Monday, July 29, 2013

Bosses with moneybags.

Muting “freedom fighters” at the heart of their “struggle”.

There was a popular caricature in years gone by of the “fat-cat capitalist” boss leaving work with his briefcase stuffed with money that had been gathered from the efforts of exploited workers.

Thys, the mine manager at one of the first sites I consulted at, and I used to have precious moments of levity at his casual safari-suit dress code and absence of a brief case to counter that caricature. Indeed, my presence there was part of that effort, more specifically to set up some form of comprehensible sharing of information that would disabuse the belligerent mobs of their misguided musings.

In all of my work at the time and at many different sites, I could never convince clients of the need to be transparent about pay differences. Even the most belligerent workforces never argued for “equal pay” – only, and then not too convincingly for “equal pay for equal work”. What was even more tragic was that the pay difference cover up was exacerbating misconceptions. Employee suspicions were far worse than the reality. Full and credible disclosure, I argued, would in fact ameliorate the murmurings.

But it all fell on deaf ears, even at one large retail site where we extrapolated an average differential of about 7 to 1 between the top-paid 10% per cent and bottom paid 10%. Of course that was before the introduction of other executive pay magician’s capes such as share options and convoluted bonus schemes. (Latest U.N. statistics puts that calculation for South Africa as a whole at 33 to 1). But at that time, I vehemently championed disclosure, pointing out that it was a differential that even the most radical unions could accept, against the background of a relatively mild prevailing South African Gini co-efficient of less than 5 compared with today’s 6.7.

What I could not achieve in those years was later done by the stroke of a Mervyn King pen. The King III governance requirements has forced executive pay disclosure at a time when the differential has been exponentially burgeoning, not only catapulting the issue into the heart of serious labour ferment, but adding to the frenzy by igniting comparisons and adolescent envy as a motive for increasing executive rewards.

What changed in a span of less than 20 years, that could turn modest, yet covert pay differentials into excessive, now embarrassingly overt gaps? -- certainly not sudden and massive changes in supply and demand for executives. That alone should confirm that the so-called executive market is thoroughly broken, and the price for executives is nothing short of fiction.

It has perhaps been forgotten that the explosion in executive pay has happened in less than 20 years, more specifically as an unintended consequence of American President Bill Clinton’s efforts to curb what was then already becoming obscene levels of executive remuneration. His executive pay tax proposals in the early 1990’s set off a wave of tax avoiding remuneration initiatives that compounded the gap many fold.

South Africa, with its 50-60 times pay differences in a highly emotionally charged environment, simply cannot escape the global soul-searching on executive pay. Switzerland for example is looking at enforcing a 9 times differential cap, on the back of a recent referendum for executive pay reforms.

One of the world’s thought leaders on executive pay, PwC has been challenging executive pay models for a number of years, concluding in its latest Executive Remuneration report that “there are few who would argue that executive pay models have produced better performance over the last decade”. The case against long term incentive plans, it says, may be based on:

  • Poor track record of aligning reward with shareholder returns;
  • Volatility of performance being rewarded rather than strong sustained performance;
  • Impossible to calibrate reliably;
  • Perceived as a lottery by participants; and has led to irrational discounting by executives, so valued at a fraction (in many cases only 25%) of their economic cost.

PwC believes that simplification and with it greater certainty will lead to a reduction in executive gross pay, simply by reducing the extent to which executives discount the real value of these incentives. It has proposed a new model to capture

  • Financial performance (but with a long-term view on underlying trends),
  • Customer,
  • People, and
  • Risk, compliance, and behaviour.

It says performance assessment criteria should be based on (1) Revenue; (2) EBITDA (earnings before interest, tax, depreciation, and amortisation); (3) Operating free cash flow and (4) Return on capital.

It is beyond the scope of this article to give all the details of the proposed model, let alone a critique of all of its elements. Encouraging as it is simply in challenging the current dysfunction in executive remuneration, my main concern is that it is still deeply rooted in profit maximisation and shareholder value criteria and will do little to effectively counter short-termism and a squeezing out of other social constituents, including labour. The model falls back heavily on elements of the Triple Bottom Line and the Balanced Scorecard, which have been around for decades with no effect on pay disparities or more balanced national economic growth globally.

Ultimately the real value of any business should not only be to one specific group such as the owners, but to all of its constituents, the most important of all being customers or the market that that business serves. Accommodating those constituents as merely co-incidental beneficiaries of the grand purpose of maximising profit is skewed, inappropriate and indeed has led to their neglect.

If, as Bill Kellogg once remarked, the real purpose of a business is to add value to people’s lives and profit is only one consequence (albeit a very important one) of that, then the real issue is to challenge the mother of all measurements, the income statement itself.

The only metric that appropriately captures the very essence of what companies should be about is wealth creation or value added. This is simply income less outside costs. I believe, however, that real wealth creation is more accurately represented as cash Value added, which means that interest, depreciation and amortization should be deducted from the commonly used value-added metric.

