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Thoughts On Metrics And Incentives

Thoughts on Metrics and Incentives first appeared at The Activist Investor. A brief meditation on motivating, measuring, and rewarding executive performance. Metrics have been in the news lately: Sensational accounts of how share repurchases boost EPS to benefit CEOs Bennett Stewart promoting his Corporate Performance Index (CPI) Corporations futzing with GAAP accounting, specifically EBITDA, to present great results. Let’s consider the metric alphabet soup, then. EPS: Earnings per Share, duh. Accounting profit divided by number of outstanding shares. EBBS: Earnings Before Bad Stuff. EPS without expenses that management doesn’t like, the zenith of futzing. EBITDA: Earnings Before Interest, Tax, Depreciation, and Amortization. A customary measure of operating cash flow, but based on accounting profit. Adjusted EBITDA: see EBBS, call it AEBITDA ROI: Return on Investment, with whatever measure of return and investment the company chooses. Highly futz-able. TSR: Total Shareholder Return. Change in share price, plus any cash to shareholders as dividends. Can’t really futz with it. CPI: Corporate Performance Index. The new metric, based on EVA (Economic Value Added). How to make sense of all this in the context of recent news accounts? For as long as investors have monitored EPS and EBITDA, companies have tried to massage it into EBBS or AEBITDA. GAAP accounting is rife with judgment, so management will seek to influence (futz with) EPS and EBITDA in subtle ways, or just dispense with it and use EBBS and AEBITDA. Investors also know that EPS measures mostly the returns part of ROI. We also want to know the investment part. Bennett Stewart years ago gave voice to these two concerns with EVA. It deals with the two problems of EPS, EBBS, EBITDA, and AEBITDA: management can futz with accounting results, and thinks capital investment comes free of charge. He spent decades trying to persuade companies and investors that EVA improves on these other metrics. We don’t know why Stewart created CPI, which starts with EVA. It seems like he wanted something similar to but better than TSR in exec comp packages. Many exec comp packages reward EPS or change in EPS. Lately, they also reward TSR. Neither idea makes any sense. Basic economics, and indeed cognitive and behavioral science, finds that one designs incentives to elicit the behavior one desires, or to discourage behavior one doesn’t. In this instance, exec comp incentives should pertain directly to decisions and other actions that executives can influence and control. Executives don’t influence and control share price. TSR measures mostly share price. On the other hand, executives control the metrics EPS, EBBS, EBITDA, and AEBITDA, in addition to controlling the decisions and other actions whose outcomes these metrics measure. That won’t work. More generally, exec comp programs should use metrics that measure company performance, not investment performance. TSR makes sense for a PM, but not for a CEO. EVA or maybe CPI makes sense for a CEO. EPS makes no sense for anyone. Critics can object to share repurchases that boost exec comp. Let’s improve exec comp and the underlying metrics – reward and punish CEO decisions and other actions, and make it hard to futz with the metrics. Leave share repurchases alone.

