The Business of Incentives

TR – Hello, I’m Tom Record and I’m here with Tom Morris. Welcome to Global Infusions, an investment podcast from the Liontrust Global Fundamental team that takes a long term view of today's stories.

Last episode we chatted about Succession and family dynasties, the wolf in cashmere and yoyoing executives who just can’t leave. This episode we’re looking at incentives – when they work and when they don’t. If your taste buds are tickled or you have any questions for our next episode, please do send them in via your client contact or through the contact us link on the Liontrust website.

So sit back, grab a cup of tea, and remember that when we talk about individual companies we are not making a recommendation to buy or sell shares and that some of these companies may not be held across Liontrust’s global fund range. And just to let you know, this episode is the last of series 1, and the last with Tom Morris. We’ll introduce our new cohost later.

So with that – Tom, what makes a good incentive?

TM – Well it’s all about alignment – a good incentive needs to align the interests of two or more parties, to maximise the chances of behaviour that benefits them all. So for instance shareholders generally want to see businesses led by managers who are incentivised to grow the equity value of the business.

TR – Sounds simple, but it’s actually not simple at all, is it?

TM – No, it’s fiendishly difficult. The problem is that coming up with incentives that superficially align the interests of two parties is easy, but there’s almost always a catch, or an exploit, that can spell disaster.

TR – So this is things like one set of shareholders wanting the share price to bounce tomorrow and another wanting the business to invest and grow over the coming years?

TM – Exactly… do you incentivise for profits or cash or margins next year, or in 3yrs, or 10yrs? And how do you even define profits? Do you look at them pre adjustments, post adjustments, as an absolute number, or per share?

TR – Because a management team can make a revenue or profit number grow just by buying another business, even if they pay a huge value-destructive price for it. So you have to be careful not to inadvertently incentive that.

TM – Agreed. Looking at per-share metrics can help, but even that isn’t foolproof.

TR – Indeed, maybe a management team has an earnings per share target that they need to hit next year in order to trigger their bonus – but not all earnings are created equal. They could probably flatter their numbers for a couple of years by doing something like reducing R&D or marketing expenses, or changing their accounting assumptions to artificially reduce depreciation charges.

TM – Yes there are a million and one ways to manipulate things, which is why shareholders need to stay vigilant.

TR – Probably the world’s most famous shareholder, Warren Buffet, talks about them a lot.

TM – Yes indeed – Charlie Munger, who has been Buffet’s investing partner for most of his life, said ‘show me the incentive and I’ll show you the outcome’ – I think he’s underselling how hard it is to actually interpret incentives, but they’re definitely extremely important.

TR – Agreed. So incentives can be tricky to design for teams within a business too. For instance incentivising sales people with a dollar target for revenue that they need to hit. Sounds reasonable, but the result is often that the sales team ends up giving discounts and cutting pricing to unsustainable levels in order to win every pitch.

TM – Yes that’s a particular problem with companies that sell long-term service contracts or project work, like in construction. The sales teams might end up booking loads of work that only later on turns out to be unprofitable, or loss making.  Often after the sales person has taken his commission and left the business.

TR – Yes that seemed to be part of the problem at Carillion a few years ago. So a sales team’s incentives need to take account of revenues and margins, with a bit of a buffer for unexpected risks. And also customer satisfaction metrics too.

TM – Yes, otherwise unscrupulous sales people could just try to stuff customers with anything they’ve got, even if it’s completely inappropriate for them.

TR – Ok enough on companies. Let’s change direction and talk about the US supreme court…

TM – Well this is a very interesting one I think. So supreme court justices are appointed for life, which means they can potentially end up serving for a very, very long time.

TR – Yes I think Clarence Thomas was appointed in 1991, and is still on the court today, so that’s what, 32 years and counting.

TM – Exactly, and he’s far from the only one to reach those sorts of numbers – Ruth Bader Ginsburg had served for 27yrs when she died in 2020, Stephen Breyer had been on for almost 28yrs when he retired last year, and there are many others.

TR – Ok so what’s the problem?

TM – Well to state the obvious the supreme court is a really big deal, and is increasingly involved in highly politically charged issues like gay rights, abortion, religion and race relations. As US politics has become more partisan, having control of the court has become more important. In that context, life terms present a source of uncertainty for the politicians that propose and appoint the justices.

TR – You just don’t know when the next opportunity is going to arise, and whether your party will be in power at the time.

TM – Exactly, and so the incentive is to try to appoint young judges, who could then potentially serve for 20 or 30yrs or more, and lock-in your ideological preferences for decades.

TR – I see. But being a judge seems like the kind of job where wisdom and experience are unusually valuable. So I suppose ideally you might want to see somewhat older people on the bench, drawing on all their life experience to make the best decisions.

