Bonus culture is root of our economic problems

Profit at the expense of investment is destroying our economy

These are bold statements, and the economy is a hazy concept that is largely inconceivable to me, so they may be wrong.

But, thanks to Andrew Smithers, a prescient economist I once interviewed on internet TV, I think I’ve experienced a moment of lucidity that has made one small section of the economic puzzle more comprehensible.

I would share more of Smithers’ notes but it takes too long for me to decode them. They’re not written in the easy language of pop-economists, and the economy is fairly low on my list of research priorities.

But his latest note strays into the subject of the bonus culture, which, has, I have already written, undermined British industry. The ever-growing piece of the pie Britain’s bosses are, on the whole, taking must be paid for and so jobs, and whole industries, are ‘relocated’ to lower wage economies making us ever more reliant on service industries, some of which (see below) are part of the problem.

Smithers note* answers the question of how to revive the economy if the Government can’t spend its way out of recession because it’s already borrowed too much, and the Bank of England can’t lower interest rates any more (encouraging people to spend), because they’re already near zero. In the words of economists: fiscal policy and monetary policy can’t work.

If government can’t spend, and consumers won’t, who can? His answer is companies can, because unlike the government, they’re running a cash surplus (which is unusual) of 6% of gross domestic product.

But they won’t because short-term targets and short-term rewards lower the risks to management of raising prices, and increase the risks of long-term investment. In the short-term investment increases costs and decreases profit margins. Decreasing profit margins means missed targets and lower bonuses.

This, I think, explains something that has been puzzling me for quite a while. How it is that profit margins have been rising in the UK and the US, while our economies are doing so badly? The answer is, high profit margins aren’t indicative of a strong economy. In fact high profit margins increase profit at the expense of salaries and wages and since corporate savings rates are much higher than personal savings rates, they’re a harbinger for unemployment and recession.

The case for change is most urgent in industries that have high profit margins and invest very little, and I wonder if you can guess which is top of Smithers’ list?

It’s banking, he says, which is very likely:

…not a fully competitive industry and has been rent-gauging at the expense of the rest of the economy.

More competition is the answer, which could be created by increasing the equity requirements of large banks.

Shareholders are right at the centre of this crisis in modern capitalism because we own the companies that pay the bonuses that motivate the directors to profit now and not invest in the future.

Frustratingly, private investors have little influence. Our companies, especially the bigger ones, are mostly owned by investment funds operating for savers and investors but often managed by people motivated by short-term performance targets and overly generous pay.

So what can we do?

We can form an opinion on whether the directors of companies we own are paid too much, either in absolute terms, or using a measure like the holding ratio invented by my fellow blogger Lewis.

We should follow the example of Nate and register a protest vote against excessive remuneration at annual general meetings (although voting down the remuneration report does not compel directors to reconsider it, and its unlikely to succeed given institutional investors’ general support for the status quo).

We can vote with our feet by refusing to invest in companies that appear to overpay. Such a policy would have kept investors out of bank shares over the last decade or so, not such a bad thing.

Although I think the personalisation of the bonus debate around individuals like RBS boss Stephen Hester is deplorable because it misses the point, the whole culture is at fault, those of us who write about companies should draw attention to those paying bonuses likely to reward disinvestment.

We can favour shares in companies that are run prudently for the long-term.

I know it’s hardly picking up a pitchfork and storming the bastions, but it’s better than being complacent. And complacency is what got us into this mess.

* There’s much more in Smithers’ note about how to stimulate recovery, principally by allowing sterling to devalue, which would make manufacturing more competitive and increase investment, and relaxing planning restrictions, which would reduce the price of land and boost construction. By stimulate investment, these moves would reduce the corporate savings rate and help ward off recession.

11 Comments

Ross Parker February 20, 2012 at 11:03 am

Is the note public? If so, could you post a link? Thanks.

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- Richard Beddard February 20, 2012 at 11:27 am
  
  I’m afraid not Ross, and the wording is very strict about (not) sharing it.
  
  It’s Note no. 399 “UK: Narrower Profit Margins and Weaker Sterling Needed.”
  
  I suggest you contact Smithers & Co http://www.smithers.co.uk ] info@smithers.co.uk , they may be prepared to send you a copy.
  
  Reply
Robert Johns February 20, 2012 at 11:18 pm

I strongly agree Richard. I wonder what Graham would say about these developments if he was still around.

In my opinion i believe long term funds for pensions should be value orientated and part of that value is of coarse the management having long term interests.

What a shame i think it is that the derivatives and bank lending led the common shareholder astray.

I wonder what things would be like if we moved back to the issuance of senior debts and
preference shares for the purposes of raising capital, surely long term stability for (investors).

We know people had a good ride from the 1950′s to the 1970′s. Would it not be intelligent for
a renewed focus on fixed income securitys again?