If used as the primary incentive criterion, it forges common purpose and common fate within an organisation and will be by far the most powerful tool in countering ever increasing pay disparities. It is the one measurement that will encourage executives to emulate entrepreneurial behaviour while reconciling shareholder and customer interests.

Of course, there are such powerful vested interests cemented in conventional accounting that one cannot expect any serious move towards something else, particularly from the accounting profession.

Indeed, giving credit where it is due, PwC’s challenge to current formulae is a laudable proposal in addressing pay disparities, one of the great distortions of our time. It is such a powerful weapon in the hands of malcontents such as our so-called economic freedom fighters that any hint at its invalidity has to be seriously explored.

PwC’s difficulty will be to reassure a sceptical audience that any tinkering with executive remuneration that implies a reduction in their gross pay, will lead to an exodus of much needed talent.

I used to be an avid poker player. Let’s call their bluff!

Monday, July 15, 2013

The compromise conundrum.

Wage compromises are not a solution in unforgiving markets.

When stances are stubbornly held in adversarial relationships annual compromises in wage negotiations amount to nothing more than temporary patchwork and ultimately simply become untenable.

Management will adjust to the compromise by cutting costs deeper, and workers return to their positions bruised, bloodied, seething with resentment and waiting anxiously to learn whether they will be the next to be turfed out of a job.

The writing has been on the wall for a long time in the mining industry, one of the country’s biggest employers and a hotbed of distrust and violent confrontations, exacerbated in no small measure by union rivalry and by the fact that investors have to seek high returns in a volatile environment with a naturally depreciation asset. In time, a mine simply dies when it runs out of payable reserves. Paradoxically, the only certainty one can establish in such an environment is through flexibility. In turn, flexibility simply cannot accommodate rigidly held demands, assumptions and unrealistic expectations.

It is further severely threatened when extreme if not outrageous positions are taken at the outset of an obscene haggle. This week’s opening gambit by the National Union of Mineworkers was for a 60% pay hike and by its rival AMCU for 100%. It is by far the most extreme demands yet that the industry has had to face and comes on the back of highly costly, violent and disruptive action that has had the industry staggering for months now.

In addition, the relentlessly tightening pincer of a decline in commodity prices on the one hand and rising costs on the other is having devastating effects on global mining with many mine operations facing closure. While some argue that this is a time for compromise on all sides, it could also be argued that it is the time to fully re-examine a wage pricing model that is deeply flawed to begin with.

That model has created the ever widening gulf between employer and employee, between capital and labour, between executives and average worker. On the one hand we have had the industry pleading its cause through some stark reality check figures outlined by Moneyweb Mining Editor, Geoff Candy that put the cost of producing one ounce of gold and replacing that ounce with a new one at between $1,250 and $1,500.

Then we had Labour correspondent Terry Bell earlier defending a double digit pay increase on the basis that “the wage deals struck by most workers over the past five or six years, let alone over a longer period, reveal that these workers have effectively become poorer; that their disposable income has bought less and less as each year went by”.

Mining, like few other industries, has very limited choices. It is not the place where you can bring your needs and wants to the “market”. That market is unforgiving, overwhelming and absolutely dictatorial.

Ultimately it is so with all markets. The ultimate paymasters of profits, wages and all benefits are the end buyers, not management, unions, or the outcome of “negotiations”, belligerent or otherwise, between the beneficiaries.

Wealth distribution has always been secondary to wealth creation. Yet, under the veil of being “market driven” we have made the secondary market the primary one, arguing that collective coercion on the part of labour; kowtowing remuneration committees on the part of executives, shareholder value on the part of capital, and tax decrees on the part of state, represent true value and contribution to the end buyer.

We are being pushed by reward, not being led by contribution. It is in line with the flawed economic construct we have developed over decades that panders primarily to our selfish needs and wants rather than our natural and instinctive desire to do something meaningful for others, the ultimate source of meaning and contentment.

But even that would be tolerable if those markets that should guide wealth distribution were unfettered and functional; where rewards at a general labour level were not determined by panga wielding mobs, unrealistic expectations and rigid legislation; where at executive level they were not the outcome of smoke and mirror board-room lotteries to create 50-60 times pay differences between highest and lowest; where productive capital is not seduced by quick and short-term returns either in flaky financial instruments or by neglecting other constituents; and where taxes were aimed primarily at enablement and not dependence.

Only a truly functional market for skills, qualifications, experience and aptitude can be an appropriate guide to pay differences and how the labour share of wealth creation should be subdivided. The overall strategic pillars of sensible distribution are meeting the legitimate expectations of all of the stakeholders and encouraging continued contribution. But even then, the actual amount has to be aligned to wealth creation itself and each reward ultimately sanctioned by those who pay for it, the end user or customer. If the recognition of value added by the end buyer is volatile according to changes in supply, demand and prices, then rewards themselves have to be flexible and constantly aligned to those changes.

That would be a purist market view – perhaps not attainable for decades to come. But what we now have is broken and unsustainable.

Tuesday, July 9, 2013

Moods and measurements.

