How to Tell If Management Has Your Back

As I (Joel) stood upon the Acropolis, I couldn't help thinking about ancient Greek society...

I just spent a few days in Athens, Greece with my wife. By far the high point of the trip was walking the Acropolis, which housed some of the biggest monuments to the Greek gods (including the Parthenon).

Here's a photo of us standing above the Acropolis. Monuments like this were built well enough to still be recognizable and impressive almost 2,500 years later... 

The ancient Athenians had to pay for these opulent buildings somehow. So like many projects today, they turned to taxes.

Ancient Athenian taxes had some similarities to modern taxes. For example, like in many places today, they were used to fund the military.

But money that wasn't used for protection went toward public infrastructure. Most of that was meant to celebrate the gods.

Many of the buildings still standing today were tax-funded. The tax system had a strong community orientation.

Greeks had a "progressive" tax system, which meant the very wealthiest Athenians paid most of the taxes. It's similar to the U.S. today when you look at the actual tax return dollars across income levels.

Most of the tax burden fell on the top 1%. But unlike the U.S. today, they were taxed based on the value of their property. It was like a version of the now-controversial wealth tax.

This tax wasn't a big deal at the time. That's because back then, folks' land holdings were highly correlated with their income.

But here's the biggest difference between taxes then and now...

It was an honor to pay taxes in ancient Athens.

Folks didn't generally try to hide or find loopholes. (We know this because there are very few historical reports of tax dodgers.)

In fact, many publicly claimed that they had paid more than their fair share. Sharing your wealth for the betterment of the city-state was one of the highest status symbols you could attain.

The wealthiest citizens viewed taxes as "doing their part" to make sure Athens remained powerful. Funding the military provided a clear sense of security. And building shrines ensured the gods looked favorably upon their city.

Of course, it wasn't entirely a selfless act. The elites earned tremendous social capital by paying taxes. The rare few who tried to skirt their obligations were widely mocked and labeled greedy.

Ancient wealthy Athenians had an intrinsic incentive to behave as they did...

On Wednesday, my colleague Rob Spivey wrote about something we like to call "incentives dictate behavior." It means that people's actions are directly attributable to their promised rewards.

In ancient Athens, folks had a strong motivation to pay taxes. Participating in the tax system meant acceptance from their peers... and the knowledge that they were helping keep their city in power.

This concept applies to a lot more than ancient Greek government. As we explained earlier this week, you can use this framework to determine how corporate management teams will likely behave.

No matter how competent management seems, its goal is to maximize its own returns. That's not always the same as maximizing the company's returns – or shareholder returns.

Take Valeant Pharmaceuticals... now called Bausch Health (BHC). In the early 2010s, part of management's annual bonus was based on making at least five acquisitions outside the U.S. It even had a "stretch goal" of making 10 acquisitions in a single year.

It should come as no surprise that management took on a lot of debt in order to buy enough businesses to maximize its bonus.

Valeant made 13 acquisitions in 2013... five in 2014... and another 10 in 2015. Its debt ballooned from $11 billion at the end of 2012 to $31 billion by 2015.

All the while, then-CEO Michael Pearson kept earning more money. He was paid $7 million in 2013, $10 million in 2014, and a whopping $142 million in 2015.  

By the end of 2015, the company had taken a turn for the worse. It was under pressure for the high prices of some of its drugs. The more investigators – and investors – looked, the more they uncovered.

Reports alleged that the company had been artificially boosting sales. Worse, it was unlikely to be able to pay off all its debt.

The stock peaked above $250 per share in July 2015. By the following March, it had fallen to $30 per share.

That's why understanding compensation is so important. Management wasn't acting irrationally by taking on these acquisitions. It was doing exactly what its pay structure encouraged.

You can – and should – do some of this analysis before making any investment...

For publicly traded companies, management compensation is published in a filing called the "DEF 14A." Checking the DEF 14A is a great way to understand how a company is likely to perform. We do this for every recommendation in our monthly advisories.

If management is rewarded for growing revenue, you'd better believe revenue growth will be a priority. Likewise, if management makes money based on stock performance, that's what the team will focus on.

A good framework will generally pay management to prioritize a mix of top-line growth (like revenue), margins (such as operating income or net income), and asset efficiency (free cash flow, for example).

It can also be beneficial if some part of compensation is based on the company's long-term stock performance.

Of course, there's no universal playbook. What's good for a company will depend on its specific goals. But to be confident in a company's stock, you have to be confident in the team behind the company. Compensation is a great place to start.

Wishing you love, joy, and peace,

Joel
October 21, 2022