Reply
- Richard Beddard February 21, 2012 at 9:20 am
  
  Hi Robert, I think there’s little doubt what Graham would have thought! He tackles management self-interest in a chapter of Security Analysis (you can get the first page here: http://books.google.co.uk/books?id=wXlrnZ1uqK0C&pg=PA511&lpg=PA511&dq=benjamin+graham+management+bonus&source=bl&ots=kVrxm6wVMi&sig=X2EGFMTpp079D1WrSPCm-iAd928&hl=en&sa=X&ei=J19DT92tKNCi8gP7kPCDCA&ved=0CCEQ6AEwAA#v=onepage&q&f=false )
  
  By the 1940 edition, which I have, abuses seemed to have calmed down due to regulations brought in after the Wall St Crash but he still observes:
  
  “They [abuses of compensation] do not really reflect upon the character of corporate managements but rather on the patent unwisdom of leaving such matters within the virtually uncontrolled discretion of those who are to benefit by their own decisions.”
  
  i.e. shareholders are at fault for not restraining management.
  
  I think the problem is worse now. ‘Shareholders’ don’t just leave it to managers to determine remuneration, fund managers actually encourage the bonus culture as a way of meeting their own short-term targets.
  
  Reply
teamdave February 21, 2012 at 2:04 pm

Richard, great article. Back to the good old days before you began the Thrifty 30.

I went looking for Andrew Smithers’ note over the weekend too after reading about him in the Observer. Couldn’t find anything though, so well done for tracking it down.

Makes you realise though how little power we have as shareholders. We have so little say in the running and renumeration of the people we hire to run our businesses. I understand rewarding performance but it seems that compensation for senior executives and boards of directors has run amok, with what seems like unlimited cash bonuses, golden pensions and share options abounding.

Perhaps there’s a need to set up an ethical fund, that only invests in companies that reward all employees, share holders and have a compensation culture linked to long term performance. But it would be so small the rest of the market would ignore it.

It seems the only way to create change is more regulation. It would seem companies are unlikely to vote against bonuses in the same way that Turkeys are unlikely to vote for Christmas.

Reply
- Richard Beddard February 21, 2012 at 4:20 pm
  
  errr Thanks Dave, for the kind of compliment!
  
  I’m on his mailing list so the kudos for tracking it down is ill-deserved, but I’ll take it
  
  I like the sound of your fund. Or maybe fund managers could attract funds by promising to be more active in influencing boards to restrain pay.
  
  Generally, I think these things go in cycles, it takes time to change attitudes. As I mentioned there’s a difference between what Graham was saying in the 1934 edition of Security Analysis (boards and remuneration are out of control) and the 1940 edition (lessons have been learned). It took the great depression and yes, regulation, but eventually things improved. Until the generation of investors and managers that survived that period had gone…
  
  Reply
John Mulligan February 23, 2012 at 3:07 pm

Hi Richard
As you know this is one aspect of what I consider is the wider problem of the accountability deficit. Briefly I shall repeat what I have said, and written about, in the past with regard to this problem. I believe that the increasing gap between those who are the ultimate owners of investment assets, be they shares, managed funds or pension pots has been one of the key trends that has enabled senior managers to extract for themselves an ever larger portion of the corporate profit pie.
My basic thoughts on this were written a couple of years ago on the Investors Association website at http://www.investorsassociation.com/content/accountability-gap.
The difficulty in addressing the overall problem regarding wider accountability and the more specific one of excessive pay and bonuses is that few people seem to know or care much about it.
I should be delighted if anyone interested in taking these aspects further would contact me either through the blog pages on the Investors Association website at http://www.investorsassociation.com/blog or email me at jpm@companynews.co.uk.
I look forward to responses and suggestions.

Reply
- Richard Beddard February 24, 2012 at 10:52 am
  
  And you’ve said all those things to me John, it’s just taking me a while to shake myself out of my complacency. Thanks.
  
  Reply
Dr. Keith Anderson February 23, 2012 at 6:56 pm

Richard, another excellent article. I recommend the Tullett Prebon Project Armageddon report re government spending: we are on a one-way ride to a gilts crisis at the moment. George Osborne’s plan to close the horrendous gap between his tax income and expenditure (£2,000 per year per man, woman and child in the country) depends largely on highly optimistic growth forecasts. But that growth cannot appear, because 70% of the economy’s sectors are ex growth: health, education, financial services, construction, retail…

The gap between what ordinary people think is a fair bonus and what is actually paid is a big problem, but will continue to exist as long as fund managers are able to vote contrary to how the people who actually put up the money (small ISA and pension savers) would want them to vote. The fund managers are paid at least as much as the directors and honestly don’t think the latter are overpaid. Although asking them about the hundreds of individual votes would be impractical, I see no reason why they could not be legally required to ask the beneficial owners for a general rule on how they should vote on remuneration. For example, “You will vote against any remuneration package that will see the recipient receive more than 5/10/20 times the median employee”.

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- Richard Beddard February 24, 2012 at 10:54 am
  
  Hi Keith. I think your suggestion is a good one. At first I thought it was impractical. But there were probably people who thought that about voting for the masses in parliamentary elections! It would be a great start if companies were compelled to divulge the median salary in their annual reports. I’m sure there was a move afoot to do this?
  
  Reply
Weekend reading: Buffett’s new shareholder letter February 25, 2012 at 9:09 am

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