Stock-based compensation is causing executives to focus too heavily on market expectations, and is in turn hampering companies’ performance and fuelling stock market bubbles, according to Roger Martin, dean of the University of Toronto’s Rotman School of Management.
Speaking at the Portfolio Management Association of Canada in Toronto on Tuesday, Martin argued that the practice of compensating executives with stocks is not an effective way of aligning their interests with those of investors.
“We’ve taken a financial system and used it in a way that’s for no one’s benefit,” Martin said.
He explained that stock-based compensation causes executives to focus on the performance of a company’s stock more so than the company’s actual performance. Because the performance of a stock is tied to market expectations, executives end up spending their time managing these expectations – and obsessively trying to meet and exceed them – rather than actually improving the company’s performance metrics, Martin argued.
“People are incented to chase expectations,” he said. “The problem is, expectations have no bounds.”
As an example of such extreme expectations, Martin pointed to Microsoft Corp. Between 2000 and 2010, the company’s stock remained relatively flat, hovering mainly between $20 and $30 per share, even though the company’s net income surged from $10 billion to nearly $70 billion during the same period.
“In the real market, it’s performed quite extraordinarily,” he said. However, “expectations were so high as of 2001 for the future of Microsoft that even by doubling or tripling their profit and sales, that didn’t move expectations at all.”
Many executives are chasing these kinds of unreasonably high expectations, which is causing the market bubbles and crashes that we’ve seen in recent years, Martin said. He believes this will continue until corporations find other forms of incentive for executives.
“What we have is a machine that produces bubbles and crashes, and at its heart is stock-based compensation. And we’re going to have more bubbles and crashes in the future,” Martin said. “Expectations will rise so high that extreme actions will be taken to meet and exceed those expectations to the point where you’ll crash.”
Compensating executives with stocks is similar to allowing NFL football players to bet on game outcomes and profit from accurately predicting the results, Martin suggested. If players were allowed to do so, they’d be less focused on winning the game than on achieving a specific score.
As a result, the NFL has instituted a rule that bans, for life, any player that bets on football. Martin suggests a similar rule banning stock-based compensation for executives.
“We need to de-link the ‘expectations market’ from the real market,” he said. “Until such time as we do that, we’re at danger of creating the next bubble or the next crash.”