Paid how much?

The ongoing public sector strike has raised several interesting points.

Not least of which is what teachers actually earn. A full-page advert in newspapers last weekend gave some very respectable figures  for teacher salaries.  A teacher just starting out, with a 4 year qualification has a total cost to employer of around R229,000 per year. This includes 13th check, pension, medical aid and housing allowance, but is a surprisingly high number. It also included the then-proposed 7% increase (versus CPI at 3.7% at the moment).

The offer was increased to 7.5% since the original advert, but the numbers below are the unadjusted numbers in the advert. These are annual basic packages excluding benefits. (It’s unclear whether the before Total Cost to Employer columns include or exclude the 13th check, which is definitely included in the TCE column).

Experience 2007 2008 2009 2010 TCE 2010
1 year 107,007 129,948 150,105 160,614 229,790
5 years 111,357 131,256 153,129 163,851 233,718
10 years 117,042 135,228 160,920 172,185 243,830
20 years 136,923 158,568 194,421 208,032 287,324
30 years 151,257 175,152 220,278 235,698 320,892

This advert prompted an immediate outcry from teachers writing to complain that they earn nothing close to that figure. This was followed up by government affirming that the figures are correct, noting that many teachers may not add up all the non-cash benefits. Continue reading “Paid how much?”

Income, Outgo, and the NHI

What about the NHI sounds like a bad idea? Free, universal, comprehensive medical care – it’s a great ideal.

What about our current healthcare setup sounds good? A small proportion of the population have access to excellent healthcare, but the vast majority have “access” to public health comprising long queues (often after long walks) to understaffed, understocked hospitals with demotivated doctors and hospital managers who combine the worst elements of overworked and disinterested. Clearly, not much. Did I mention that the tax structures around medical scheme contributions have benefitted the wealthy over the poor?

If the obvious solution seems to be solving this problem by changing from our current system to the new proposed NHI, I have some bad news. The problem identified above isn’t a healthcare problem. At least it’s not only a healthcare problem. Continue reading “Income, Outgo, and the NHI”

Make A Million competition encourages financial meltdown

[There is an additional post for the 2010 competition on how to not lose money in the make a million competition.]

The Make a Million competition is in its fourth year. The aim? Take a personal investment of R10,000 and compete with other “investors” to earn the highest return over a short period of a few months.

The competition itself has always struck me as a little strange. No doubt the purpose is to raise the profile of PSG and encourage new clients to begin share trading with them. However, it is also positioned as an educational programme where newbies can learn to invest in the stock market.

Invest? Oh, you mean speculate like crazy?

The irony is the strong use of the word invest in all of this. Investing is taking carefully considered long-term positions in great companies at reasonable or cheap valuations to benefit from the improving prospects of the underlying business and be rewarded for providing capital to the business.

The nature of this competition can be likened to a exotic type of binary option. Whoever makes the highest return in this short period (far too short for the economic and business fundamentals involved in real investing to play a serious part) wins the “pay-off”. The sensible strategy is to find the most volatile assets possible and plough all the cash into these few positions in the hope that they skyrocket. The downside is limited to R10,000 (ok, R10,650 if one includes the entrance fee) and the upside has the 7 digits of a million rand.

The competition is at least partially marketed  at those new to trading. This is NOT the right way to introduce investors to the stock market.

Introducing MaM4 with Single Stock Futures

This year, the competition has outdone itself in terms of promoting irresponsible speculation through introducing Single Stock Futures (SSFs). In this way, investors get to increase the volatility of their positions several times, to increase the possible (not expected!) value of their portfolios. Again, the downside is limited, so strategies that ramp up volatility (at the expensive of expected return) can be shown to be optimal.

The sneaky thing is that as participants increase the volatility of their portfolios, the expected value of the winning portfolio increases! The average return of all portfolios will be unchanged, and may quite likely even decrease. However, the winning portfolio (which both I and Nassim Taleb would both call the luckiest portfolio) is likely to be more impressive. A misleading, if attractive advert for stock speculating and PSG. As the volatility of individual portfolios increase, the range of outcomes (positive and negative) increases. Since the largest portfolio will win, we have increased the expected size of the winning portfolio.

All sounds horribly like the cause of the current financial meltdown

The current global financial disaster was largely created  through excessive gearing, poor understanding and management of risks, arguably weak regulation, and performance incentives that directly motivate risk taking for decision makers.

One of the key lessons of economics is that incentives drive action. Executives and traders were given huge upside potential in terms of bonuses and stock options for good performance, and the relatively limited downside of a still-significant salary and maybe a polite “moved on to new challenges”. We reward for upside performance and ignore risk in the process.

Nassim Taleb’s (if anything more relevant now that a few years ago books, “Fooled by Randomness” which I strongly recommend and “Black Swan” which is just ok) core point is that their is so much randomness and uncertainty in investment results that it is nearly impossible to identify real skill.

So the old Make a Million competitiion promoted risk-blind speculation over short time horizons. The new one takes this several steps further into the irresponsible.

Change Make A Million, save your soul before it’s too late

PSG, Moneyweb, Galileo Capital, JSE, ABSA Capital, Satrix and Deutsche Bank, do the right thing. Change the competition to one that is responsible.

