In Pursuit of Long-Term Sustainable Alpha

8/16/2014

This article is an introduction to how companies can lay the foundation for long-term value creation. We will discuss three major steps they can take to achieve this goal. First, companies must develop a clear understanding of sustainable long-term value. Second, companies must have compensation plans that properly incentivize employees to create long-term value. Lastly, companies must attract investors who can be partners in creating long-term value.

Step 1: Clearly define long-term value creation

 

When Stern Value Management talks about shareholder value, we do not mean annual share price return or increases in net income or dividends. On the contrary, we encourage companies to invest in R&D, marketing, and employee training – even if earnings take a hit – as long as these investments are value accretive to the company. When we talk about shareholder value, we mean sustainable long term value creation.

The major benefit of sustainable long-term value creation is that it offers all stakeholders the chance to be better off. Contrary to what some critics of shareholder value believe, this framework differs starkly from short-term trading profits, which are a zero-sum game. In other words, traders create alpha by buying low and selling high. Instead of creating value, short-term returns simply entail transferring value from one party to another. Therefore, short-term returns do not benefit the larger economy since no net value is created. On the other hand, true shareholder value creation is beneficial for all stakeholders.

Long-term value creation is a by-product of focus on all stakeholders. Deciding which stakeholder must get more focus varies case by case. For instance, in industries and countries with a dearth of talent, employee focus must take priority over everything else, and shareholder value will automatically follow. Similarly, in industries where companies offer similar products to the same group of consumers, corporate strategy should focus on consumers, and long-term value will follow. In each case the focus of value creation may be on different agents, but the objective remains the same: to create long-term sustainable value.

Step 2: Properly incentivize and reward employees

 

Now that we clarified the meaning of shareholder value creation, the next step is to ensure that company employees are motivated and incentivized to create long-term value and act in the best interests of shareholders. In other words, to earn an alpha on their investment, shareholders have to rely on the acumen of management for running business operations. Shareholders need to ensure that management does not under-invest, i.e., abandon sound, but long-term investments, due to unfitting motivation. They also need to make sure that management makes optimal decisions even if, for instance, they come at the cost of a drop in share price in the short term. The best way for shareholders to achieve this is by employing people who believe in operational excellence and capital efficiency, and take well-calculated risk by acting as if they were the owners of the company. To make sure that employees are incentivized to make decisions in the best interest of shareholders, companies should reward employees for shareholder value creation, and hold them accountable for shareholder value destruction.

The table below highlights the importance of incentivizing employees the right way.

The fourth outcome, which is not depicted in the table, is one in which company value is destroyed, and employees are held accountable for the loss of value. Rightfully speaking, it is the correct way to align shareholders’ and employees’ interests; Stern Stewart recommends this approach under our proprietary “memory bank” scheme (described later)

Now that we have shown the importance of having a proper incentive compensation plan that rewards employees for creating long-term alpha, below we share a list of tips that companies should follow when setting an incentive compensation plan:

• Require that the board approve a compensation plan that clearly integrates the overall philosophy of value preservation and value creation – a plan that measures the correct performance metrics and motivates behavior that shareholders want (e.g. investing in long-term value creating projects such as R&D, even if they takes years to realize positive cash flow);
• Make sure that the company’s incentive plan is not discretionary or complicated to understand – too much discretion may lead to manipulation and too many performance metrics may lead to confusion. Some financial measures often conflict with one another. For example, an increase in sales and profits may not always translate to an increase in economic profit;
• Make the board set objective performance targets that are definite and easily measurable for employees; performance targets based on budget negotiations have become the nemesis of the corporate world and hinder the process of financial and strategic planning;
• Make sure that performance is aptly incentivized – significant enough to change employee behavior, but, at the same time, fair to shareholders in terms of cost;
• Make sure that the incentive compensation plan penalizes underperformance and encourages sustainability, as opposed to short-termism. To counter shortsightedness and extend decision-makers’ horizons, part of compensation must be held at risk in a “memory bank,” and be paid over time for sustaining good results;
• Make sure that the incentives are customized to obtain the kind of behavior that is desired of employees; promote teamwork rather than individualism;
• Make sure that the incentive compensation total bonus payout or penalty is not limited by certain levels of potential over- or under-performance – may there be no limits to the bonus payout or penalty (no caps or floors);
• Finally, shareholders must demand that management institute a system of effective and regular communication of its strategic roadmap.

For any corporation, an appropriate incentive plan design should be the most important component of its strategy, and should not fall solely on the shoulders of HR. A right incentive design can resolve most of the corporate world’s woes, by getting rid of “gaming the system,” aligning shareholders interests with those of employees, and stimulating a long-term vision. In the long-run, successful companies are those that encourage long-term thinking through their agents of value creation, their employees.

Step 3: Attract investors who are interested in long-term value

 

 

Lastly, to foster an ideal company environment that promotes long-term sustainable value creation, management should attract investors who can be partners in long-term value creation and not short-term trading profits; management policies must filter out all shortsighted investors.

Management must have a lucid short- and long-term strategy for the business and they must clearly and regularly explain them to investors. Management must ensure that they communicate the right time horizons for their decisions, and set the right expectations for investors – this will refrain myopic investors from investing in the company and encourage investment from investors who think long-term. For this to happen, management can gain investors’ confidence by:

• Making the right decisions and communicating the possible short-term impacts of their decisions;
• Timely allocating capital and investing in initiatives that stimulate long-term sustainable value creation, such as restructuring, research, marketing and employee training, to reward investors by increasing efficiency, embracing innovation, and building brands;
• Ceasing to focus on quarterly earnings guidance for equity analysts. Instead, companies should concentrate on communicating the three- to five-year value-creation strategy and articulate material global risks. Tired of the attention diversion caused by periodic earnings, companies like Unilever [NYSE:UN] and Coca Cola [NYSE:KO] stopped giving quarterly earnings guidance;
• Periodically updating investors, through the drivers of performance and health, about the milestones achieved, overachieved, and missed;
• Being transparent and prompt in communicating mistakes and not hiding the bad news.

Executives who think long-term can help retain investors who are not fixated on quarterly numbers. As a result, investors will be able to better predict management’s actions, and investors who do not agree with management’s priorities and trade-offs will not invest or move elsewhere. This roadmap could also help employees, who would now have better clarity of what is expected of them.

Overall, companies should follow the three major steps outlined in this article to lay the foundation for long-term value creation. More importantly, they will help companies view themselves as value deliverers to shareholders, stakeholders, and society at large. The corporate world needs more of responsible and trustful governance that can work for everyone’s betterment.

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