Gary Burnison is CEO of Korn Ferry.
Long-term shareholder value. It’s like motherhood and apple pie—who’s going to argue with that principle? But if we stop to think about it, do shareholders really care about the long term anymore?
In recent conversations, I never seem to encounter anyone who is looking past next year and often not past the next quarter. The only exceptions are start-ups and early-stage companies that need longer runways to generate results. But for well-established firms, today’s long term is yesterday’s short term—not much more than a few months. It’s a reflection of the world we live in today. Everything is happening faster—product cycles, innovation, disruption.
So given the pervasive short-term focus, why are CEOs today being compensated based on the long term? After all, the average CEO tenure today is about five years or 20 quarters. Yet if a CEO doesn’t show results in a far shorter time period, that tenure is in question.
Clearly, there’s a mismatch. The traditional thinking around long-term shareholder value is no longer aligned with today’s disruptive world. Strategic thinking is no longer a once-a-year exercise. Add to that the average holding period for stocks these days. Estimates vary widely, from seconds for algorithmic trading to a few years by the traditional buy-and-hold investor. One study I saw showed the average holding period had shrunk from about eight years during the 1950s and 1960s to a little over eight months currently. Whatever data you look at, the trend is clear: overall investing is measured in quarters, not years.
In addition, the “hands” holding most stocks these days tell a compelling story. According to one study, passive investing using funds that replicate major stock market indexes account for nearly half the stock market. Rather than picking stocks to hold in their portfolios, individual investors are more interested in capturing overall market gains, without any particular affinity for the stocks they hold.
Where’s the long-term shareholder perspective in that? Other than Warren Buffett, who famously said his preferred holding time is “forever,” for most people, investing is a short-term game.
Often, investing means focusing on revenues for the next quarter. A case in point: the extreme volatility that occurs when a company gives guidance on upcoming results. Theoretically, the value of a company is based on the net present value of its future cash flows. But if a company indicates its revenues will be even 1 or 2 percent lower for the year, its stock price could swing as much as 15 or 20 percent in a day, reducing its market valuation dramatically.
There’s another mismatch when it comes to the long term, which brings us back to CEO compensation. Over the last decade, companies have migrated toward increasing long-term incentives. According to Korn Ferry’s Compensation Survey, of the average total direct compensation for CEOs of $14.4 million in 2018 (an increase of 15.2%), long-term pay accounted for almost three-quarters of it at $10.5 million.
CEO compensation typically includes a reward for annual performance, generally in cash. In addition, long-term rewards are often given using stock options, restricted stock, and performance shares. Performance shares, which typically account for most of the long-term incentives, contain some “leverage,” meaning that after a vesting period, the payout will rise or fall depending on how a company has performed as measured by a combination of strategic operating metrics and relative stock-price performance. As a result, those performance shares could be worth anywhere from zero to two or three times their face value (or more)—mostly based on stock price.
Given the 10-year bull market and the influx of index funds buying stocks, we’ve been in an extended period of a rising tide that has “lifted the boats” of individual stocks. This has created some dramatic gains in CEO compensation, largely because performance shares granted years ago are paying out big, mostly due to stock price appreciation.
This begs the question: are these incentives really creating alignment with shareholders?
Rethinking CEO Compensation
It’s time to revisit CEO compensation. For one, if the goal is alignment with shareholders, then incentives such as performance shares should be more tied to company-specific, strategic operating metrics rather than primarily the stock price. We’re seeing a trend in that direction, and it’s likely that more CEO incentives will be linked to operating targets and environmental, social, and governance (ESG) criteria, instead of just baskets of stocks or broad market indexes.
Perhaps the most important consideration, though, is to broaden thinking from “shareholder alignment” to “stakeholder alignment.” In addition to shareholders, there are two very important groups included in stakeholders: employees and customers. Performance depends on how well companies motivate, reward, and retain employees and grow the customer base. Barring an industry disruption or breakdown, when these two groups are taken care of, shareholders will also be the winners.