“Incentives dictate behavior.” – Check out how this concept can help redefine your wealth and investments! [Wednesdays: The Independent Investor]
Miles Everson’s Business Builder Daily speaks to the heart of what great marketers, business leaders, and other professionals need to succeed in advertising, communications, managing their investments, career strategy, and more.
A Note from Miles Everson:
Welcome to “The Independent Investor!”
We’re excited to share with you another great investing tip.
Every Wednesday, we discuss various investing tips, insights, and coaching comments that can help us achieve true financial freedom. These things can also positively impact both our personal and families’ lives.
In today’s article, let’s talk about a new way to define “wealth.”
Continue reading below to know how you can measure and redefine your own wealth. This will be beneficial not only for your investment portfolio but also for your personal life and career.
The Independent Investor
What are the forces behind your actions?
Do you do something each day because you simply know it’s good for you?
Do you do something each day because of some external reward?
There are many reasons why we do what we do. Sometimes, we’re motivated to act because of internal desires and wishes. Other times, our actions are driven by extrinsic motivation.
According to the Incentive Theory of Motivation, actions are often inspired by a desire to gain outside reinforcement. This suggests people are pulled towards behaviors that lead to rewards and stay away from actions that could lead to negative outcomes.
What types of rewards are people usually attracted to?
Rewards under the Incentive Theory of Motivation range from material to non-material things. These could be in the form of:
- Good grades
- Additional allowance
… and others.
Money is also another good external reward! In many instances, money motivates people to do chores, work, etc.
Let’s focus on how powerful money is in influencing someone’s behavior in the worlds of finance and investing…
Incentives Dictate Behavior (IDB)
Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist of Altimetry Financial Research, says IDB is a phrase he and his team use a lot at Altimetry.
IDB means everyone in a firm—from CEOs to shop floor sweepers—is driven to behave in a certain way based on their promised rewards.
In terms of evaluating stock investments, Professor Litman says IDB is one of Altimetry’s more formidable research applications.
Here’s how he and his team use it:
Every listed company in the U.S. is required to submit the DEF 14A form to the U.S. Securities and Exchange Commission (SEC). The DEF 14A is where management teams report their companies’ compensation methods.
Once the form has been filed, Professor Litman and his team will look at it and study the metrics and targets that determine a firm’s short-term and long-term bonuses. They also look at whether or not various teams in the company receive compensation in cold, hard cash, in stock investments, or in any other options.
According to Professor Litman, these are the things that make the DEF 14A critical. It doesn’t just reveal how much the higher-ups are paid, but also how and when these people get paid.
After all, it doesn’t make a big difference to know that a CEO of a multi-billion dollar firm receives USD 1 million or USD 2 million in bonuses. That information won’t do much for investors.
The more important thing investors need to know when looking at a company’s DEF 14A is that management is getting paid to do the RIGHT things to create shareholder wealth.
If corporate executives are simply chasing after arbitrary calculation of profit—like those under generally accepted accounting principles (GAAP)—they will likely make the wrong moves for shareholders while raking in more money for themselves.
That’s why it’s essential that before you invest in a certain company, you first take a look at the incentives that drive the management team’s behavior.
Photo from GOBankingRates
One of Wall Street’s favorite financial metrics is the earnings before interest, taxes, depreciation, and amortization (EBITDA).
The mainstream financial media has been lauding this metric as vital to company analysis for decades. As its name suggests, this calculation looks at earnings NOT including company expenses.
Don’t you think there’s something wrong about this metric when viewed in an investing perspective?
Even investing giants like Warren Buffett, Seth Klarman, Charlie Munger, and others think EBITDA is terrible… and they’re right for saying that!
Think about this: Compensating the management teams of large companies using only EBITDA creates perverse incentives. If executives get higher bonuses for higher EBITDA, why should they care about being over-leveraged?
[Over-leveraged: This means a company has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses.]
They won’t be charged for their interest expenses anyway.
Likewise, if management teams want to use all that debt to buy different kinds of properties, plants, and equipment, they can easily do so. Since depreciation and amortization aren’t deducted from EBITDA, they won’t be punished for overspending.
See the problem in this metric?
EBITDA only tells management teams about an earnings number that holds no accountability for the assets and capital needed to create growth in a company.
It’s ridiculous! Yet, it’s still at the core of lots of management compensation plans. According to Professor Litman, in cases of IDB failure, it wouldn’t be a surprise that when management compensation goes up, investor wealth falls.
Telecommunications company Leap Wireless, the former owner of Cricket Wireless, was an example of this problem. It had a dubious DEF 14A.
The company put the wrong metrics in place and management was doing what it was paid to do. Sure, Leap Wireless grew its EBITDA all right. However, its stock price drove through the floor in the process.
What does this tell you as an investor?
IDB analysis through companies’ DEF 14A is important. This will help you understand whether or not a company is worth putting your money into.
Besides, by knowing the incentives or factors that drive a company’s management team’s behaviors, you’ll identify if corporate and management executives are doing the RIGHT things to create shareholder value.
IDB Goes Far Beyond Stock-picking
According to Professor Litman, IDB applies not only to stock-picking but also to your career and personal life. After all, compensation and incentives mean a lot to different people.
For example: Employees dedicate their time and services to a company in exchange for money. However, it’s also important to note that money is not the only motivating factor for workers. There are other reasons why people devote their time to boost their careers.
At Altimetry, Professor Litman says they hire and promote personnel with different types of workforce engagement in mind. Only one of those drivers is monetary. Others include job responsibility, learning opportunities, and interpersonal relationships.
He and his team believe when people are TRULY engaged in their work, it’s almost never about compensation or incentives alone.
Other levers like being part of a business that operates with a more noble purpose than simply “making money” are great drivers of a highly engaged workforce.
This also ties directly to how workers view “wealth.”
If they only think of themselves in terms of net worth, that’s all they’ll ever achieve… and they’ll miss out on everything else.
That’s why when looking at your own wealth, make sure to consider other ways by which you can measure it—intellectual stimulation, enjoyment, or an avenue to experience more love and happiness.
… and ALWAYS remember: The next time you think about your wealth, consider it as a culmination of lots of great things in your life, not just the money you have in the bank or in your investments.
We hope today’s topic inspired you to look at your investment strategies and wealth differently!
(This article is from The Business Builder Daily, a newsletter by The I Institute in collaboration with MBO Partners.)
About The Dynamic Marketing Communiqué’s
“Wednesdays: The Independent Investor”
To best understand a firm, it makes sense to know its underlying earning power.
In two of the greatest books ever written on investing, the “Intelligent Investor” by Benjamin Graham and “Security Analysis” by David Dodd and Benjamin Graham (yes, Graham authored both of these books), the term “earning power” is mentioned hundreds of times.
Despite that, it’s surprising how earning power is mentioned seldomly in literature on business strategy. If the goal of a business is wealth creation, then the performance metrics must include the earning power concept.
Every Wednesday, we’ll publish investing tips and insights in accordance with the practices of some of the world’s greatest investors.
We make certain that these articles help you identify and separate the best companies from the worst, and develop your investing prowess in the long run.
To help you get on that path towards the greatest value creation in investing.
Hope you’ve found this week’s insights interesting and helpful.
Stay tuned for next Wednesday’s “The Independent Investor!”
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