Pay To Downsize

5. August 2015

The Financial Times columnist Andrew Smithers in London proposes that companies with executive incentives that focus on profits save much too extensively, thereby blocking future growth. This is understandable because - in the short run - profit is easier increased by reducing costs than by increasing sales or investing in new business. As a result, profit sharing programs achieve exactly the opposite of the desired outcome, namely reducing rather than increasing profits. We now have first evidence from the Swiss market that companies with a focus on profit sharing incentive systems grow less than others (German article in NZZ am Sonntag).

Profit sharing an incentive do downsize

Obermatt has evaluated 40 Swiss companies in respect to their incentive structures and their impact on growth, profits and shareholder returns. The result: companies with balanced remuneration systems grow three times more than those with an emphasis on profit-sharing. With “profit-sharing” we mean remuneration systems based on EPS (earnings per share), ROE (return on equity), ROCE (Return on Capital Employed), RONOA (return on net operating assets), ROS (return on sales, EBIT% sales) and Economic Profit.

In 2014, companies with balanced incentives not only grew more but they also had a 6.5 percentage points higher shareholder return and delivered more profit, too. (see graph below).

What does the profit focus mean for shareholders?

Obermatt divided the SMI Expanded companies (excluding financial institutions) into two groups: companies focusing exclusively on profit sharing (12 SMI Expanded companies) and those with a broad mix of compensation elements such as growth criteria and market comparisons for performance measurement (17 SMI Expanded companies). Financial institutions were excluded from the analysis because their compensation practices differ greatly from that of other companies.

The focus on profit has a negative effect on Swiss shareholders. Profit sharing reduces the growth outlook and thus reduces the stock returns as Andrew Smithers has demonstrated for the US and UK and Obermatt could now also determine for the market in Switzerland.

The good news: The majority of companies pay to grow

Luckily for the SMI, only a minority of one-third of all companies use only EPS, ROE, ROCE, RONOA, and Economic Profit – i.e. pure profit sharing. The majority pay to grow. For example, SIKA who, for years, has been comparing its revenue growth against publicly traded competitors. This is known as an indexed compensation. At Sika sales and profit growth is measured relative to the market. Therefore, management is not penalized if it grows above the market, because above market performance means above-market compensation. Last year, SIKA surpassed all its competitors.

In compensation systems without market comparisons (without indexed compensation) good performance usually leads to higher goals in the following year. The executives are therefore punished for their good performance. No wonder growth suffers under these conditions.

Market indexed compensation is more stable, especially for Long-Term-Incentives

For remuneration committees and independent directors, indexed compensation has the advantage that it promotes growth and contains no incentive to downsize. In addition, it is also more stable than budget-based compensation, because external fluctuations are neutralized. This is particularly important in long-term incentives (LTI). Experience shows that indexed LTIs fluctuate less than ten to twenty percentage points even for three- or five-year plan periods. Stability in LTI payments means satisfied executives. Last but not least, indexed payments are more predictable because unexpected market fluctuations are neutralized. An indexed compensation is therefore never an inexplicable surprise - neither for the managers nor for the remuneration committee or the shareholders.