A New Way to Define 'Wealth'

Joel Litman

'Incentives dictate behavior'...

It's a phrase we use here a lot at Altimetry. In simpler terms, incentives dictate behavior (or "IDB") means that everyone – from CEOs to shop floor sweepers – is driven to behave in a certain way based on his or her promised rewards.

In terms of evaluating stock investments, IDB is one of our more formidable research applications.

You see, every listed company in the U.S. is required to file a form called the "DEF 14A" with the U.S. Securities and Exchange Commission ("SEC"). The DEF 14A is a place for management to report its compensation methods.

Management discloses the metrics and targets that determine its bonuses... whether those bonuses are short- or long-term in nature... and whether the team receives compensation in cold, hard cash, in stock, or in options.

That's what makes the DEF 14A so critical – it doesn't just reveal how much the higher-ups are paid. After all, it doesn't make a big difference if the CEO of a multibillion-dollar company receives a $1 million or $2 million bonus. That's not going to change much for investors.

But this form also highlights how and when these folks get paid. And that information is incredibly important. We want to see that management is being paid to do the right things to create shareholder wealth. If executives make an extra million or two while driving tens of millions of dollars more in shareholder equity... they earned it.

But if corporate executives are simply chasing some arbitrary calculation of profit – like those determined under generally accepted accounting principles ("GAAP") – they will almost certainly make the wrong moves for shareholders... all while raking in more money for themselves.

After all, the incentives that drive the management team will dictate its behavior.

Our IDB analysis is all about vetting management's alignment with investors (or lack thereof)...

To understand what I'm talking about, let's take a look at one of Wall Street's favorite common financial metrics – earnings before interest, taxes, depreciation, and amortization ("EBITDA").

The pros and the mainstream financial media have been lauding EBITDA as vital to company analysis for decades. As the name suggests, in a dubious effort to create a metric "closer to cash flows," this calculation looks at earnings not including expenses like interest, taxes, depreciation, and amortization.

But investing legends like Warren Buffett, Seth Klarman, Charlie Munger, and a whole list of other giants think that EBITDA is a terrible metric. And they're right.

Compensating the management teams of large companies using only EBITDA metrics creates perverse incentives. If executives get bonuses for higher EBITDA, why should they care about being over-leveraged? They won't be charged for their interest expenses anyway. It's included in the calculation.

If management wants to use all that new debt to buy all kinds of properties, plants, and equipment... no problem. Since depreciation and amortization aren't subtracted from EBITDA, management won't be punished for overspending.

In short, EBITDA tells management that it needs to drive growth in an earnings number that includes no accountability for the assets and capital required to create that growth.

It's inane. It's ridiculous. And yet, it's at the heart of lots of management compensation plans. In these terrible cases of IDB failure, when management compensation goes up, investor wealth falls.

Telecom companies are a good example of this. Leap Wireless, the former owner of Cricket Wireless, had an incredibly dubious DEF 14A. The company put the wrong metrics in place, and management was doing what it was paid to do. It grew EBITDA all right... and drove the stock price through the floor in the process.

IDB applies to far more than stock-picking...

Compensation can mean a lot of things to different people. Of course, workers provide their time and labor for money. But there are many other reasons why people devote time to their careers.

At Altimetry, we recruit, hire, and promote our personnel with seven different types of workforce engagement in mind. Only one of those drivers is monetary. The others include things like job responsibility, learning opportunities, and interpersonal relationships.

In my experience, when people are engaged in their work – when they fell really motivated – it's almost never about compensation. The other levers, such as being part of a business with a more noble purpose than simply "making money," are phenomenal drivers of a highly engaged workforce.

This directly ties into how we view wealth as a society.

If we only think of ourselves in terms of net worth, then that's all we'll achieve... and we'll miss out on everything else.

So when looking at your own wealth, be sure to consider the other ways by which you can measure it. That could be intellectual stimulation... enjoyment of some purpose... or experiencing more love and happiness.

The next time you consider your wealth, remember – it should be a culmination of so many other things, not just money in the bank.

Wishing you love, joy, and peace,

Joel
August 19, 2022