“Stockholders as a class are king”, wrote Benjamin Graham in his 1949 edition of The Intelligent Investor [1] . He insisted that shareholders “can hire and fire management and bend them completely to their will.” Then Graham deleted this section, which has been omitted in subsequent editions of The Intelligent Investor ever since.
Graham had become disillusioned with the ability of shareholders to rectify the ‘agency problem’ that exists between them and corporate management. He pointed out that shareholders are owners of a company. They own the profits. They own property. The CEO works for the shareholder, and yet shareholders do little or nothing to ensure that managers act in their interest. Graham complained that when managers act against shareholders, “shareholders are a complete washout” that “show neither intelligence or alertness”.
What was he fussing about? If he was alive today, what would he tell us about the signs that management was acting in, or against, the interest of shareholders? This edition of ‘Graham’s lost dream’ will pay particular attention to the two Cs - Compensation and Candor.
The ‘Agency Problem’ between managers and shareholders:
Before exploring this issue further, it important to lay down what we mean when we say ‘agency problem’. In this case, the ‘principal’ are the shareholders. The ‘agent’ are the management. The agent should act in the best interests of the shareholders’ because, as noted, they own the company. When this service breaks down and management becomes self-serving, shareholders are faced with an ‘agency problem’. We will now go through different areas of management, outlining scenarios where management acts like the principal or the agent.
CEO Pay and Compensation:
You want to invest in a company where management's pay and compensation is tied to the company's performance. This is perhaps the best way to ensure that managers act as agents. Probably the best evidence that the interests of managers and shareholders are reconciled is when management has a substantial shareholding in the company. If the company goes downhill, the net worth of the people running it falls too. Pat Dorsey from Morningstar [2] prefers to see managers' pay that is made up predominantly of bonuses, rather than fixed salaries.
Furthermore, Jason Zweig [3] warns against managers with stellar salaries, suggesting that these companies are "run by the managers, for the…