TM – But what politician is going to nominate a 60yr old in this environment, when they might die or choose to retire in their 70s, barely 10yrs later, at which point your political enemies might be in charge and fill the vacancy with someone from the other end of the ideological spectrum.

TR – So they just end up nominating younger people in their late 40s or early 50s instead.

TM – Exactly. Age and ideological purity have become the key criteria, rather than experience, moderation and wisdom.

TR – So you’re saying if there were a 10yr term limit, the perverse incentives might be mitigated somewhat, and the US might end up with a higher quality supreme court? I can see that argument.

TM – I think it makes sense, but I very much doubt it will happen.

TR – I doubt it too. So Tom, you’ve been to Florence before?

TM – Yes, I was last there in 2012 I think.

TR – Well the dome on the cathedral is spectacular. And back in the 1420s they were trying to work out the best way to build this giant, heavy structure, they ended up employing an engineer called Brunelleschi, who, calculated how it would be possible to put it together. At one point though, the church was so stuck that they considered filling the cathedral with earth and building the dome around it.

TM – Ok I can kind of understand that – sort of a giant sandcastle cathedral, and then use that as the almost scaffolding around which you built the actual cathedral. I mean it sounds messy, and you’d be left with a finished cathedral full of soil – holy soil?

TR – Well here’s the cunning incentive part –  they were going to scatter gold coins in the soil inside the cathedral to incentivise people to dig it out when they had finished.

TM – Oh that is clever. Give people a reason to take the soil out. I like it.

TR – Indeed! OK, so before we move on to the news, I’d like to introduce our new co-host, Tom Hosking.

TH – Hello!

TR – Tom works with us and has been a frequent contributor with interesting snippets and stories over this first series.  So Tom H, welcome!

TH – Thank you very much.

TR – Why don’t you kick us off with any thoughts on incentives.

TH – thanks, Tom.  Well for I'm my first on-air contribution I thought I would mention Goodhart's Law. We simply can't talk about incentives without mentioning it. It’s usually stated as "When a measure becomes a target, it ceases to be a good measure".

TM – Yes welcome Tom – you’ve been a behind the scenes contributor to the podcast right from the start, so I’m really happy you’ll be taking over from me. So what does Goodhart’s law really mean in practice?

TH – Well, it's most easily understood with examples and the most famous one is the Soviet nail factory. There, the number of nails produced was seen as a good measure of productivity.

TM – That makes sense

TH – However, when the factory managers were told to produce an increased number of nails, they reacted by producing millions of tiny, useless nails. When the state planners wised up and switched to a weight criterion, the factories started producing giant, heavy and equally useless nails.

TM – Ha!

TR – Ok – so when the target was linked to a reward, that can create a huge incentive to game that metric. So this is similar to when the British offered rewards for dead Cobras in colonial India, which led to a spate of very profitable snake breeding!

TH – Yes exactly. The nail factory is possibly a fictitious story, but it illustrates the point well. A more recent example that is definitely true comes from the world of academia.

TR – So professors gaming the system?

TH – Yes, so a professor’s productivity and significance is often measured by how many times their research is cited by other scholars. It matters for career progression. And that’s why in 2018 an Indian computer scientist called Sundarapandian Vaidyanathan won an award from the Indian government for being among the nation's top researchers. However, it was later discovered that 94% of the citations of his work came from himself or co-authors.

TR – Wow – 94%! That's ridiculous.

TH – Yes, incentives matter. And it's not always about gaming a metric – sometimes it can be well intentioned. So, carbon emissions from a company's own operations are usually measured and disclosed. However as soon as it becomes a target, there’s an incentive for a company to either divest the most energy intensive parts of their business or outsource them to other parts of the supply chain.

TM – Something similar has happened on a bigger scale – European countries have been incentivized to outsource emissions to countries like Qatar, the biggest supplier of liquefied natural gas, and China, where much of our heavy manufacturing has moved to.

TH – Yes. Simply targeting one narrow measure can be over-simplistic and brings about unintended consequences.

TR – Apart from being careful, are there any other ways around Goodhart's law?

TH – It comes back to what Tom was saying earlier. It’s really tough to build an incentive system that measures what you actually want, and not a rough approximation. This is what the Soviets got wrong: what they really wanted was happy customers with lots of good, useful nails… but without a capitalist system, there was no way of measuring that so they had to use a poor approximation. One way round it is to use multiple criteria instead of a single standard.

TM – The good incentive plans for company CEOs are often structured in that way, with 10% weight for one criteria, 25% for another etc. Etc. But you have to be careful not to make it too confusing, so executives can still understand what they’re supposed to deliver.

TH – Yes exactly.

TR – Great stuff, now over to you Tom M with the news! What has caught your eye this month?

