Show me the incentives, and I’ll show you the outcome, a checklist to evaluate management
It's all about people
Of all the mental models Charlie Munger has mentioned, this is the one that had the biggest impact on my life (and investing decisions).
This mental model has helped me ‘see’ through certain apparent conflicts I had with colleagues at work (who in retrospect had different objectives and incentives) and why certain C-level staff of listed companies behave the way they do.
Lots of investing books talk about “Skin in the Game” to align the incentives for the leadership team with the shareholders. In this article, we’re going to see if we can come up with a checklist we can use to evaluate leadership. (the L in SPECIAL, go here to find the full ranking system). The topics we’ll discuss are:
What is skin in the game?
From skin to soul in the game
Quant: What do the numbers tell us?
Where to find information on incentives?
The outsiders: lessons learned from Mr. Thorndike
A quick question first
Who in your eyes is a current great business leader creating shareholder value?
What is skin in the game?
The definition on Wikipedia states the following:
to have incurred risk (monetary or otherwise) by being involved in achieving a goal.
But I believe Thomas Sowell, a renowned economist says it best
We win or lose together.
The % of insider ownership is the easiest way to have a first idea of ‘skin in the game’. You could compare this to the net worth of the individual and their annual salary to see if it matters.
There can also be too much skin in the game.
If you find a company that is 80% owned by the CEO, then you must take into account that minority shareholders have no power. If the CEO wants to make ‘bad’ decisions, tough luck…
Nassim Taleb wrote a book titled Skin in the Game. The following passage hits home:
Things designed by people without skin in the game tend to grow in complication (before their final collapse). There is absolutely no benefit for someone in such a position to propose something simple: when you are rewarded for perception, not results, you need to show sophistication.
But is skin in the game enough?
From skin to soul in the game
Pure ownership and historical commitment go a long way. The more someone invests time, energy, and money into an endeavor, the more they will build up commitment bias. Commitment bias is bad for an investor when he keeps holding on to that stock he already invested so much time in, but is not necessarily bad for an owner-operator who wants to build a great business. There are may other biases:
Soul in the game takes it one step further. Does the CEO or other C-level management CARE about the product or service they are building? Are they mentally invested in the company?
The holy grail: A founder so driven by his idea, that his goal is to make the idea a reality. He would go for it, even without the money. This is a great but an insufficient condition for great performance.
I’ve talked about my investment mistakes in the past. When I look at a company like Tinybuild (Ticker: TBLD), despite its underperformance, I’m convinced the CEO has soul in the game (he also owns more than 50% of the company). Does that mean future performance will be stellar? Not necessarily.
What does soul in the game mean? The great Vitaliy Katsenelson wrote a book about it.
Love what you do
Be a student of life
Have pride in your work
See the art in the mundane
Be a net positive for society
Do not allow money to dictate your craft
Focus and strive for continuous improvement
What can you do as an investor?
See if you can find interviews with management. Read (or listen) the earnings calls, not to look for additional information, but to read between the lines. This can be misleading as often, C-level management are trained communicators. I usually look for their capacity to admit mistakes. A person that can admit mistakes is the first sign of a learning organisation.
Quant: What do the numbers tell us?
Ryan Telford is a quantitative investor and stock analyst. He did a backtest based on insider ownership to see how it has impacted the performance of returns. He uses portfolio123 to run these screens. Here are the results:
He took the TOP 100 stocks from the Russel 2000 index with the highest % insider ownership and ran a backtest.
The result: 1.2% CAGR as opposed to the index 6.7%. Well, that’s not good!
The second test was to use % Ownership as a single factor, with 52-week rebalancing.
Note: This means every week, portfolio 123 ranks the stocks based on insider ownership. You would rebalance your portfolio based on the ranking. Since the ranking is determined by an increase or decrease in insider ownership, you’re effectively increasing your holdings that had insider buys and decreasing where insiders have sold.
This time it outperformed by 3%. In other words, the data is not conclusive.
A last analysis he did: On a list of 10 baggers over 10 years, the amount of insider ownership decreased over time.
But a decrease of over 10% over 10 years was only visible in 5 of these companies.
The takeaway?
Insider ownership matters but is not sufficient. What the owners do is more important. What (capital allocation) decisions do they make?
Where to find incentive information?
Percentage ownership is the easiest to find, and usually, this relates to the CEO or a founder. You rarely see a CFO or other C-level member have significant ownership. (CFO’s have a tendency to float from one company to the next). You can use tools like finchat.io or unclestock.com to quickly check the insider ownership percentage.