First Fed Hike Puts These ETFs In Focus

Months of speculation and nail-biting hearsay about the timeline of the first rate hike in almost a decade finally ended yesterday thankfully, with neither shocks, nor surprises. The Fed pulled the trigger at long last, raising benchmark interest rates by a modest 25 bps to 0.25-0.50% for the first time since 2006, making it official that the U.S. economy is out of the woods; though still has miles to go. The step also sets the U.S. apart from other developed economies and had a great impact on the global currency market. The Fed believes that the possibility of further improvement in the labor market as well as in inflation is ripe at the current level. Muted inflation mainly due to stubbornly low oil prices has been an issue for long for the Fed. But in the 12 months through November, the core consumer price index grew 2% (matching the Fed’s target), the highest reading since May 2014 , followed by the 1.9% advancement in October. Unemployment rate fell to 5%, a more than seven-year low level. Average hourly earnings are rising of late. What’s more noteworthy was that the Fed did not move an inch from the ‘ gradual ‘ rate hike trajectory. Also, the central bank indicated that while the job market criteria is apparently accomplished, the Fed’s future focus would be on the inflation reading, which is yet to pick up at a sustained pace. Global growth worry is another factor, which is holding the Fed back from acting fast on tightening. Fed’s Projection The Fed lowered its 2015 projection for personal consumer expenditure inflation to 0.3-0.5% from 0.3-1.0% and 0.6-1.0% guided in September and June, respectively. The projections were also slashed for 2016 and 2017 from 1.5-2.4% to 1.2-2.1% and from 1.7-2.2% to 1.7-2.0%, respectively. The expectations for 2016 and 2017 real GDP growth have been ticked down to 2.0-2.7% from 2.1-2.8% guided in September (Fed’s June prediction for 2016 was 2.3-3.0%) and to 1.8-2.5% from 1.9-2.6%, respectively. However, the real GDP growth expectation for 2015 has been changed to 2.0-2.2% from 1.9-2.5% projected in September. As already discussed, unemployment was the true healer with its 2015 expectation being 5%, almost in line with the 4.9-5.2% expected in September. The coming two years will also see the same uptrend as estimates for 2016 were lowered from 4.5-5.0% to 4.3-4.9% while the same for 2017 remained unchanged at 4.5-5.0%. The notable changes were in the projection for the benchmark interest rate for 2015, 2016 and 2017. Fed’s funds rate for the longer run may be maintained at 3.0-4.0% but projection for 2015, 2016 and 2017 were changed from negative 0.1- positive 0.9% to 0.1-0.4%, from negative 0.1- positive 2.9% to 0.9-2.1% and from 1.0-3.9% to 1.9-3.4%, respectively. Market Impact However, the historic move did not mess up the market, as the investing world was prepared well ahead of the meeting. In fact, the Fed gave the global market enough time to digest the news when the central bank brought the December rate hike possibility back on to the table in October end. With no drama in the December meeting, the market is now focusing more on a sluggish rate hike, not just the hike itself. As a result, probability of a dovish rate hike trail ahead cheered equity investors almost across the globe. Even the highly vulnerable areas like emerging markets also tacked on gains during the Fed meeting. This produced a handful of surprise winners and losers post meeting. However, bonds obeyed the rule book and started diving as soon as the Fed enacted the lift-off. The two-year benchmark Treasury yield jumped 4 bps to 1.02% on December 16 – a five and a half year high. However, the yield on the 10-year Treasury note rose just 2 bps to 2.30% and yield on the long-term 30-year bonds saw a 2 bp nudge to 3.02%. All bond ETFs were in the red. Given this, we have highlighted ETF winners and losers from the Fed move: The PowerShares DB US Dollar Bullish Fund (NYSEARCA: UUP ) – Natural winner The U.S. dollar is a common winner following the lift-off. The U.S. dollar ETF UUP gained 0.04% after hours. The iShares MSCI Emerging Markets (NYSEARCA: EEM ) – Surprise Winner Emerging markets normally fall out of favor in a rising rate environment as investors dump these high-yielding, but risky, investing tools for higher yields at home. However, possibility of a gradual hike boosted the emerging market ETF EEM by about 2% on December 16. The fund added 0.2% after hours. The SPDR S&P Regional Banking ETF (NYSEARCA: KRE ) – Natural Winner The regional bank sector was pleased by the Fed decision and the resultant rise in yields, as it tends to benefit from the steepening of the yield curve. As a result, regional bank ETF KRE was up about 1% and added 0.1% after hours. The Market Vectors Gold Miners ETF (NYSEARCA: GDX ) – Surprise Winner but Potential Loser As soon as the greenback gains, commodity prices fall. Gold, one of the key precious metals, might have gained from the slower hike bet, but is likely to lose ahead. The SPDR Gold Trust (NYSEARCA: GLD ) tracking the gold bullion added over 1.2% while the largest big-cap gold mining ETF GDX added about 4% on the same day. The latter saw more gains as it often trades as a leveraged play on gold. But both lost over 0.3% and 0.6% in extended hours. The iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) – Surprise Winner but Potential Loser Mortgage REITs perform better in a low interest rate environment. However, though high-yield REM added 3.2% yesterday, it might see a slump ahead. Original Post

Should You Be A Passive Investor These Days?

