The Double-Agency Problem In Investing

In investment, the “agency problem” is commonly known, which refers to the fact that the management of a company usually acts on their own interests, at the shareholders’ expense.

There many examples of such problems:

1. Expensive Acquisitions.

Among all the bad actions, expensive acquisitions are the most damaging ones. Managers often come up with all kinds of excuses to show shareholders why this is a good deal, and how much synergies they could achieve after this deal. The reality is their pay/bonus is often proportional to the size of the company. Even without the financial reward, they surely enjoy the increased power as the company becomes bigger.

2. Large bonus and stock based compensation.

It is quite often that the bonus for a CEO or CFO is much larger than his/her base salary. I have often seen CEO taken a bonus at 0.5% or 1% of the market cap every year, sometimes even when the company is having a bad performance or losing big!

Well, 0.5% or 1% may not sound like a lot, but if that 1% is saved and added back to income, it will transfer to a big proportion relative to the earnings.  So if the company if valued at P/E 20, the earning is 5% of the market cap. Adding 0.5% on top of that, it translate to 10% extra earning, or at the same P/E multiple, it will give 10% more share price.

This is just the bonus of top management, not counting the bonus of all the executives and board. Very few small investors would go and check proxy statements for these details.

Besides taking bonus, they are also very good at boosting their return on options, and dressing up their financials.

First, by not issuing dividend or issuing a smaller dividend, they could buy back shares instead. What is the difference? Regular dividend doesn’t increase the value of options, but share buyback does. So without moving a finger or delivering extra real operating performance, just by buying back shares (no matter how high the price is), they can make good gains on their options.

The ironic thing is that shareholders actually like to see share buybacks. It just shows how pitiful the shareholders are in the mercy of the management. They like share buybacks because quite often there is the other even worse alternative: they can find out that the management is using the cash on balance to make an expensive acquisition, or mess up the business and eventually go under, which means there is no return at all for shareholders, ever.

Even if there is no expensive acquisition, cash hoarding makes the management feel safer, but makes investors poorer simply because the cash is sitting there without being deployed. The time value of money is lost, and no compounding returns on that cash at all. This kind of hidden value destruction is not to be overlooked, but not obvious to all the small investors. At the end of the day, a manager good at capital allocation and act on shareholder’s interest can be even more valuable sometimes than a manager very good at operations.

Adding insult to injury, after taking millions or even hundreds of millions in stock options, management often want investors to ignore that cost completely. They emphasize on EBITDA, Free Cash Flow or non-GAAP earning figures which don’t contain any charge on options/stock related expense, because those are “non-cash” charges. A simple word “non-cash” wipes out all the dilution effect they have created consistently year after year.

This is what they often do: they dress up the earnings by wiping out the “non-cash” stock based compensation, showing a better earning, and use the “cash” to buy back some shares to eliminate the dilution effects created by the stock based compensation, effectively moving the cash from operating cash flow to the financing cash flow, boosting both operating cash flow and free cash flow. And after all this, they call that share buybacks as “returning” to shareholders.

Not only the small investors who don’t understand the trick get cheated, even the knowledgable professional analysts on buy side and sell side often forget about the tricks when they do the valuations.

It is also not just some of the companies, virtually all the high-tech companies routinely and traditionally come up their non-GAAP figures, with analysts helping their course: all the earnings forecasts are non-GAAP earnings, and forward P/E is using non-GAAP earnings for calculation. Another trap for small investors. For many high tech companies, such as Google, Tesla, or Netflix, just the options/stocks based expense could make a huge difference on their P/E calculations.

3. Accounting manipulations.

The more I learn about investment, the more accounting tricks I could find. And eventually I found out that the accounting manipulations are actually the “norm”, not just for the “criminals”.

To be fair, most of them are relatively mild, such as taking up revenue earlier, or recording a one-time charge-off in order to boost up the following quarters’ earnings. These are smoothing out the earnings, but not having a huge long term effects. People tend to focus on the kind of financial fraud like Enron did, hiding huge losses in off-balancesheet entities, but the type of earning manipulations I just talked about can be damaging to small investors as well, since they often misjudge the stability of the earnings, or get surprised by a sudden change of the business fundamentals. As a result, they tend to sell at the worst moment, and buy at the worst moment.