There are however other things that go beyond simple ownership.
There are 2 ways to find the information on incentives structure for the management team and maybe for other people within the organisation
The proxy statement
Reading an annual report backwards
Let’s start with the annual report.
The incentive structure, employee shareholder plan etc are usually one of the last things you’ll find in the “notes” of an annual report.
Stock based compensation is not necessarily a bad thing, if the “way” it is structured is in line with your goals as an investor. Typical examples are options on stock at a price higher than the current one, where there is a vesting period for some years.
There are of course examples of companies with a very bloated SBC structure. Here are 5 well-known companies with an SBC/revenue > 30%!
ARM Holdings (ARM)
Roblox Corp (RBLX)
Unity Software (U)
Sentinel One (S)
Freshworks (FRSH)
As a bonus, Reddit, which sits at 66%? My data is wong, right?
What is a proxy statement?
When a shareholder vote is needed to decide on certain topics, a proxy statement needs to be filed. For some investors, this is the first document they read after an initial screening of the company. What about you?
Here are some of the topics a proxy statement could cover:
Election of Directors
Corporate Governance
Shareholder Proposals
Executive Compensation
Mergers and Acquisitions
Board Committee Reports
Related Party Transactions
Equity Compensation Plans
Always check this statement during your analysis. Now let’s take a look at the best of the best in creating shareholder value ⬇️
The outsiders
We can’t write about leadership and try to generate a checklist without mentioning the outsiders by William Thorndike. If you haven’t read the book yet, I highly recommend it. Eight chapters will go through 8 CEOs of which are Henry Singleton, John Malone and of course the master, Warren Buffett.
Based on his book he found these outsiders to typically exhibit the following key traits:
Independent thinking: Outsider CEOs are analytical and rational, preferring to come to their own conclusions rather than following conventional wisdom. They are often quantitative thinkers, with many having engineering degrees rather than MBAs.
Frugality and humility: These CEOs tend to be frugal and humble, focusing on operations rather than public relations. They avoid the spotlight and are not typically considered charismatic leaders. (remember Lynch: Look out for big spending on flashy HQ’s)
Frugality drives innovation like other constraints do.
Jeff Bezos
Analytical approach: They are highly analytical, using rational analysis to make decisions about their businesses.
Broad perspective: They are often "foxes" rather than "hedgehogs," meaning they have knowledge across various disciplines and industries, which allows them to bring fresh perspectives to their roles.
Patience and decisiveness: While they are patient in waiting for the right opportunities, Outsider CEOs act boldly and decisively when they identify a great chance for success.
Investor mindset: They think about their companies as investors, making decisions based on what provides the best returns rather than ego or empire-building. Aim for the best company (profitability/efficiency), not the biggest
Focus on capital allocation: They pay particular attention to capital allocation, often making unorthodox choices like buying back shares when peers aren't, or ignoring traditional measures of value.
Understated personality: They tend to live seemingly boring lives, are often happily married, and do not seek public attention or fame.
Fresh perspective: Many Outsider CEOs are first-time CEOs, often new to their industries, which allows them to approach problems without being bound by conventional wisdom.
Independence from peer pressure: They care little about what others think of their decisions, allowing them to make choices that may seem unorthodox but yield superior results.
Do outsiders run your companies? Go through your portfolio. Can you find an outsider within?
The outsider checklist is a paradox. You need lots of information on the individual to be able to assess these 10 traits. But this goes against trait 8, an understated personality, and thus often little information is available online. Therefore, the best way is to look at past decisions and actions to inform their skills:
What are their past capital allocation decisions? (opportunistic buybacks when the price was low?)
Do they behave countercyclical? (example: Adyen hiring when others were firing)
What do the companies spend money on? Flashy things or focus on business operations. Do they have extreme stock-based compensation?
Summary
Is skin in the game sufficient for great business performance?
No
Is the soul in the game sufficient?
No
But the right incentives can make or break a business. In the end, a business is a group of people working towards a common goal. A founder or CEO has to choose the following topics:
Type of organization
Type of communication
Vision, mission, and goals
Incentives for reward or punishment
The outsiders make different choices than most would. But it’s not that easy to identify an outsider.
We arrive at the full checklist to verify leadership quality:
I hope your portfolio companies are run by leaders who build shareholder value!
As always,
May the markets be with you!
Kevin
This is one of most insightful posts ive come across on substack. Thanks for sharing this kevin!
Jen-Hsun Huang comes to mind as a great leader creating shareholder value.