Having our economic destiny driven by manic-depressive markets.

There’s been much talk again recently about what drives what in economics: the immeasurable or the measurable, the way we calculate or the way we behave; the way we think or the way we feel.

It clearly is much more than chicken or egg, and regular readers to The Human Touch will know which side I favour – the title of my column says it all. But then I must concede that I am a product of an age when things were relatively stable, our serenity rattled mostly only by the threat of a nuclear 3rd world war.

Exchange rates were fixed. Even our money supply was disciplined to how much gold we had in our vaults and changing our exchange rate was a huge political event – “devaluation” implying weakness, mismanagement and instability. At the time a 5% devaluation was “groot skande”; a 15% downward adjustment to the dollar a threat to popularity at the polls. No wonder politicians handed the whole sorry affair over to “the markets” where currency values can move by more than that and both ways within weeks, with only obscure blame on domestic management, but mostly on the pretext that “it is not I that am weak, but he that is strong!”

Remember “Decimal Dan, the Rand/cents man”? At that time you could buy a British pound for R2 and $1½ dollars for R1. It was weird. At home you were poor, but when you travelled you felt like a king among paupers – that’s if you could afford the flight, both physically and financially. My first flight to Holland on a Trek Airways DC-4 took nearly a week – I still remember it as being a lot longer, those propellers no doubt having made a permanent contribution to my chronic tinnitus.

Interest rates were even more tightly controlled. You could not change the bond rate without parliament getting involved. As a young bachelor I remember well the scramble for a fairly abundant supply of “rent-controlled” apartments. We had control boards, which occasionally would challenge Economics 101 by putting up prices because there was a product surplus, but somehow always managed to maintain food supplies at affordable prices. Inflation in the happy hippy 60’s was a term mostly only academics used.

It was a time of oppressive economic controls. Paradoxically it was also a time of great self-control and self-discipline. Many of us compiled budgets with our first pay cheques. An intriguing entry I found under “income” in one of my first monthly budgets was: “Found in pocket = R1”. Of course, detractors from this seemingly idyllic picture can rightfully counter that we had a laager economy, a terribly misguided ideology, and were totally out of step with both what was right and with what was happening in the rest of the world.

So before a warped nostalgia takes me to a point where I lose my conviction born in the 70’s that the markets have a certain magic, that they make better decisions than corrupt governments, that they are better informed than a handful of self-serving bureaucrats and that freedom of choice in all our affairs is worth defending to the death, I need to chant my favourite mantra: “perfect markets perfectly reflect all our imperfections.”

There’s been increasing vindication for the view that moods drive markets and that behaviour drives systems, structures, institutions and ultimately our economic destiny. Our “leading indicators” are no longer restricted to scientific data but include many mood measurements such as opinion surveys and confidence indices. At the same time, there’s been growing scepticism about measurements – not only their veracity but whether we are, as Einstein might have asked: “counting what counts; and ignoring what does not count.”

Without doubt the two are linked, but moods affect the interpretation of measurements, even if they are accurate and valid, and in turn influence the markets to achieve an outcome which comes close to self-fulfilling prophecies. Going back to when most will not remember, and when many of us foolishly believed that economics was an exact science, there were really only two groups who one listened to for market forecasts: the fundamentalists and the chartists. The former, especially economists were great at hedging their forecasts with “on the other hand”. Charting was often viewed as a bit of hocus-pocus. Still, their pretty pictures had sufficient following to influence outcomes.

Today we have the quaint distinction between traders and investors – the former being mood merchants and the latter mostly herd followers trying desperately to maintain the courage of their convictions. When they can’t do that and succumb to the traders’ trumpets they become their fodder, caught in the cappuccino froth.

Traders (we used to call them speculators) need bi-polar markets. They thrive on mood-swings: the sharper and shorter the better with the best players making much more money on panic than tortoise moving confidence. And if they can’t peddle that panic, they are not beyond colluding to rig important triggers like LIBOR. Now driven, as opposed to simply using nano-second electronic trades they are ready to pounce on the slightest differential between trading platforms.

Now all of that would be fine, if speculators were not so many and did not have such an inordinate impact on very important prices and rates that affect the real economy and our economic destiny. Consider McKinsey Global Institute estimates that put the “value” of annual financial speculation at $1.2 quadrillion – 15 times more than the $80trn annual value of Gross World Product.

There’s a first for me! I have never written “quadrillion” in an article before!

Most of that trading centres in bank created I.O.U’s we call money, in the process destroying one of the four essential requirements for money: as a store of value. As a stable measurement of value it is on increasingly shaky ground, but is still holding on to its role as a means of exchange. Regarding the fourth, something you can count in (numeraire) … well you could use sea-shells or poker chips for that.

The predominantly naïve part of my character allows me to reconcile these mind boggling developments with one simple thought. Despite the froth, the underlying coffee remains. The sustainable and for me the most solid part of the economy still rests on life enriching, day to day exchanges that provide us with both means and meaning.

Let the dogs bark….the most effective counter to panic is patience.