In the case that the company’s fraud does get discovered, and get fined, guess who suffers? It is the company who pays the fine, or the shareholders who pay the bill! At the mean time, managers’ legal costs are often covered by the legal insurance the company (shareholders) purchased for them!

4. Shares with different voting power.

Suppose a “friend” comes to you and ask you to invest in his company.

He says: “you can own 90% of my company if you put in 90% of the capital. Oh, BTW, forget about the fact that I only put in 1% of capital, based on the current (manipulated) earning power, my company is worth 10 times of the book value now. So my 1% of capital is worth 10% of the company now. After you get 90% of my company, you will be entitled to enjoy the 90% of the earnings. However, you will own the class B stocks, and I own class A stocks, since my class A share have 10 times of voting power than your class B share, despite the fact that you are the 90% owner of the company, I am still the controlling owner, and I can decide whatever I want to do with the company and its earnings, and pay however big the bonus to myself, including giving myself any type of stock based compensations. In another word, I will eat the “meat”, but you are entitled to 90% of all the leftovers, if there is any. Oh, don’t worry, there could be some dividend at some point, when I want to throw some bones to investors to boost up the share price so I can get a new round of share offerings at a high price.”

Now, does that sound like a good deal to you? But you should thank your friend, because he told you everything you are supposed to know. Not like most of the IPOs, although this kind of facts are included in the SEC documents they have to file, they (and the investment bankers they hired) would tell you none of such things when they sell your their version of the stories.

5. Poison pills and entrenched positions.

You might think managers are more like employees, and shareholders are the true owners. Theoretically, that is true. But practically, the management knows how to get an entrenched position, putting their friends on the board, and putting “poison pills” in the “change of control” contingencies.

Because shareholders are scattered and often not knowledgable enough, they often feel powerless to fight the management. Even when they do, it often results in a long struggle, causing distraction to day-to-day business (which often means deteriorating business) and distress on share price for the uncertainty (unless most shareholders are too angry at the management). Once you invited the wolves in (or tried to own a share of that wolf den), it is hard to get rid of them…

6. Misleading investors.

Some of the problems listed above such as expensive acquisitions can be prevented if the management has significant stake in the company. So if the CEO and chairman own 20% – 30% of the company, it is unlikely that they would intentionally make an expensive acquisition to sacrifice the shareholders’ interest. However, even in that case, it won’t prevent them from hiding the bad news or staying over-bullish to mislead investors. To be fair, the CEO should be bullish about the company, and they actually have a job to maintain the company’s public image. However, there is a grey area between staying optimistic and protecting the company’s reputation vs. giving false or misleading presentations to misguide investors.

Any over-bullish statement or attempt to hide the worrisome facts would mislead the investors and make them overpay for the stocks. Obviously, this problem doesn’t exist when the investors actively manages the company themselves. Therefore, it is another type of agency problems.

Ok. Those are some of the agency problems. It means that small investors have to find a trustable management who cares about them, but they are often not empowered by the knowledge and skill to tell who is trustable. What about just buy a mutual fund and rely on those professional money managers?

That is the second “agency problem” I want to talk about here, which is not as widely known.

People bought mutual fund either because they don’t have the knowledge to pick stocks, or because that is the only choices in their 401ks (401k often doesn’t allow investing in individual stocks directly).

So does mutual fund help in this case? The answer is “no” for most funds.

Just take a look at the cost structure of mutual fund. Usually it charges 1% of the total balance no matter what the performance is. So the money managers get paid no matter what the performance is.

Looking at this, most people don’t ask the question like: why do they even get paid when they don’t achieve a good performance? For their labor? Do I even know how many hours they have put in their work? And how much for one hour?

The second question is: if they get paid for the same amount, what is their incentive of delivering a better performance?

Some might argue that if they are not doing well, they get penalized because people will choose a different fund. That is neglecting the fact that it usually takes a long time to tell how good the performance is. Also, quite often, the number of people that would buy a mutual fund depends more on marketing and relationship related deals, than just performance.If you can get the news media to sell your version of the story, it would work more than a charm. If you can persuade your partners to carry your fund as the only choice in the 401k plan, you don’t care too much about your performance as long as it is not too bad.

That is exactly what money managers are seeking. They don’t need to get a very good performance, but they want to make sure it is not too bad, relative to the index or general market. In other words, they care more about the relative performance, than the absolute performance.