TM – Well I know I often start with an AI story, so I thought I go for the opposite end of the spectrum this episode and talk about a very old technology: tape storage drives.

TR – Cutting edge in the 1950s!

TM – Well yes, but it turns out sales are still growing, in gigabyte terms at least. Overall capacity sales reached a new record last year according the industry trade body, at 148 exabytes, which is 148 billion gigabytes, up 0.5% on 2021, which itself was up 40% on 2020!

TR – I’ve read that it’s useful for ransomware-proof back-ups, because data can be kept completely offline, offsite and protected from being altered.

TM – Yes a key plot point in the new mission impossible film, which I saw last week. Tape storage is a really good fit for tamper proof storage, and it’s pretty much the cheapest storage method too. So tales of its death have been greatly exaggerated.

TR – The Mark Twain of data storage!  So my first story is about the glue that holds international travel together – and in particular container shipping rates.

TM – Yes, I know that they rocketed during the pandemic and then collapsed again afterwards

TR – Indeed, so the cost of shipping a container from Shanghai to LA went up 8x from the beginning of 2020 to September 2021, before it started falling back down to normal levels again.

TH – Yes, and we’ve all seen how that led to price increases of imported goods and shortages

TR – Well, one trade route that caught my eye is the Europe to US route, where pricing carried on going up and only peaked in November last year.

TH – So 14 months later than the China-US route

TR – Yes, it seemed to be defying gravity, and although it’s a less trafficked route than between the US and China, it was really important for companies like Fevertree that were exporting tonic bottles to the US. Well, this year rates have collapsed back to their normal level. So the great covid unwind is finally coming through.

TM – And I imagine many companies will have hedged their exposures so the benefit might take another 6 months to come through into cost of goods sold, but good to see some normality returning 3 and a bit years after covid kicked off.

TR – Indeed.

TM – So next up from me is a stat I saw about admissions at Harvard.

TR – There’s been a lot of discussion about ivy league admissions recently after the supreme court ruled that race conscious admissions were unconstitutional.

TM – Yes indeed, but this stat is on something slightly different, called ALDC.

TH – And what is that?

TM – It stands for athletics, legacy, dean’s list, and children of faculty staff. So athletics is people admitted due to their sporting prowess, legacy refers to people admitted as children of former students, dean’s list is people whose families are big financial donors, and children of staff is exactly what it sounds like.

TR – So those don’t sound like groups that should really be given preferential treatment in an academic meritocracy.

TM – Agreed, but the stat that surprised me, as reported in the FT, was that 43% of Harvard’s intake came from one of those ALDC groups. 43%!

TH – That’s scandalous!

TM – Yes I agree! How are you supposed to have social mobility when money and your family tree are regarded as legitimate admission criteria. It’s ridiculous.

TH – Next up from me, given we’ve just had the Wimbledon final, is a sporting anniversary. It's exactly 50 years since the founding of the WTA, the Women’s Tennis Association.

TM – Ah yes it was founded by Billie Jean King in the 70s? We talked about it in the Business of Sport episode I think.

TH – Yes indeed. And the women involved marked the occasion this month by going back to the place of the inaugural gathering at the Gloucester hotel in London just before Wimbledon started.

TR – King really was ahead of her time wasn't she?! The women's game was fragmented and underdeveloped. She consolidated the tours and it's down to her that Tennis today is probably the most equal sport between the sexes.

TH – Agreed. And one other remarkable thing is how stable professional tennis has been for decades. There have only been minor changes to it. Some successful like the Laver Cup, founded by Roger Federer in 2017. And others less so: do you remember the infamous Adria tour started by Novak Djokovic in 2020?

TM – Oh yes... that's the one where a bunch of players went out partying in a Serbian nightclub, came down with covid, and it had to be cancelled!

TH – Yes, that's the one- it was not a roaring success. Separately though, Djokovic also co-founded an alternative mens players’ union, called the PTPA. They have said that although they are not starting a rival tour, they would negotiate with anyone who wanted to.

TR – Do you think the Saudis would want to?

TH – There are clear similarities here with what has happened with Golf aren't there?

TM – And that is the big news story in sport this month isn't it, that the Saudi strategy worked: funding a breakaway tour, luring leading players and then eventually agreeing a merger. Saudi is now the major power behind men’s golf! Something that would have been unbelievable a couple of years ago.

TR – Saudi Arabia wants to diversify away from oil and exert soft power in the world. Sport is an easy target for those twin goals isn't it. And so far they've targeted Golf, Formula 1 and this year football too.

TH – The biggest silver lining I can see would be if the money ends up promoting women's sports. Take the WTA, in March of this year, they received $150m of investment from CVC, the private equity firm. The WTA is hoping that CVC’s experience in sports will help it increase the value of its sponsorship and media rights.