Some interesting ideas for an alternative, less unconscionable competition:

  • Be based on at least performance over a full year (I accept a 10 year competition isn’t viable!)
  • Allow investors to choose a portfolio at the start and NOT trade. (oh, this doesn’t encourage brokerage and adrenalin and excitement? Pity.)
  • Not allow investors to use geared products such as warrants and SSFs. Serious investments in underlying equities only please.
  • Change the prize to be split amongst every investors who makes a return of Inflation + 15% over the period. This way, participants aim to generate very good returns with high probability (this target is still difficult for a real-world asset manager!) rather than go all-out for maximum return.
  • Alternative performance targets could also be offered. Best risk-adjusted return, with risk-adjustment by traditional standard deviation, or downside variance, or maximum draw-down. You could also consider performance relative to the index as a whole, which would prevent scenarios where nearly everyone or hardly anyone wins the prize because of movements in the overall market.
  • Abolish the abominable practice of allowing more than one account, more than one entry, and the ability to re-enter if one’s funds drop low during the competition. What were you thinking anyway?

These are just a few thoughts I had. Virtually anything must be better than what you’re doing at the moment.

Don’t use Altman’s Z-score for managing a turnaround

I attended workshop presented by the famous credit analyst and model builder, Professor Edward Altman. He is probably most famous for the invention of the seemingly immortal Z score, which is still in use 40 years after its creation in 1968.

During the workshop, Professor Altman recounted a story about how a company managed themselves out of near-failure using his Z score. I’m not denying the facts of the story, and I’m not even saying that use of the Z-score at this company (GTI Corporation) didn’t help the turnaround. I am proposing that using Altman’s Z-score to manage turnaround would be ill-advised.

Download the full Viewpoint below.

Don\'t use the Z-score to manage a turnaround

The first of many BEE deals drowning

Moneyweb’s article on Barlow’s re-striking of BEE options echos my earlier post on the trouble of underwater incentive options.

The sense of the article is that this sets a bad precedent. Of course, the precedent has been set years ago – I’ve personally calculated the additional costs under IFRS2 for BEE deals in danger of expiring worthless because the share price didn’t perform as expected. I’ve also seen deals where performance conditions for BEE partners have been massively relaxed because the performance was massively below the original targets.

But more than that, what choice do companies have? I’ll quote my comments on the Moneyweb article below:

Company’s issue the share options in order to improve their black shareholding for BEE purposes. The cost of this was born by shareholders, presumably because the alternative was more costly. (One can argue “right” and “wrong” but here we are talking economics not politics.)

Now, if the options expire out of the money, then the company loses the BEE points. In that case, providing the cost of issuing new options is still less than the cost of not being appropriately BEE rated, then the rational choice is to issue new options. Re-striking existing options is just a pragmatic approach of achieving the same end.

IFRS2, the accounting standard that governs the measurement of the expenses of issuing share options to employees or BEE partners, will require the increase in the value of the options to be expensed. Thus, the economic cost of issuing the options will be recorded in the income statement as well as being a true economic cost.

If the BEE partners had been given shares rather than options, then there would be no chance of them expiring out of the money. They would then experience upside and downside just like ordinary shareholders. However, to achieve the same % black ownership, the expense incurred would have been greater.

The company took a gamble that the share price would rise, hoping to save a buck. Market turned against them, and now they have to dip back into their pockets to pay a little more. Does it make sense for a company to gamble on its own share price? Wouldn’t it be better to take the hit upfront, with no fuzzy option-like liabilities floating around, half-hidden on the balance sheet?

The really frustrating thing is that often the utility cost of the issue options (to the current shareholders) is greater than the utility benefit gained by the BEE partners due to the restrictions on sale and concerns around concentration of risk.

Share options issued by companies for various purposes have many hidden dangers. If you’re planning to use them, it might be worthwhile getting a second or third opinion on:

  1. How to structure it
  2. How much it will cost under a range of scenarios
  3. What impact it will have on the financial statements
  4. How much it will cost to be valued for each financial period as well as audited
  5. Whether it will incentivise the desired behaviour
  6. Whether the beneficiaries understand and appreciate the structure, so that utility discounts are limited
  7. How the costs and benefits of the chosen approach compare against alternatives

Each of these 7 points requires careful thought, experience and training. A little consideration and planning can give dramatically better results.

When you’re underwater, what’s the incentive?

Employee Share Options became popular during the tech boom of the last millenium. They were used before, but the explosion across more companies, across more levels of employees and as an expected part of executive remuneration was a product of the Silicon Valley boom.

There are pros and cons for share options. Used correctly, they help to align management’s interests with those of shareholders, share profits objectively and allow startup companies to attract heavy hitting staff without needing to reach deep into pockets for cash salaries and bonuses – especially when the cash doesn’t exist yet. The complexities, abuses, high cost, relatively low perceived value, warped risk taking motivations and difficulty in understanding the workings outweigh these benefits in many cases.

A specific problem is that of underwater options. If the share price decline significantly below the original issue price (commonly used as the strike price), the incentives created by the options are changed. Typically, the incentives either:

  • disappear since management isn’t confident of being able to turn the problems around before the options expire; or
  • management take on excessive risk in an attempt to benefit from the upside of successful gambles while being largely protected from failure.

In the case of Old Mutual’s Black Economic Empowerment (BEE) deal, the situation is a little different. Direct managerial control is limited, which reduces the problems of the second point. However, the first point will likely lead to polite requests for sweeter deals, restriking or the issue of additional instruments. All in all not a great deal for shareholders.

If nothing is done, and if the share price continues on its current trajectory, it’s likely the deal could expire without the permanent transfer of ordinary shares to BEE shareholders with grave consequences for Old Mutual’s BEE deal.

I’ve used Old Mutual purely as an example. There are many other companies facing similar problems given the state of the stock market and the higher interest rates (to which notional loans are often linked). I’m also not aware of all the details of Old Mutual’s deals and arrangements.