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The Circus In Which the Modern CEO Lives

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This post is in response to the comments left by readers on my post yesterday, "What CEOs and Hedge Funds Don't Want the 99% to Understand."

Readers often challenge what they see as my dark view of CEOs and hedge fund managers, telling me that they aren't really the manipulative, volatility-embracing folks that I make them out to be. They are half right.

Readers are right that I don't care much for hedge fund managers. They trade value rather than build value, playing a zero-sum game that has no benefit for society. And they behave badly, happily destroying companies so that they can make profits shorting them on the way down. Rather than enjoying preferential tax treatment, hedge fund managers should face adverse tax treatment and pension funds should not be allowed to invest with any manager that charges both a fee for assets under management (e.g., 2%/year) and a carried interest (e.g., 20% of the upside). This is exactly the compensation structure of a CEO with a luxurious base salary plus lots of stock options. As we found in the dot.com bubble, this salary plus stock options provides nothing but an incentive to swing for the fences because you can do very nicely on the base (here the 2%) and if you hit a home run, you get wildly rich. If, as is likely, you strike out, someone else (the investor) pays 100% of the price. Providing an incentive for hedge fund managers to swing for the fences is absolutely counter to the interests of pensioners or educational institutions that count on endowment income, as so very many found to their chagrin in 2008-2009. Hedge funds need to be taxed aggressively and have their supply lines of capital cut off for the good of the economy now and in the future.

In contrast, I empathize with CEOs. Many of them try to be good but in the crazy, twisted system in which they live, it is really hard to focus on the right things -- like serving customers and building a competitive business for the long term.

Stock-based incentive compensation is right at the root of the nutty circus in which they live. When a worker is given incentive compensation, if she doesn't pursue goals that attempt to earn the incentive compensation pay-off provided, she is being insubordinate. So if a salesperson is given a quota of selling $2 million of widgets in the year with a bonus of $50,000 if she achieves the target, she is insubordinate if she doesn't attempt to sell $2 million of widgets. If a CEO is given stock-based compensation -- say a grant of stock options at market price on January 1 of the year -- it is strictly and simply an incentive to make the stock price rise from its current level. That is the only way the CEO will earn the targeted incentive compensation. Thus if that CEO doesn't concentrate on causing the stock-price rise from the current level, he is being insubordinate.

This makes it very important to understand what determines stock prices. A stock price is nothing more or less than the product of the collective expectations of investors as to what will happen to the company in the future. It is not something real; it is something ethereal, produced in the minds of investors and based on their beliefs about the future, whatever those beliefs happen to be. Those beliefs can be influenced by what is really going on in the company, but they are in no way limited by reality. That is why in the back half of 2008, the stock market dropped in half when the economy shrunk by 3%. Expectations swing much more wildly than reality.

This means that stock-based incentive compensation directs CEOs to focus not on improving the real performance of the company but rather on raising expectations of future performance. This means that they need to spend lots of time talking to Wall Street analysts, using guidance to encourage them to raise their expectations as to future performance. Or it means making lots of acquisitions to provide the appearance of growth. Or it means buying back stock so that it looks like earnings per share grew a lot giving yet another appearance of growth.

In this Wall Street circus, it is very difficult for the CEO to ignore the expectations of the analysts. Rigorous academic research has proven without a shadow of doubt that it is better for a company to meet or beat analysts' earnings expectations than it is to perform absolutely better. That is, imagine a company earned $1.00/share last quarter: under Scenario A, analysts' consensus forecast for this quarter was $1.15 and the company actually earned $1.12; and under Scenario B, analysts' consensus forecast for this quarter was $1.07 and the company actually earned $1.10. The research shows that the company's stock price will be definitively higher under Scenario B -- the lower real performance of $1.10 vs. $1.12 in Scenario A -- because the real performance beat Wall Street's expectations.

This is why other academic research shows that the majority of large company CFOs would cancel or postpone attractive investment projects -- i.e., ones that they are certain are good for the company's long term performance -- in order to meet analysts' consensus forecast for the current quarter.

This is the circus in which the modern CEO operates. They are insubordinate if they don't work to raise expectations about future performance and instead concentrate on real performance. Wall Street punishes them harshly for not meeting short-term expectations. And the hedge funds circle around like vultures attempting to make a buck no matter how much their actions damage perfectly good companies.

Given that they live in the surreal circus, it is truly impressive how many CEOs actually do try to build their companies for the long term and tell Wall Street to stuff it. Unfortunately, it is hard to do and many CEOs succumb to playing destructive short term games that enrich themselves, impoverish their shareholders, abandon their employees and damage our economy.