The result of this is that they won’t buy when market is cheaper, and won’t sell when market is more expensive, they just tag along the general market. But that is actually not true, it is actually just the opposite, for an open-ended mutual fund: they buy more when the market is more expensive because they get more money flowing in during a bull market (everyone want to catch the good trend), and they will sell more when the market is down and getting cheaper because more money is flowing out their fund during a bear market (forced redeeming). That is why some mutual fund managers are forced to sell at the very panic moment of the market in October 2008. Some of them don’t even know how to choose which one to sell, so they sell in alphabetic orders! They sell stocks with symbols from A to N today, N to Z tomorrow! The net effect is that they end up buying back the same thing they sold at a much lower price! Although it may be unfair to blame the money managers for this action (since it is the individual investors who made the bad decision), it does add to the transaction costs of the mutual fund.

Now, what about buying a fund that was performing well? Many friends told me that they would check the 10 year performance of a fund, if it is going up steadily (Good return with low volatility, essentially higher sharpe ratio), it should be a good choice.

That sounds reasonable right? But it is actually very deceiving. To understand this, I need to tell an old trick first. If you send out 1000 mails to 1000 people recommending different stocks, predicting a stock will rise in the next week, natually, half of them will work, half of them will not. Then you select the 500 people who got the predictions that happened to have worked, and send them some new recommendations again. After repeating this trick 6 times, you will have 15 customers left who got recommendations that worked 6 times in a row. For those customers, they would believe you are the “oracle” since it is very hard to get right 6 times in a row (only 1.5% possibility in statistics). And chances are they would trust you as their money managers.

Many investment firms use exactly the same trick: they don’t own just one fund, they start many different funds with different investment strategies. Some will work well, some will not. Over the years, they close out the funds that didn’t work well (which naturally should have lost most of its customers anyways), and only brag about the ones what worked well. This is a basic “survivorship bias” at work.

So given the double-agency problem, how can a small investor choose? Maybe they should get away from the stock markets and not invest at all?

The answer is “no”.

While stocks could have all kinds of problems, we must remember that it is often the highest return and most flexible investment vehicle regular people can have access to. People could invest on other things like real estate, but that also requires some good knowledge, large amount of capital and often come in limited choices (limited in local area and subject to local property tax policies).

Holding cash is not a solution, as the government often tries to steal from savers by printing money in a non-responsible (and invisible) way. Despite all the uncertainties in the stock market, the damage caused by inflation when you only hold cash is a “certain” way to lose.

Also, we must not ignore the compounding power of investment. At 10% return a year, 50 years would turn $10,000 to $1,170,000.  As Charlie Munger said, if we have some basic investment skills and stay rationale, we will be “determined” to be very rich eventually.

I would often put “compounding” and “diversification” as the two most powerful magic tricks in finance.

So small investors should definitely consider stock investments, but need to follow the right approach. There 4 choices I can think of:

1. Learn a lot about investment, and be an expert at it.

This approach will pay back in a big way eventually, but certainly not for the majority. They simply don’t have the time and the interest to get the expertise.

2. Learn some basics about investment, and invest with good temperament.

This should work fairly well for most of the novice value investors. But small investors usually don’t have good temperament. So it is not realistic for the majority either.

3. Buy a low cost passive index mutual fund.

This is the method Buffett suggested. If done consistently over many years, it should yield fairly good result due to the compounding power of any investment. If you are not so sure about the economy of US, you can also buy a diversified index fund over the entire world.

4. “If you don’t know jewelry, at least know your jeweler.”

It is much easier to know your jeweler than try to be an expert at jewelry. So if you know a good money manager, you can just trust him/her and rely on his/her skills.

It might be difficult for small investors to access a good hedge fund, but there are still some mutual funds with good managers. Also, some investment companies like Berkshire Hathaway are essentially working like a fund, although it is not as tax efficient as a fund (but still pretty good if it owns business directly or not selling stock investment until after many years).

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One Response to The Double-Agency Problem In Investing

  1. You’ve hit the nail on the head with this one. I can’t believe some of the behavior that goes on behind the scenes in the board room.

    How one can pay themselves a bonus at all when times are tough and workers are being let go left right and center is beyond me.

    Corporate America needs a new long term focus to how they structure executive rewards. I don’t know how you do this, but all the focus on short term bonus’ are leading to extremely short term (with terrible consequences for the long term) thinking.

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