investment banks from research houses, with no financial linkage. A professional body for research houses would ensure independence in much the same way as the auditing profession. There is no better way of enforcing good behavior than the threat of censure from a professional body that has the power to prevent its members from practicing.

Source: ASIC review of investment banks post UBS-Baird government run-in shows poor practice

US Light Vehicle Sales disappointing

June US Light Vehicle Sales came in at a disappointing seasonally adjusted annual rate of 16.689 million vehicles. Light vehicle sales, an important barometer of consumer confidence, have been trending lower since November 2015. Further falls would be cause for concern.

Light Vehicle Sales

CEOs Are Paid Fortunes Just to Be Average | Bloomberg View

From Barry Ritholtz:

Verizon’s purchase of Yahoo! for $4.83 billion, while an interesting exercise in combining content, networks and mobile services, highlights the broken norms for paying executives of U.S. corporations…….Yahoo Chief Executive Officer Marissa Mayer will walk away with more than $200 million for doing little more than keeping the seat warm for the past four years.

Research has shown that external influences account for the majority of a given company’s share price. A rule of thumb is that the company itself is only responsible for about a third of its price movement. The market gets credit for about 40 percent, while the performance of the company’s industry drives another 30 percent.

There are of course exceptions. Apple’s incredible share run-up on the iPod, iPhone and iPad is hard to match.

….Share price isn’t a very precise way of compensating for value delivered. Indeed, share price may be one of the worst ways to judge an executive’s performance….

There should be ….. reform in corporate pay policies; executives who deliver returns that match the market or industry should be compensated like low-cost service providers. It’s long past due that this happens.

Barry raises an interesting point. Why not pay executives for outperformance, above the market, in the same way that fund managers are paid performance fees for outperforming the index?

But there is another issue related to stock options. Executives are betting with other people’s money. If the bet comes off and the stock outperforms, they cash in their share options. If the bet doesn’t come off, the shareholders suffer and the executives walk away scot-free. They will be more inclined to take risks if they have no skin in the game.

The investment bank I worked for in the nineties had a far more sensible approach. Executives were loaned large amounts at attractive interest rates for the purpose of buying shares in the company. When the stock price rose they became extremely wealthy. But if the price had fallen, they were accountable for the loan. It certainly made executives more risk-averse — they thought and acted like shareholders. Not a bad idea in the banking industry.

Source: CEOs Are Paid Fortunes Just to Be Average – Bloomberg View

Privatisation has damaged the economy, says ACCC chief

In a blistering attack on decades of common government practice, Australian Competition and Consumer Commission chairman Rod Sims said the sale of ports and electricity infrastructure and the opening of vocational education to private companies had caused him and the public to lose faith in privatisation and deregulation.

“I’ve been a very strong advocate of privatisation for probably 30 years; I believe it enhances economic efficiency,” Mr Sims told the Melbourne Economic Forum on Tuesday. “I’m now almost at the point of opposing privatisation because it’s been done to boost proceeds, it’s been done to boost asset sales and I think it’s severely damaging our economy.”

Mr Sims said privatising ports, including Port Botany and Port Kembla in NSW, which were privatised together, and the Port of Melbourne, which came with conditions restricting competition from other ports, were examples where monopolies had been created without suitable regulation to control how much they could then charge users……

Deregulating the electricity market and selling poles and wires in Queensland and NSW, meanwhile, had seen power prices almost double there over five years, he said.

I have also been a strong advocate of privatising state assets, but Rod Sims raises some important concerns that need to be addressed.

There is a strong trend in capitalist economies away from free enterprise and towards privatised “monopolies”. Investors place a great deal of emphasis when evaluating stocks on a company’s “economic moat” or competitive advantage. Both of which imply the ability to restrict competition. While this may maximize revenue for the individual economic unit, it is harmful for the economy as a whole.

Which brings me back to Mr Sims’ point. Higher prices paid for infrastructure services destroy the competitiveness of the economy as a whole, with profound implications for exports and productivity.

Source: Privatisation has damaged the economy, says ACCC chief