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Reputation and Remuneration

Reputation and Remuneration

I found myself with a bit of free time recently, and spent an enjoyable several days reading “Thinking, Fast and Slow”, which summarises the work of Daniel Kahneman, one of the world’s leading authorities on heuristics and biases which can influence decision making (and a winner of the Nobel Memorial Prize in Economic Sciences).

Included in the many insights in the book is a discussion about when we might expect experts in a field to possess high levels of skill, and when we should treat them with skepticism. To summarise, an expert with many years’ experience in a field can be expected to genuinely be an expert only when certain conditions are met. These include:

· The field they work in must have a degree of structure or regularity, such that a given set of inputs lead consistently to the same outcomes; and
· Feedback must be timely – Experts need to have learnt from experience to associate inputs with their resulting outputs, which means that the outputs need to become apparent reasonably quickly.

Examples of situations where these conditions are met include chess and table tennis, where the pieces and the ball behave consistently, and players quickly learn whether their chosen move or shot was a good one. The ability of skilled chess players to simultaneously play a large number of opponents illustrates this. They have learnt to instantly recognize patterns on the chess board, and already know moves will be effective against those patterns.

Economics is one example of a field where these conditions aren’t met. Economies are highly complex, change over time, and have a human element which promotes inconsistency. Also, it can take many years to see the ultimate result from a particular set of conditions. This helps explain the very poor track record of expert economic forecasters.

It strikes me that another area where this logic applies is in relation to CEO salaries. The relationship between CEO skill and company performance is a highly complex and uncertain one, with competitor actions, comparative advantage – and luck – all playing a big role in the outcome. In addition, the outcomes are typically not known for a number of years. I’m also reminded of Warren Buffet’s musing: “ When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”.

In view of this, it seems to be that it must be all but impossible for a board of directors to be able gauge with a high level of accuracy the true worth of a CEO, and particularly a CEO who has not been in the role for an extended period.

Given this, we can probably say with confidence that a board of directors that routinely awards astronomical pay packages for CEOs who spend 4-5 years at the helm is throwing away money that rightfully belongs to shareholders.


Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Roger has often remarked something to the effect that there is nothing riskier than buying into a business with low returns – and I agree.

    If I were on the board of a large business with terrible economics I’d pay whatever I thought necessary to attract the kind of amazing management talent that could keep the business on the right side of the cost of capital because a bad year isn’t something you can overcome in a good one. I’d also want to KPI them in a way that reflected the long term transitional needs of the business, as important as the stock price is to keeping a business whole, I’d much rather have a CEO focused on where our next cash stream is coming from.

    If I made a mistake hiring a CEO into a business with bad economics, I’d want to be able to get rid of him quickly – we cant afford bad judgement because we’ve already got bad economics, I also think it would be unlikely that we’d be able to hire an unbelievable manager into an economically challenged business unless we made sure that if it didn’t work they could leave quickly, gracefully and with a parachute to sustain them to the next job – or we’d have a really hard time getting them to move. I also think that if an unbelievable manager was willing to move without all this stuff, he’s not unbelievable – winners know the score.

    It’s popular these days to get on the soap box and bash management for being stupid – but they’re generally smart people with great track records making decisions based on the environment in front of them and they pay market rates. The sooner we get away from the tall poppy syndrome and pretending we’re all perfect, the better for all of us – alternately we could legislate a CEO price ceiling – it would “solve” the problem and give us another great economics case study.

    • From the BBC March 3rd 2013:

      Swiss voters have overwhelmingly backed proposals to impose some of the world’s strictest controls on executive pay, final referendum results show.

      Nearly 68% of the voters supported plans to give shareholders a veto on compensation and ban big payouts for new and departing managers.

      Business groups argued the proposals would damage Swiss competitiveness.

      But analysts say ordinary Swiss are concerned about a growing economic divide in the country.

      The vote came just days after the EU approved measures to cap bankers’ bonuses.

      ‘Fat cat initiative’
      The final results showed that all 26 Swiss cantons backed the proposals.

      In all, 1.6 million voters said “Yes” against 762,000, who rejected the idea.

      The BBC’s Imogen Foulkes, in Berne, says multibillion dollar losses by Swiss banking giant UBS, and thousands of redundancies at pharmaceutical company Novartis, have caused anger in Switzerland – because high salaries and bonuses for managers continued unchanged.

      The new measures will give Switzerland some of the world’s strictest corporate rules, our correspondent adds.

      The “fat cat initiative”, as it has been called, will be written into the Swiss constitution and apply to all Swiss companies listed on Switzerland’s stock exchange.

      Support for the plans – brain child of Swiss businessman turned politician Thomas Minder – has been fuelled by a series of perceived disasters for major Swiss companies, coupled with salaries and bonuses staying high.

      Our correspondent says the main example is banking giant UBS, which wrote off billions in the wake of the 2007 sub-prime mortgage crisis, and then had to be bailed out by the Swiss government.

      A further incident came in February when it was announced that the outgoing chairman Novartis’, Daniel Vasella, would be receiving a 72m Swiss francs (£51m; $78m) “non-compete” pay off over six years, designed to stop him working for other related industries.

      The payment was later scrapped, but it provoked anger and amazement in Switzerland, because his salary had been regarded as too high and the firm had been cutting jobs, our correspondent adds.

      One of the organisers of the referendum, Brigitte Moser Harder, told the BBC she thought the Swiss people agreed with the proposals because the gap between rich and poor had become wider.

      “From the beginning, 2006, we had the support of the people of Switzerland because you know not everybody in Switzerland is rich.

      “It’s also a social problem because the high wages got higher and the small ones sometimes just got lower. I think people have the support of the Swiss people because of that.”

      Meanwhile, under an EU deal agreed last week by the bloc’s 27 nations, bonuses will be capped at a year’s salary, but can rise to two year’s pay if there is explicit approval from shareholders.

      The UK argued the EU bonus rules would drive away talent and restrict growth in the financial sector.

  2. Andrew Legget

    It sounds like an interesting read.

    Life seems to be broken up into things that are quantifiable and those that aren’t, I believe there is a third category which is those places that aren’t quantifiable but we wish were. So we set up models to try and predict the future under the name if economics. Not to say these models are not helpful or that they are wrong but that we can never be certain of an outcome in these areas until they happen. Until then it is an informed guess backed by calculations.

    We can be confident of future outcomes where there is an exact answer. If x then do y. These areas are few and far between . The more we introduce human behaviour though the less certain we can ever be. Fear, hubris, greed etc are all differing emotions but skew the chances of a certain outcome happening. Bias is everywhere in the stock market and so are emotions so we should never expect the market to be truly rational. This however creates opportunities.

    Ceo’s are humans and there for will commit the same mistakes. They are hired for their insights in predicting what in most cases can’t be predicted. In this i feel sorry for them as it is an endeavour which will at some point prove their psychic abilities wrong.

    One thing I have realise is that the world tends to repeat itself, same mistakes are made over and over again and the beginning iod these seem to be human emotions whilst well intentioned. The mistakes of the past will continue to happen in the future as will creative destruction.

    I will finish this thought with a quote which I think links not only into creative destruction but also buffets quote. I have been reflecting on this for a little bit.

    “The world breaks everyone … those that will not break it kills. It kills the very good and the very gentle and the very brave impartially. If you are none of these you can be sure it will kill you too but there will be no special hurry.”

    It is amazing where you can find things that help you reflect on a completely different area.

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