Passive investing is over-rated. Robo-investing just rebalances passivity. Do your own due diligence. It pays better. Investors in 2015 may be forgiven if they feel like bobbleheads. The volatility of the markets, the speed with which opinion-holders dispense information about any event (some of it even accurate) and the sheer volume of too much data can make our head, and our thoughts, swing too rapidly hither and yon, leading us to trade wildly, making brokers richer and investors poorer. Of course, there are investors who claim they do not care one whit where the markets are or at what price their securities are selling. They take pride in spending no time studying the ways of the market but, rather, seek only to match the long-term performance of the market they choose to invest in and let the chips fall where they may when there are corrections. Many such investors are adherents of John Bogle’s approach to investing and delight in calling themselves Bogleheads . Whenever I disagree with the premise of that thinking, “the phones are sure to light up” and the comments section will be filled with righteous indignation or derision from these acolytes. The idea of buy-and-hold passive investing and holding a broad brush of securities is hardly new – but its popularity waxes and wanes with the market itself. For instance, whenever the US stock market is doing well as (until this year) it has since March of 2009, people who invest with a rock-steady eye on the rear-view mirror will pound the drum for passive investing via the cheapest ETF. (click to enlarge) But how many of these investors, or their predecessors, really did hold on to their portfolio from Oct 2007 to March 2009 – and if so, what in tarnation were they thinking? As you might recall seeing the chart below, that was a particularly terrifying slide of a minus 53.5% in less than a year and a half. Buying passive index ETFs and holding is popular yet again, looking at the rear-view mirror back only as far as 2009, but those looking backward in March of 2009 abandoned this strategy in droves: (click to enlarge) There has to be a better way of investing than either day-trading between biting one’s fingernails to the nub, or stubbornly clinging to the notion that its OK to hold on during a 53.5% rollercoaster decline because after all, “the market always comes back.” (It’s true that the market came back after 2009 but it took 5 years, 4 months and 15 days to break even, not allowing for inflation. Not very helpful if you plan to retire in 5 years!) My strategy is different. While I would “like” to be able to buy ETFs that do all my thinking for me and spend my time skiing, diving, hiking and traveling, at my age I really can’t afford to see my portfolio decrease 53.5%. Can you? That’s why my approach is an active one. I may tactically employ index ETFs, ETNs or mutual funds to realize my investing goals, particularly in areas in which I do not have the technical knowledge to differentiate among the contenders. In biotech, for example, I’m happy to own a basket of health care firms that includes pharmaceuticals, biotechs, hospitals, etc. I will also, at those times when I see a short-term opportunity for the entire market, use index funds because their greater liquidity allows us to be nimble without paying too much in bid/ask spread to do so. So my overarching strategy, of necessity, is to be an active participant. I use far more actively-managed mutual funds and closed-end funds to populate the foundation of my own investing pyramid, while selecting individual companies’ stocks that are sector leaders for the very top (and relatively smaller square footage!) of that pyramid. With this approach my firm, and I as Chief Investment Officer, has to be better at picking winning companies than those who merely mimic the averages. In doing so, we seek the best companies in the best sectors as measured by growth in revenue; growth in real (as opposed to merely per share) earnings; honest and capable management, preferably with skin in the game; companies that reinvest earnings in capex, R&D, or other avenues of enhancing future value (versus, say, borrowing money to buy their own stock to goose earnings per share 😉 a rate of return that exceeds its primary competitors within the sector; and, finally, companies that represent good value for the price we pay. In my experience all sectors go through periods of price contraction. Assuming the above factors are met, if the sector encounters short-term headwinds, that’s the time we like to buy. Of course, this often means we might be early in our buying. This doesn’t bother any of us if our analysis of all the above suggest there is unlikely to be a better time to nibble, or buy, or buy in size. An example today might be the energy sector, down a whopping 21% year to date. Another would be the content creators and distributors, down because the assumption made by many is that, with the Internet, entertainment and content will become more distributed, lessening the value of creative offerings by the best in the business. When the entire sector declines, that’s the time we like to pounce on the best of the best; companies with the strongest balance sheets will pick up the pieces of firms more highly leveraged and, in so doing, will concentrate even more talent under their roof. Our goal is to pay a fair price for a good-to-great company, not a priced-for-infinite-growth price for a great company. There is no doubt that Amazon (NASDAQ: AMZN ) is a brilliant company. I respect the company but it simply isn’t part of our strategy to pay a massive premium for assumed eternal growth. Sooner or later, success breeds competitors, some with very deep pockets. I remember when University Computing, Polaroid, Xerox, and so many more were alleged to have first-mover advantage “unassailable” moats. The funny thing about moats is they can dry up or be forded. Somehow I don’t see deep-pocketed Wal-Mart, Target, and others rolling over forever in the online world. Give me a solid company at a fair price any day… I’ve written extensively about energy firms before and will again. For all the years I’ve been in this business, I’ve listened to people saying that oil and natural gas or done for. Never happened. Won’t in our lifetime. If somebody wants to sell me Chevron (NYSE: CVX ) at 75 (it’s August low was 70) I’ll back the truck up. If someone wants to sell me their Exxon (NYSE: XOM ) at 72 (its August low was ~69) I’ll back the truck up. Will I hold them forever? No, but I believe I’ll make a fine return until the next time investors panic out of a basic need like energy. So, to answer the question I posed in the headline, “Should You Be a Passive Investor These Days?” my answer is: absolutely not. I am out of sync with the current black box, quant, and robo-advisor thinking so much in vogue today, but I am in sync with the likes of Benjamin Graham, John Templeton, Warren Buffett and Peter Lynch, all of whom sought the best companies at the best price and held them until they no longer offered exceptional value. I’d rather be in the company of such as these any day over the current “You can’t beat the market so don’t even try” crowd! In my next article, I’ll answer the questions, “Who are the best entertainment and content providers?” and “Are any of them worth buying?”