TM – Men's competitions seem to find it easier to attract big sponsorship deals. The grand slams now all offer equal prize money to men and women, though it took them a looong time, with Wimbledon I think only getting there after pressure from Venus Williams in 2007, loads of other tournaments still don’t, so hopefully this partnership will help there.

TH – Yes more prestige, more viewers, more sponsors, in a self-reinforcing circle.

TR – Well, moving on to something light-hearted - Next up from me is a story about Beavers and the SEC.

TM – Now that’s an unlikely combination – large furry rodents and the US securities regulator.  Go on!

TR – Well this goes back a bit to the late 1960s, when Beavers were in fashion – the Weavers Beavers Association create a fervour among investors that pelts would become the next big thing for hats, coats, scarves… that sort of thing. And you could invest in it.

TM – Ok, so how did you invest in beavers?

TR – It was all very simple – you’d buy a breeding pair for north of $3k, the Association would look after them, for a fee, and they would have babies called kits, which could then have their own kits. Before long you have a beaver herd which could be sold for their pelts. The problem was that the sales people were very good at selling their own beavers and not so good at selling everyone else’s beavers that they were being paid to look after.

TH – A great example of misaligned incentives.

TR – The SEC got hold of it and decided that this was a fraud where you bought something that was looked after by the person you bought it from and then that person would sell it to a third party.  So you had an investment contract.

TM – It sounds like there are parallels with some blockchain offerings today.  Which gives me an excuse to praise Taylor Swift for her very sensible decision to stay clear of all the crypto nonsense because she thought the exchanges were dealing with unregulated securities.

TR – Indeed. Maybe she knew the Beaver precedent!

TM – Next from me is a story that caught my attention a couple of weeks ago. Did you know that Gatwick already has a second runway?

TR – What! No, I remember they were lobbying for permission to build one a few years ago, but in the end the government went for a third runway at Heathrow instead, not that there seems to have been any progress on that.

TM – That’s what I thought too, until I found out that Gatwick had a second runway all along, which it only used for emergencies. Earlier this month it applied for planning permission to upgrade that runway to make it suitable for regular use, by moving it 12m to the North, so that there’s enough of a gap between it and the main runway that they can both be used at the same time.

TR – A sneaky second runway, without having to expand the footprint of the airport – this sounds like a much less disruptive option than expanding Heathrow.

TM – Agreed – they actually claim it could be completed by 2030.

TH – It hasn't been a good press month for Gatwick at all. They were also named the worst airport for disruptions in Europe with 54% of its flights in June being delayed.

TR – That is bad, I'll try to avoid Gatwick this summer.

TH – And the airport you should make every effort to go to instead is… Helsinki. Only 18% of its flight were disrupted in June. The best in Europe.

TR – Hm that wasn't going to be my top summer destination.

TH – Maybe not, but I did go there in January and it is a lovely country. The Finns are not the sort of people who would deceitfully hide a runway at all!

TM – Ha! And speaking of holiday tips, did you see the recent announcement from Japan Air Lines?

TH – Yes, wasn't it something to do with reducing check-in luggage by lending passengers clothes?

TM – Yes, their new initiative is called "Any Wear, Anywhere".

TR – Ba-dum! I see what they were trying to do there

TM – Ha! It's a clothes rental scheme where Japan-bound passengers can rent clothes for the duration of their stay, eliminating the need to pack any.

TR – Interesting idea but I'm not sure it will catch on. People want to wear their own clothes no?

TM – Yes I think that's correct- I'm not that worried for Samsonite!

TH – To finish with – I know you talked in the last episode about Disney bringing back Bob Iger as CEO on a supposedly temporary basis – I saw that they’ve just extended his 2 year contract by… 2 years!

TM – Disney is addicted to Bob Iger. He’s a great manager, but this is a real problem now. It feels like despite the board saying they are prioritising succession planning, they just can’t do it. I honestly wouldn’t be surprised if they eventually appoint a version of ChatGPT trained to sound like him as the next CEO.

TR – Tom, any final words before we call an end to series 1? 

TM – I just wanted to say what a pleasure it’s been, and how grateful I am to you Tom for doing this with me, to Amy and Ellie who help us to put each episode together, to Liontrust for backing us to do it, and to all the listeners for coming along with us over the last two and half years. I’ll really miss you all, and I look forward to tuning in from home next month!

TR – Thank you to Tom Morris for a very enjoyable first series, and to Tom Hosking for co-hosting next series and finally to you for listening to Global infusions - a podcast that believes that the best discussions are had over tea and cake. We hope you've enjoyed your cuppa and our thoughts on the business of incentives. Please do subscribe through Apple or Spotify and with that we wish you goodbye!

TM & TH – Goodbye!